Applying the Elliott Wave Theory

ValueTrend’s Keith Richards thinks the odds for a second market pullback outweigh the odds for a return to the bull market just yet. “Wrong or right,” he says, “I have a plan. Do you?”

Elliotts_Wave_Theory

Elliott’s complete 8-wave cycle. 1, 3, 5, a and c are impulse waves; 2, 4 and b are corrective waves.

As I age, I become more of a skeptic. As Canadian rock group Rush once sang in their hit “Tom Sawyer” – “His mind is not for rent, to any God or Government”.

As a skeptic, I subscribe to Skeptic magazine—a science magazine dedicated to critical scientific analysis of common beliefs. The magazine continues to cause me to pause when I hear opinions and rhetoric spewed by the media, government or ordinary people.

One example of such rhetoric is the recent talk of the ‘flattening curve’ in COVID-19 cases. It’s likely that the biggest impact of this virus is the psychological effects. Yes, the virus curve may show some signs of abating. But it’s early, and the show ain’t over yet.

I’ve heard from a reliable source who worked in the insurance industry in statistical programming that the reality behind this disease is very far from being predictable. Hopes of a relatively quick return to normal life, and the development and distribution of a vaccine, may be well ahead of reality. Yet, the government has an ulterior motive of offering hope. So hope is given.

Does the Elliott Wave Theory apply to this market?

A side effect of that hope is a stock market rally—like now. Was the April rally a ‘Wave B’ of Elliott Wave Theory (EWT) . . . aka the counter trend rally? If you subscribe to our ValueTrend newsletter, you will have read my thoughts on that potential. I am not an EWT theorist. But, the 3-wave down principle probably does apply to this market.

EWT people talk about declines moving in three stages: (a) down; (b) rally up; and (c) final washout down. For what it’s worth, perhaps, the April rally since March 23 is the ‘b’ rally wave (head-fake) within the 3-wave sequence. That prognosis would make some sense based on the unlikelihood that a world wide catastrophe such as we’ve seen will be reversed in a few months. As such, we may get wave ‘c’ final downturn as the earnings numbers begin in earnest in the summer.

Aside from EWT, there is the good old psychological makings of a bear and bull market. Basically, investors go through various stages within a market cycle. Within the bull market stage, they are:

■ Disbelief & uncertainty
■ Optimism
■ Euphoria
■ Overconfidence

Within the bear market stage, they are:

■ Anxiety
■ Denial (potentially where we are now)
■ Panic
■ Capitulation

I’m not saying that I know that we are in the EWT ‘b’ wave or in the ‘Denial’ phase per the above. I’m not saying that I have any true insight on the flattening of the virus curve, or the timing before life and the economy returns to normal. But I do know about technical analysis of stock trends.

I have a plan. Do you?

Technical analysis offers tools to look for clues as to when we complete a bottom. I don’t identify a bull market until we see a higher peak, and a higher trough on a weekly market chart—and I can make a first step back if the market moves over the 200 day moving average. In April, we had a rally. This is encouraging. But we don’t have a higher trough and equally, if not more important, a move over the 200 day moving average. So, it’s a bear market by my way of looking at things.

For that reason, I hold 35 per cent cash in our equity model given the potential for another selloff over the summer. If I’m wrong—fine. I under-perform the markets by about a third this summer. The most likely situation is for a pullback. I’ll be surprised by a break of the 200 day simple moving average (SMA) in the near term—which currently lies around 3000 for the S&P 500.

I do not expect a break of the old highs at 3400 any time soon either. But, rules are rules. I know what to do if one or both signals occur. I will buy if the S&P 500 moves above its 200 day SMA. If things break down after that or move into a sideways swing-type market, I can buy and sell using the 200 day moving average. Or, if I deem it necessary, use a shorter moving average as my guideline.

But if I’m right about another leg down, or some sort of near re-test of the March lows in the coming months, I will suffer about a third less in losses. That, plus I will have cash to buy stocks at another market low point. From my perspective, the odds for a second market pullback outweigh the odds for a return to the bull market just yet.

Wrong or right, I have a plan. Do you?

Keith Richards is Chief Portfolio Manager & President of ValueTrend Wealth Management Inc. He can be contacted at info@valuetrend.ca. He may hold positions in the securities mentioned. The information provided is general in nature and does not represent investment advice. It is subject to change without notice and is based on the perspectives and opinions of the writer only. It may also contain projections or other “forward-looking statements”. There is significant risk that forward looking statements will not prove to be accurate and actual results, performance, or achievements could differ materially from any future results, performance, or achievements that may be expressed or implied by such forward-looking statements and you will not unduly rely on such forward-looking statements. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please consult an appropriate professional regarding your particular circumstances.

This is an edited version of an article that was originally published for subscribers in the June 2020/First report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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