The Elliott Wave Principle:
Ralph Nelson Elliott, a floor trader in the 1930s, discovered a series of chart patterns that he believed to represent social crowd behavior trending and reversing in recognizable and repeatable patterns. He used a chart of the Dow Industrials as the main focus of his research, though he believed the ebb and flow of the investors constant battle with fear and greed was true of individual stocks and any other element where crowd behavior had a major impact.
The rules of the Elliott Wave Principle, as it is known, are simple enough, especially if you leave out the mathematical Fibonacci component as we have done here.
The basic pattern starts with a five wave zigzag in the direction of the move - up in bull markets, down in bear markets - and is called an impulse wave. This first move represents the rumor move, where the stock or stock index is advancing (or declining) off a base (or support level) in anticipation of a future event. An example of this would be the market indexes rising after interest rate cuts by the Federal Reserve on the anticipation of a stronger economy in the future, or a company expecting increased earnings due to a new product launch or restructuring. This first impulse move is called Wave 1
After the buying of that initial impulse wave dries up - and no stock or index advances in a straight-line forever - a three step A-B-C retracement of the impulse move begins, and is called Wave 2.
The complete cycle of that first advance and retracement is itself part of a larger pattern, so once the selling of the Wave 2 correction dries up, a larger impulse Wave 3 begins with a significant breakout to new highs. This is the reality wave, where what was promised in the Wave 1 rumor move becomes reality. For instance, if that first rally was driven by the anticipation of a companies increased earnings due to a new product launch, or restructuring, then the subsequent advance occurs as the extra profits come in as, or better than expected.
Once all 5 waves of the Wave 3 impulse move are complete, a larger three step A-B-C corrective wave begins, and is called Wave 4.
One critical element of Wave 4 corrections is that they do not penetrate the high point achieved in Wave 1, causing the 3 step countertrend move to have the look of a 'W' in bull markets, and a 'M' in bear markets.
Once the selling pressure of the Wave 4 correction subsides then a blow-off speculative Wave 5 impulse move begins. This is the territory of the novice, and the investor who trades on emotion. Unlike the solid advance of Wave 3 - the reality wave - Wave 5 advances are carried on a wave of speculative greed with the desire to get-rich-quick spurring on the momentum players, who often feel they cannot lose with this stock since it is seemingly acting so well. They scoff at the cautious words of the veteran trader who warns of excessive valuations. "It's different this time, old timer," is their mantra.
Even if the prospects of increased earnings - as in our previous example - continue to be good, they have already been factored and priced into the stock by this time and offer no support as the inevitable correction takes hold. "Buy on rumor, sell on fact," is the mantra of the veteran trader who is apt to be a grateful seller into this Wave 5 rally.
Wave 5 rallies are usually shorter than those associated with Wave 3, and the advance near vertical after successfully breaking the Wave 3-Wave 4 resistance area.
Once the buying frenzy and short covering of the Wave 5 impulse move has run its course then, once again, a three step A-B-C correction follows, this time to correct the entire 5 wave impulse move, and the whole process begins anew.
The Elliott Wave Principle simply attempts to add structure to all those zigs and zags stocks and stock indexes are apt to take, and is simply a graphical view of the extreme swings investor sentiment goes through during the normal course of a bull and bear cycle.
Below are 4 charts to help track and analyze Yahoo's late '90s early 2000s mighty impulse bubble rise and corrective fall using the Elliott Wave Principle as a guide of expectation and reality.
1a. Yahoo's bull market impulse move going into the peak in 2000.
1b. How an Elliott Wave bull market impulse wave should look.
1c. Yahoo's bear market corrective move following the peak in 2000.
1d. How an Elliott Wave bear market corrective move should look.
While there may have been many changes since Ralph Nelson Elliott walked the floor of the stock exchange - imagine waiting for the pony express to deliver your trade fill? - the dramatic manic-depressive swings of investor emotions clearly remains the same, as evidenced by the extremely high correlation between Yahoo's rise and fall - echoed by hundreds, if not thousands, of other momentum darlings of the late 1990s - and what Elliott cataloged 7 decades earlier. Since it is doubtful the ups and downs of investor emotions are likely to change anytime soon - if ever - we can expect to see these boom-bust patterns repeat - and repeat and repeat - in the future. Elliott Wave offers a clear road-map of expectations from which to gauge reality to help the investor buy low and sell high and, more importantly, keep the profits.
Results are tabulated using the opening price the day following a new trading signal, and exclude commissions, dividends, or interest paid on cash balances during sell periods. Stock prices highlighted in blue are temporary - using the end of day quote the day a new buy or sell signal is generated - with the final price adjusted the following trading day when the opening price is available. Past performance is no guarantee of future success
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