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Friday, October 10, 2008 10:53 AM

S&P 500 Crash Count

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In Elliott Wave terms The S&P 500 is in wave 3 of 3 down. I will attempt to explain this in terms those not familiar with Elliott Wave can understand. Here goes:

Wave 3's are long and strong and unrelenting. They can be in either direction. When wave 3 is headed up, everyone is waiting for a pullback to get in. That pullback never occurs.

When wave 3 is down everyone wants a rally to either get out or get short. Those rallies either occur intraday or they do not occur at all.

Wave 3 of 3 is where everything you do is right or everything you do is wrong, depending on whether you are long or short. Playing for countertrend moves is highly unlikely to be a winning move for anyone but the extremely nimble.

With that backdrop, here is a chart of the S&P 500 with the wave 3 of 3 "crash count" highlighted.

S&P 500 Weekly Chart

click on chart for sharper image

In Elliot Wave theory, "impulsive" waves trace out in patterns of 5 and corrective waves in patterns of 3. Note 5 clearly distinct waves down off the October 2007 high until the March 2008 bottom (the big red 1).

Wave 2 up, a corrective wave(the big red 2) peaked in May. When wave 2 ended, wave 3 began. In theory, wave 3 like wave 1 should subdivide into 5 clearly distinct waves. Indeed that is how it seems to be playing out.

Wave 3 of 3 Down

Wave 1 of 3 ended in July, Wave 2 of 3 ended August, and we are now in the unrelenting 3 of 3 down where every attempt to play for a bounce has been like "catching knives".

I have a small blue 3 labeled, but that is not final. We do not know where 3 of 3 down finishes. Here are the implications.

Given that we are in a 5 wave impulsive pattern, wave 3 of 3 has to end first before we can think about the 4 of 3 up. 4 of 3 up will be followed by 5 of 3 down. If this sounds complicated, just look at the chart above with waves (1 of 1, 2 of 1, 3 of 1, 4 of 1, 5 of 1) all distinctly visible with blue numbers, ending with a big red 1 down.

Wave 4 of 3 UP

Where to from here? Wave 4 of 3 up has not started yet. Technically I expected wave 4 of 3 to start at 960. However we blew right through that number to the downside.

I do not expect wave 4 of 3 up to be a strong up although it could be reasonably long (2-3 months) in duration. Here is the reason to NOT expect a big bounce:

Sentiment in a wave 2 up is often very strong as it is accompanied by big short covering rallies. In wave 2 up, people still believe “we are off to the races again”. No one is convinced the bull market is over. Indeed, I received more than a few taunts about the S&P only being down 10% for the year. Most had expectations that a new high would soon be forthcoming.

In wave 4 of 3 up, sentiment will be more of “suspicion” as opposed to “we are off to the races again”. Consider the big 3 of 3 down as the “recognition” phase where everyone finally realizes all is not OK.

If we continue heading south as it looks, the 960 target for 3 of 3 we blew past on the downside, could serve as huge overhead resistance in any corrective wave up.

Wave 5 of 3 Down

If the pattern plays out like it is setting up, wave 5 of 3 down will reverse all of the gains of 4 of 3 up and then some. Once wave 5 of 3 down ends, we can then put in a big red 3 on the chart.

See the chart below for how this may look.

Wave 4 Up

Wave 4 up will begin after 5 of 3 down finishes. Look for wave 4 up to be choppy and overlapping (ups and downs in seemingly random patterns). 4 up will be tough to play. It is best to avoid it unless you are extremely nimble.

Once again, "suspicion", as opposed to “we are off to the races again” will be the overriding sentiment.

Wave 5 Down

Wave 5 down will be the washout phase where everyone throws in the towel who is going to. Pessimism will reign supreme and many will swear off the stock market for good. Given that we blew straight past 960 without so much as a pause, the likelihood that wave 5 down blows right through the 2002 bottom is quite high.

Possible Pattern

click on chart for sharper image

Notice that in the grand overall scheme of thing we are likely in wave 3 of 3 of C down, clearly nasty stuff. The target of 600 is an estimate based on an approximate retrace of 62% of the peak of Wave B (.38 * 1576 = 599).

A 50% retrace would stop close to the 2002 bottom of 775-800. Unfortunately, we are running out of time for that to be a likely target. That is one of the implications of blowing past 960 without so much as a pause.

The Theory And The Man

I have taken a lot of flack for many years about Elliott Wave. Nonetheless, I think it is a valid tool. I tend to use E-Wave when the patterns are clear. However, E-Wave is not the be all or end all of anything. No tool is.

Here is a word of caution: If you are determined to find patterns of 3 and 5 you can easily find them, even when they are not really there. Much of this is subjective. However, if one just steps back without a goal of forcing patterns, the clear valid counts will scream right at you.

The charts above are screaming. Those are the charts you want to pay attention to.

Much of the malignment of E-Eave is on account of its founder, Robert Prechter. This is where it is important to separate the tool from the man. As many know, Prechter has been calling for a crash for decades. He has also called for gold to retest the lows near 250. Time and time again Prechter has given conditions in which he would proclaim a new bull market in gold. Time and time again he has failed to do so.

Prechter needs to come out and say "I was wrong about gold" and "I was hopelessly early on my crash call". Instead, his personal wave counts have frequently been convoluted. Many E-Wave practitioners do not pay attention to much of what he is saying.

However, that is a slam against the man, not a slam against the methodology.

Socioeconomic Theory

It is important to note that Prechter has led the way in aspects of socioeconomic theory such as attitudes change first and price follows. Prechter is correct and here is a prime example:

Think back to the Summer of 2005. People were camping out overnight hoping for the chance to buy a condo in Florida. Overnight sentiment changed. It was many months before there were significant price declines in housing. Yet, you still hear today ideas such as "consumer sentiment is down because house prices are down". Such statements are clearly backwards.

Home prices will not go up until sentiment changes, not the other way around.

Right now, people are still walking away from homes. That is one reason why liquidity measures by the Fed and Treasury are doomed to fail. More philosophically, You Cannot Patch a Busted Dam With Water.

The Fed and the Treasury could probably learn a lot from Robert Prechter. There is almost no chance they will listen.

Mike "Mish" Shedlock
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