Sunday Edition: The Most Important Pattern In A Bear Market Bottom

October 9, 2016

Sunday Edition: The Most Important Pattern In A Bear Market Bottom

Over the last several months we’ve focused on sharing with you several of the fundamental metrics Thomas Moore uses to identify deeply undervalued companies on which to sell put options to generate income. We hope they’ve been beneficial.

In today’s Sunday Edition I’m certain to draw a lot of skepticism from those “purists” who believe that markets are both efficient and driven exclusively by the fundamentals.

On the other hand, if you believe that markets are not only irrational but are driven by psychology and what some like to refer to as “animal spirits,”  then you might appreciate what I share over the next several weeks in these Sunday Editions.

The body of study surrounding all things investor psychology has come to be known as behavioral finance. Today I will be sharing with you a pattern that I believe manifests the collective psychology or animal spirits of the “market” and a pattern that I personally believe is the absolute best chart pattern to identify the end of a bear market and the beginning of a new bull market.

This pattern can also be used to identify the top of a bull market and beginning of a new bear market, although I will readily admit it is harder to do successfully.

This pattern deals with what is known as a “fractal.” Here’s the definition of a fractal:

A curve or geometric figure, each part of which has the same statistical character as the whole. Fractals are useful in modeling structures (such as eroded coastlines or snowflakes) in which similar patterns recur at progressively smaller scales, and in describing partly random or chaotic phenomena such as crystal growth, fluid turbulence, and galaxy formation.

In plain English: smaller versions of this pattern link together to form even larger versions of the same pattern.

If indeed markets are fractal in nature it would mean that this pattern becomes useful to identify the end of a bearish move and beginning of a bullish move, or vice versa, in all time frames from a one minute chart to a daily chart and all the way up to a monthly chart showing several decades of historical price data.

I know this sounds a little esoteric, and quite frankly it probably is, but it is very useful when understood properly.

If you haven’t already guessed, the pattern I’m discussing revolves around a theory known as The Elliott Wave Theory in conjunction with certain mathematical ratios discovered by the famous mathematician Leonardo Fibonacci.

In the mid 1930s, Ralph Nelson Elliott discovered that financial markets trend and reverse in recognizable patterns.  He called this phenomenon The Wave Principle.

His theory remained very obscure and might have literally died out had it not been for A.J. Frost and Robert Prechter, Jr. who kept it alive and popularized it in their book Elliott Wave Principle.

I would like to quote their book:

Although it is the best forecasting tool in existence, the Wave Principle is not primarily a forecasting tool; it is a detailed description of how markets behave. Nevertheless, that description does impart an immense amount of knowledge about the market’s position within the behavioral continuum and therefore about its probable ensuing path.

I chose to quote this paragraph specifically because I think it encapsulates not only what the theory is, but also what it is not and the reason I believe most technicians who may initially give some credence to the Elliott Wave Theory end up dismissing it as poppycock.

The theory is not a perfect forecasting tool, but then neither is any form of analysis whether fundamental or technical in nature, or dealing with investor psychology.

In my opinion, the real value of the theory is that you can look back and see that markets are indeed patterned. Knowing this provides you a roadmap by which to view all financial markets and gives you confidence that certain patterns do and will manifest and repeat.

No, you will not always know exactly where a market is in its current unfolding of a given pattern, and you will be forced to reassess your view and opinion on where you believe a given market is currently at, however, rest assured at some point that pattern will complete and start anew.

I believe the Elliott Wave Theory really shines when it comes to determining the long-term trend and in perfecting your entry into a new trend. It also provides you with a specific stop loss point when a pattern has “failed” and is unfolding differently than you may have originally thought.

With that let’s get down to the brass tacks of the pattern.

At its most basic level the theory states that markets progress with two modes of wave development. Motive or impulse waves and corrective waves.

For those who really want to understand the nuts and bolts, I highly recommend Elliott Wave Principle by Frost and Prechter.

For today’s post I will keep this much more cursory. Motive waves have a five-wave structure (labeled 1,2,3,4,5), while corrective waves have a three-wave structure or a variation thereof (labeled A,B,C). See illustration below.

A motive wave powerfully impels the market while a corrective wave is a countertrend move against the motive wave and partially corrects the move that precedes it.

One complete cycle consists of eight waves, the five motive waves and the three corrective waves.

elliotwave-01
Source: Elliott Wave Principle by Frost and Prechter.

The Elliott Wave Theory might seem a bit challenging to grasp at first since the idea of fractals appearing in financial markets is a foreign concept. As you analyze markets in an attempt to identify this repetitive pattern, keep in mind that smaller versions of the pattern link together to form even larger versions of the same pattern.

While the Elliott Wave Theory contains many intricate rules and variations, I believe it is in these details that traders and investors get lost and become disenchanted with the entire theory.

The real value of the theory as I see it, is in the visual picture that plots itself on a chart with each passing period of price data. Once you know the basic shape of a complete cycle, as shown in the illustration above, you will begin to pick up on this pattern over and over in all financial markets and it will become easier to identify what I refer to as a trend reversal zone, which is nothing more than a price range in which the completion of the cycle is likely to end and begin anew.

To assist us in identifying that trend reversal zone, and narrow the range where we believe a C point (end of cycle) is likely to occur, we apply what is known as Fibonacci retracement levels to the prior motive wave.

Let’s look at an actual market chart.

tradingview gdx
Source: tradingview.com.

This is a chart of GDX which represents gold and silver mining companies and has been a top performer so far in 2016, but now appears to be in a larger correction.

The Elliott Wave Principle in conjunction with Fibonacci retracement levels can provide clues as to when and at what price the correction might end before resuming the prior uptrend.

Beginning in early 2016 through mid August the price of GDX has risen from a low of $12.40 to a high of $31.79, and has done so in a pretty parabolic fashion. I have labeled this move 1-5 and it constitutes our impulse or motive wave.

Beginning at the high of 5 through today the price has fallen from $31.79 to to $22.79 in what is now a larger correction of the entire motive wave. I have labeled this A, B, C and it constitutes our corrective wave against the prior motive wave.

I have also added three Fibonacci Retracement levels which are the .382, .50, and .618 of the entire motive wave. These three levels provide a price range between $19.68 and $24.26, where I would expect the Elliott Wave cycle to complete and start anew as the uptrend resumes.

In my opinion, being able to visually identify a clear Elliott Wave cycle, coupled with a Fibonacci price range, provides greater clarity as to the most probable future direction of GDX (up), giving a trader or investor greater confidence in committing capital to this specific sector.

Caveat: Without getting into too much detail and possibly confusing you (if I haven’t already), it is possible that what I have labeled as point C is in fact the end of a larger A leg (there’s that fractal thing) and is only the first leg down in the correction.

If this is the case then we should expect a B leg bounce, that does not exceed the high of $31.79 labeled as 5, and one more final C leg down to complete the larger A-B-C correction before resuming the uptrend. Even under this scenario though, the correction is likely to be contained within that Fibonacci range of $19.68 and $24.26.

Regards,

Shane Rawlings
Co-Founder, Investiv