To borrow a colloquialism from the world of IT, "garbage in – garbage out." Personally, what I often refer to as garbage are choppy, directionless and unemotional markets.
For me, Elliott wave patterns that fall into that category are corrections – that is, waves 2 and 4. Their overlapping, jittery internal wave subdivisions are notoriously difficult to count. Forecasting their termination points is just as hard. However, even during the toughest market corrections, the Elliott Wave Principle gives you a distinct advantage.
Here's how: While to the rest of the trading public corrections may look hopelessly endless, Elliotticians know that corrections cannot be sustained. When the market resumes its trend, a correction will always be completely retraced. The trick is to properly identify one.
Let's look at this daily chart of the U.S. 30-year Treasury Bond as a case in point. (Some Elliott wave labels have been erased for this publication – Ed.)
The basic definition of an Elliott wave correction is any three-wave move, labeled on a chart ABC. The three-wave decline from the January 2008 top of wave (5) you see on the chart above fits the definition; it even ended with an ending diagonal triangle, the Elliott wave pattern that C-waves often take. The decline also had that characteristic choppy, directionless and unemotional corrective quality. So, because we counted that decline from the January 2008 high as a correction, we knew in late July, when wave C was ending, that the whole structure would have to be retraced completely by a subsequent rally.
That rally is now underway, as the chart above shows.
That's the kind of forecasts even basic Elliott wave analysis can help you make. You can further enhance it with other technical indicators. For example, the blue line in the chart above is a 21-period exponential moving average (XMA). I maintain XMA in most of my Interest RAtes Specialty Service charts: It's a simple indicator that can confirm you are in a correction. Here's how.
As you can see, the highs and lows of the price bars cross the XMA both up and down. Here's what that means: When a true, strong trend is underway, prices stay locked either above the 21 XMA (bullish trend) or below it (bearish trend). But when you see price bars choppily cross the 21 XMA without committing to either the bullish or bearish bias (like they did in wave C of the decline from the January 2008 high, for example) chances are, your market is in a correction.
Corrections are periods of fear, one of the markets two main drivers (the second one is greed). That's what we've been engaged in lately – fear-based trading. Fear progresses from disappointment to uneasiness to outright panic – and finally, to capitulation, which is usually the moment of a bottom.
The problem is, in "linked" markets like equities and bonds, capitulation doesn't work like you'd expect. In linked markets, all that exists at the end of a fear-based panic is a vacuum of bids that pulls the rug out from everyone – buyers and sellers. Take a look at the January 8 top in the chart above, for example: Things looked dandy that morning until a sharp intraday reversal came – and took the market on a whopping month-long selloff. The moment of capitulation only came 30 days later.
Remember that Elliott Waves are a graphical representation of the fear and greed cycle that drives market psychology and creates the "waves" on a chart in the first place. While trading is never easy or bereft of emotion, the steady application of this technical approach can allow you to keep your head (and money) when everybody else is losing theirs.
Bill Fox is EWI's Senior Bonds Analyst. He has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994; most of his subscribers are professional bond traders spread around the globe.
Trade stocks, forex or energy? See full menu for EWI's Specialty Services here.