DOW THEORY & ELLIOTT WAVES

Fortunately, there are effective techniques for analyzing the stock market that can reveal when a bear market is underway and how large and how long a given stock market decline may prove to be. Two of these techniques are Dow Theory and the Elliott Wave Principle.

At the turn-of-the-century, Charles Dow, one of the founders of The Wall Street Journal and its first editor, proposed that there are three types of stock market movements: the primary trend, which can last over a year; a secondary or intermediate trend, which can move against the primary trend for one or several months; and minor or daily price movements that only last for hours or days. Dow Theory seeks to determine when there is a change in the primary trend by comparing movements in the Dow Jones Industrial and Transportation averages. In fact, one of the reasons these indices appear on top of each other in the Wall Street Journal everyday is so that investors can apply Dow Theory.

According to Dow Theory, the initial warning sign that a turning point in the primary trend is near is when a "divergence" develops between the Dow Industrials and Transports. This happens when the Industrials reach new highs or lows in the primary trend while the Transports fail to do so. An example of this occurred in 1990, prior to the last Dow Theory bear market signal. When the Dow Jones Industrials Average reached an all-time high of 3000 in July of 1990, the Transports did not achieve a record high- the Transportation index had peaked back in 1989. Thus, the peak in the DJIA was not confirmed by all-time highs in the Transports. Soon thereafter a Dow Theory sell-signal was generated and stock prices fell 20 percent by October of that year.

Under Dow Theory, major stock market "buy-" and "sell-signals" occur when, following a divergence between the Industrials and Transports like occurred in July of 1990, the two averages confirm a reversal in stock prices by reaching new highs or lows in the secondary trend, respectively. The value of this investment strategy is impressive and statistically significant. Between 1897 and 1981, an investor who bought and sold stocks according to Dow Theory buy- and sell-signals would have reaped a return more than nineteen times that achieved from buying-and-holding (1).

As for right now, a major Dow Theory sell-signal could occur in the near-future. As the DJIA climbed to new all-time highs above the 11000 mark recently, the Dow Jones Transportation and Utility Averages failed to reach record highs.

Since the Transports did not reach an all-time high along with the Industrials, there was a Dow Theory non-confirmation. Accordingly, when the Dow Industrials, Transports and Utilities break to new lows in the secondary trend, a new bear market will be signaled. This means that, when the Utilities fall below 314, the Transports drop below 3300 and the Industrials fall below 10400, a new Dow theory sell-signal will be generated. This will signal the first bear market since the third quarter of last year when the stock market fell 20 percent.

While Dow believed that there were three types of trends in stock market movements, during the 1930's Ralph N. Elliott, an accountant who closely examined long-run charts of stock prices, proposed that there is virtually unlimited bull and bear trends of differing scale (2). Specifically, he asserted that stock prices move in wave-like patterns that abide by fractal geometry such that any given wave-structure is composed of smaller wave-structures comparable to the whole. The basic pattern looks like this:

When this pattern is multiplied to show Elliott Waves within Elliott Waves, it appears as follows:

As can be seen in the diagram above, any given cycle involves an uptrend ("bull" market) which consists of five waves, up-down-up-down-up, and a downtrend ("bear" market) consisting of three waves, down-up-down, such that smaller cycles make up the cycle as a whole. Likewise, each of the smaller cycles are comprised of still smaller wave patterns and so on and so forth.

When applied to long-term patterns in the U.S. stock market, an alarming picture results. Elliott Wave five-wave patterns have developed into what is called a "Grand Supercycle" top. This uptrend in stock prices and collective expectations has been 200 years in the making and has outlined the rise of America into a great world power. The rising Elliott Wave patterns have developed according to the following outline:

As you see below, U.S. stock prices have risen in five-wave patterns as above:

Robert Prechter, the "Elliott Wave Theorist" who has popularized the Wave Principle on Wall Street with accurate intermediate- and long-term predictions, believes that the stock market is now reaching the Grand Supercycle top. There are strong indications that this belief is correct. First, the stock market is the most overvalued ever according to common measures of valuation like PE ratios, dividend yields and price-to-book values (see Part I for more information.). Secondly, if one examines charts of the rate of climb in stock prices (see below), it is revealed that the most recent rise in stock prices to above Dow 11000 was at a rate only paralleled by what occurred just prior to unprecedented Great Depression bear markets during the 1930's and the 1987 crash. Thus, investor expectations are at an unprecedented optimistic extreme and the stock market is at some sort of historic top after which a major collapse should occur. Certainly, this is the profile to be expected for the Grand Supercycle top that is preceding probably the worst bear market ever.

(SOURCE: The OEX Trader)

(SOURCE: Stock Market Cycles)

If, indeed, an Elliott Wave Grand Supercycle peak is at-hand, then, based upon typical Elliott Wave time and price relationships, one should expect a bear market that will involve a three-wave retracement of the five-wave rise in stock prices from the late-1700's when the New York Stock Exchange opened. Typically, such retracements are 62% of the preceding move in prices, which entails a drop in the DJIA to around 4300. However, since what should now occur is a historically unprecedented Grand Supercycle bear market, there is reason to expect a correction at least on the scale of the 1929-1932 bear market. This implies a 90% drop in stock prices, or a drop to Dow 1000 or so. Regardless of how far the stock prices might fall, if a Grand Supercycle bear market has really started, the decline should occur over the course of several years if not decades.

All in all, based upon Dow Theory and the Elliott Wave Principle some reasonable projections can be made about the future course of stock prices for the foreseeable future. Specifically, if the Dow Utilities fall below 314, the Dow Transports drop below 3300 and the Dow Industrials break below 10400, then a major Dow Theory sell-signal will occur. This likely means that a Grand Supercycle bear market is getting underway that will involve a drop in the DJIA to 4300 or lower over the course of the next several years or decades. This decline should take the form of an Elliott Wave, down-up-down corrective pattern. Thus, using Dow Theory and the Elliott Wave Principle, some parameters are available within which reasonable stock market investment decisions may be made.

FOOTNOTES

2. See The Elliott Wave Principle (©1985), by Robert Prechter and Alfred Frost, for a comprehensive overview.

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