Fiat currency and Asset Price: Market and Elliott wave

In this post I would like to discuss my long term outlook (3 -5 years) for stock indices. Before I get into the post I would like to discuss the basis of wave structure, which forms the basis of Elliott wave theory. Although Elliott wave theory is a very complex and subjective its basis is very simple. According to it every directional move in the market is made of five waves followed by three corrective waves.

Although I am not a practitioner of Elliott wave theory and I don’t agree/understand most of the intricacies of this theory, I still broadly agree with eight wave structure given by R.N Elliott.One thing which has changed since RN Elliott founded this theory is the intervention of government in market which has increased drastically since 1930’s. Government intervention not only distorts the market but also changes characteristic of waves which tend to extend the upside and lower the downside potential. But ultimately rules of economics will take over and results into impending collapse of the entire economy in the form of severe recession or stagflation.

Let us look at the given chart.

WAVE STRUCTURE

In this chart I have marked the five impulse waves and three corrective waves. Let us look at the characteristics of these waves.

Wave 1:- starts in the end of large correction. Mostly people believe it to be a bear market rally and another chance of short selling. Interest in equity market is very low. When wave one starts the mass is disenchanted and suspicious of stock market rallies and don’t trust that it will last. Most of the smart money gets into the market in Wave 1. Valuations are generally very low during wave 1 and there is all round environment of pessimism.

Wave 2:- Wave 2 generally corrects up to 50% or 61.8% of wave one. It reinforces the belief that the rally of wave 1 was a bear market rally. Most of the dumb traders creates fresh short in the market. The correction is generally very swift accompanied by very low volume, indicating drying up of selling pressure.

Wave 3:- This is generally the most dynamic wave in the entire structure. The up move is very strong and broad based buying is observed across all segments. Increasingly favourable fundamentals enter the picture as confidence returns to the market. Third wave usually generate the greatest volume. Optimism starts to return and people starts taking interest in stocks. By the time third wave ends P/E expansion is observed, companies come out with great results during starting of third wave and analyst upgrades occurs. The economy begins picks up, credit expansion starts and there is celebration all around. Third wave are generally 1.618X to 2.618 times of Wave 1.

Wave 4:- This is a corrective wave mostly have sideways trend. Companies may come out with sudden earning misses; economy gives sudden negative surprise with limited impact. People are confident and believe that the problems can be surpassed.Wave 4 generally retrace up to 38.2% of wave 3. Last bouts of smart money get into the market. Most of the dumb investors who have entered the market at the top of wave 3 panics and sell out.

Wave 5:- Fifth wave is always less dynamic than third wave in terms of breath and volume. The speed of price appreciation in wave 5 is always slower compare to the speed of price appreciation in wave 3. Blow off rallies are observed during the end of fifth wave. (One of the classic examples of blow off rallies is Nifty during September 2007 to January 2008 moved up from 4400 to 6300). Extreme cases of overvaluations are observed and people start believing that it is the new normal and high valuation is going to stay on forever. Most of the new investors and dumb money enter the market during this wave. Even people who have never invested start talking about stocks. Most of the smart money exits the market during this wave.

Wave A: - During wave A, investment world is generally convinced that this reaction is just a pullback pursuant to the next leg of advance. The public surges to the buy side despite the first really technically damaging cracks in individual stock patterns. During the last leg of Wave A there is lot of skepticsim but everyone believes that ultimately this is just a pullback. Most of the people average during initial leg of wave A. During the beginning of wave A and end of Wave 5 peace and prosperity appear guaranteed forever. Arrogance and complacency reigns.

Wave B: - Wave B is phonies. They are sucker plays and bull traps, speculators paradise, orgies of odd lottery mentality or expressions of dumb institutional complacency or both.They often involve a focus on a narrow list of stocks.Fundamentals weaken subtly while aggressive euphoria and denial prevails in general public and institutional investors.

Wave C: - Declining wave C are usually devastating in their destruction. It is during these declines there is no place to hide except cash. The illusions held throughout wave A and B tend to evaporate and fear takes over.Wave C’s are persistent and broad. Wave C ends in complete despair and disenchantment amongst investors and traders. People vow never to get back into stock market by the time Wave C ends. Most of the analyst trims their coverage to large cap blue chip stocks. Valuations reach very low levels and still analyst give sell calls. It is during this pessimism the foundation for wave 1 are laid.

These waves can be observed in each and every time frame starting from five minutes intraday charts to long term charts. The basic structure of these waves will remain the same irrespective of the time cycle in which they are formed i.e. if it is a bull cycle there will be five up waves and three corrective waves and if it is a bear cycle there will be five corrective waves and three up waves.Although Elliott wave analysis is very subjective and gives various options which are difficult to comprehend when the waves are unfolding but still it gives us the best possible scenario and can be useful in predicting long term trends.

Armed with the above information let us look at the given Dow chart. Here we can see that primary up move in Dow started in 1920 and the up move continued up to the year 2000 when the markets peaked out. We can also see that there were two major corrective phase during this period, first from 1929 to 1938 and second form 1964 -1982.

Dow Wave Chart

According to the given count we can see that the corrective wave A started in 2007 to 2009. Corrective wave B started from 2009 and may have been over when Dow made a high of 13000 in June 2011.I expect that now Wave C is unfolding which if true is going to be the most dynamic wave downside. Since there is tremendous uncertainty in the current macro environment I think it would be unwise to rule out the probability of wave C unfolding from these levels.

Dow Long term Trend Line

Let us look at the second chart of Dow. If wave C unfolds one of the potential target for Wave C is the trend line. This can happen in two ways. Either there is sideways correction for several years like what happened during 1964 -1982 or there is sharp cut like 1929 -1938.

If the correction is steep and downwards potential target for Dow will be around 5000. If the correction is sideways than markets will move in sideways zone for next decade with wild swings on both sides. In that case there won’t be much price correction but there will be a long time correction. It also means that although Dow will not lose its value in nominal terms but it will lose its value in real terms.

Dow Chart exhibiting Side ways correction

We have seen that 1970’s was the decade of stagflation. Economy witness very high inflation with very low growth rates and that caused the sideways correction in Dow for 18 years with wild swings which were as much as 50% - 70% from top to bottom. 1929 -1938 was a period of depression and therefore it caused a steep correction where the price correction was severe but the time correction was limited.

What happens in this decade will completely depend on the government policy. If the government choose to take the pain straight away we will have a recession resulting into a steep correction. If the government will choose to postpone pain and keep creating money we will have stagflation resulting into a sideways correction with wild swings.

Let us also look at the retracement chart for Dow. We can see that the uptrend which started form 1920’s is still intact and Dow have never violated the trend line on the downside. The current support of the trend line for Dow is at around 5000 levels so if there is any sharp correction in Dow 5000 will be a potential target. If the trend line breaks on the downside than it may even correct to 3300 levels.

Dow yearly - Retracement Chart

Last chart I have pasted for Dow is a quarterly candle stick chart. We can see that during the current reversal is Dow the quarterly candle stick pattern are very similar to the previous two tops made in 2000 and 2008 respectively. Therefore it confirms my fear that this reversal is not a short term correction buy its going to be a severe correction.

Dow quarterly candle stick chart

I know these levels will seems ridiculous to my reader but in end of deep correction market trades at ridiculously low level. The irony is that most of the investor will not buy the market even at those low levels. In 1970’s US markets constantly traded at a P/E of 5 for a decade but no one wanted to buy stocks back then. I won’t be surprised if we will see a P/E compression in this decade due to very high level of uncertainty emanating from European sovereign and bank crisis and unstable Chinese economy which may implode within next few years.

But I would like to remind to my user that this is only one probability and not a certainty. What happen will completely depend on how government react, ultimately they can delay the process but can’t avoid it.Even if they won’t allow markets to correct in nominal term it will correct in real term.

Now let us look at the given chart for Sensex. We can see that the up move in sensex started in 1979 and it completed its five wave advance when it made the top in January 2008. I have also marked the corrective wave A which went down from 21200 to 7650 and corrective wave B which went up from 7650 to 21000. I think the correction which have started form current year is going to turn out as wave C and markets are going correct very severely form here.

Nifty Long term Wave chart

If these assumption is correct that the current wave unfolding is wave C than the Sensex will atleast correct upto 10,000 – 12,000 levels.

I have taken the next chart form www.Indiacharts.com. In this chart he had give his wave count for sensex and he is also marking the current wave as Wave C. These are two very interesting article updated by on indiacharts Kondraiff wave cycle and long short report for readers who are interested.

Nifty Wave chart - Indiacharts.com

Let us look at the long term trend line for sensex which started form the lows of 1979. This trend line like the trend line in Dow is a 45 degree trend line, and sensex have never closed below this trend line on quarterly chart. Even in the fall of 2008 sensex took support exactly on the trend line and bounced back from there. If there is any severe correction in the market, it will atleast go up to the trend line which is at 10500 levels.

Nifty Long Term Trend Line Chart

If the trend line is broken than Sensex will complete its retracements. If we look at the retracement chart for Sensex we can see that it completes 50% retracement at 10600, 61.2% retracement at 8300 and 76.4% retracements at 5000 levels.

Nifty - Retracement levels

Again I would like to remind to my readers that this is just one probable scenario and it is not a certainty but according to my view looking at the current economic and political scenario in India I think this will be the most probable view. Again we should remember that by the time wave C ends markets trade extremely cheap but there is so much pessimism in the market that people don’t even want to buy stocks at those cheap values.

This brings me to the end of my long post.

I hope my readers will find this post to be informative and useful. Following are the two charts exhibitng wave characterstics