What's in a rally wave and why it matters now: How "B" waves and "2nd" waves can seem similar but point to very different futures for equities

In Elliott Wave theory, there are five basic types of corrective waves: wave 2, wave 4, the lettered waves "B", "D" and "X". This post will take a look at the personalities of two of these - "B" waves, and "wave 2" waves (second waves). And explain why it matters which category this rally's in - for what comes next! Just so you know, because of the fractal nature of Elliott Waves, the larger waves that play out over days, weeks, months and years, are themselves composed of smaller subwaves in smaller time frames. Just for illustrative purposes, I'm including (below right) a chart of the Nikkei index started by my late mentor, onto which I've expanded on his count annotations, extended the price to indicate how it's moved through to the present, and indicated a third EW alternative (that this is a "B" wave up) onto the two primary ideas from his original chart (that this is either a wave 2 up, or part of a new bull market wave up such as a wave 1 for a new bull market). This goes along with what I understand to be the two dominant points of view on the current rally, at least in U.S. equities markets - that this is a "B" wave up (Tony Caldaro), or a wave 2 up (EWI and others who share EWI's overall point of view). [I recognize there can be some still viewing this as a possible wave 4, but won't address the merits of that, and for space considerations won't get into wave 4 personalities here.]

And for a quick point on why it matters whether this is a "B" wave or 2nd wave up - it matters because of what's projected to happen next. If this is only a 2nd wave up, then we can expect a 3rd wave down. So, let's see ... the SPX fell from 1576 to 667, a move of 910 points (cool, basically 10 times our 90-point range that the SPX tends to move in with its large waves!). Since third waves are never the shortest wave, then we could expect a 3rd wave to be either equal to the first wave, or have some Fibonacci relationship to it ... if wave 3 down is less than wave 1, then the fifth wave must be shorter than the 3rd wave (since the 3rd wave can never be the shortest). But we don't care about that right now - let's just say for example, that wave 3 down would have a fractional length of .618 times the wave 1. So, 910 times .618 is 562. If the SPX drops from 1018 - or let's say 1022 since that remains possible nearby and then we're assuming we go bearish into this hypothetical 3rd wave - then 1022 minus 562 = 460. (Hey that's neat, it would "fit" with some of my own Fib. projections ... except, my projections would be for the completion of the move - so not an exact fit - but, I digress.) The deal is, we'd then expect a wave 4 correction, and then the final wave 5 would go lower again.

Following this hypothetical, let's say the 4th wave retraced .382 of the third wave. So, that would add 215 points (.382 applied to the 562) to 460, = 675. (Hmm, that would retest the March lows from below.) Then, let's say the 5th wave measured .618 of the wave 3. So that would be a range of 347 for the wave 5. Subtracting that from the hypothetical 4th wave peak of 675 would place the final wave 5 bottom at 328. Keep in mind this is hypothetical in a lot of ways! - depends on whether we are dealing with an impulse count down from 1576; whether 1022 would be the wave 2 top; whether the wave relationships would be .618.

Also be aware that folks like the EWI group seem to be calculating much more bearishly - the numbers would be more like the third wave being equal to the 1st wave, etc. If wave 2 topped at 1020 and wave 3 dropped 910 points, that would have wave 3 bottoming at 112 (the equivalent of about 1,200 in the Dow Jones Industrial Average). And the bear market would not be finished, because there would still be a wave 4 consolidation followed by a final drop into the wave 5 even lower!

Conversely, let's say this is a "B" wave instead - in that case, we'd expect that the next drop down in the "C" wave would finish the low. If the "C" wave had the .618 relationship to the "A" wave that bottomed at 667, then it would complete at the 460 level calculated above. (But if the wave C were symmetrical - equal in length to the wave A, it would complete at that 112 level - although I know Tony has mentioned some other numbers in between, as possible targets.) After that, we'd expect "the low" to be completed followed by a much, much more vigorous bull market rally (whether cyclical or secular depending on the even bigger long-wave picture).

Those of my readers who are EW aficionados can guess that I'd be thinking, this could still be a wave 4 in the SPX and finish a wave 5=C from my expanded flat idea for that index - even if the count is different in other indices, which I believe it probably is. With a target that could be as high as 600 SPX, although it could also have lower objectives down to about 460 area. (A story for a different day, however - already told in several posts at my UBTNB3 blogspot, you can probably locate under the "Big-picture charts" label.)

Obviously the other alternatives that bears and short must consider - either the wave 2 or "B" wave hasn't finished topping out yet! Such as taking another several months or into the year 2010 and reach much higher levels. Or even "worse" that the bear-market low is behind us and we're up in either a much bigger (expanded flat anyone?) B wave that could go to new highs, or in a first wave of a larger fifth (V) wave that again could go to new highs. Folks - any of these possibilities is enough to make sure that, if the market doesn't trend reverse from the Fibonacci levels we've already seen around 1014 and 1018 pivot, and QQQQ's at $39.82 - then we don't want to fight the market testing higher retracement and pivot levels.

But again I've digressed - let's get back to wave personalities - I'm going to quote from information in the classic Elliott Wave book by Frost & Prechter, Elliott Wave Principle (the book with the blue cover sold by the EWI group in Georgia, originally written in the early 1980's with appendices written later in the 1980's) (again I like EWI for the theory and stuff, I just stopped relying on them for definitive wave counts - even when they do issue retractions and corrections you usually get them too late! and I sure appreciate Tony's constant updating of his ideas, even when I like to do my own EW analysis):

Second Waves

Second waves often retrace so much of wave one that most of the profits gained up to that time are eroded away by the time it ends. [My note - depends on the amount of retracement of course!] This is especially true of [option] purchases, as premiums sink drastically in the environment of fear during second waves. [My note - fear if the wave 2 is down - excitement if it's an upward correction.] At this point, investors are thoroughly convinced that the bear [bull] market is back to stay. Second waves often end of very low volume and volatility, indicating a drying up of selling [buying] pressure.

EWP book, pp. 79-80. Just a quick comment, this is why some analysts calculate selling and buying (demand) pressure very closely. We commonly look at the raw volumes, as well as Bollinger Bands (which measure volatility as referred to in this manner) and other indicators that help identify these things, many of which were invented or refined after the EWP book was written.

B Waves

B waves are phonies. They are sucker plays, bull traps [when in the upward direction, the type we're looking at here], speculators' paradise, orgies of odd-lotter mentality or expressions of dumb institutional complacency (or both). They often involve a focus on a narrow list of stocks, are often "unconfirmed" (see Dow Theory discussion ...) by other averages, are rarely technically strong, and are virtually always doomed to complete retracement by wave C. If the analyst can easily say to himself, "There is something wrong with this market," chances are it's a B wave. ...

- The upward correction of 1930 was wave B within the 1929-1932 ABC zigzag decline. ....

As a general observation, B waves of Intermediate degree and lower usually show a diminution of volume, while B waves of Primary degree and greater can display volume heavier than that which accompanied the preceding bull market, usually indicating wide public participation.

EWP book, pp. 81-83. I must point out that this relates to "classic" Elliott Wave and I do not know how this may play into Tony Caldaro's refined Objective Elliott Wave methods. My guess would be that it's either the same or not too far off. Also - you can guess based on the descriptions why the EWI folks consider the 2007 peak to be a very large B wave of its own. (And perhaps also why my view of the gold chart is that the primary count should be that 1007 marked a B wave, while the idea it was a first wave should be the alternate count ... but again, that's another story.)

So there you go - a basic backgrounder in the psychology of B waves versus second waves. And why it matters which this rally is, from an Elliott Wave perspective, because of what it says about what happens when the rally is done. Also - take note, a B wave usually retraces about 50% of the move it's correction (that's why I focus on the QQQQ's at $39.82), or makes a 50% rally (as we've seen in many indices as Merriman pointed out yesterday), or can retrace 38.2% (one reason why I focus on this 1014 level in the SPX, which also depends on how its internal subwaves can be interpreted). Point being - the markets have retraced to a level that is more consistent with a "B" wave than a wave 2. Not saying this proves EWI and those who share that count to be wrong - just pointing it out ... (well besides, we cannot confirm the rally's peaked out and finished anyway!). But if the rally is about over now, or very soon, then frankly the retracement level does look more like a "B" wave ... just sayin'.

And yes, another reminder - I acknowledge we don't have confirmation yet that the rally has topped out, and similar whether or not a 4-year cycle low bottomed in March or that we're seeing a 4-year cycle crest finishing now. There remain higher levels that this market could reach - I acknowledge that. All I'm saying is that there are plenty of reasons to think that the rally can be concluding. Examples of why I say this include:

- the QQQQ's are faltering around their 50% retrace to 39.82
- the SPX has reached a very significant Fibonacci retrace level
- the dollar has reached a very significant Fibonacci retrace level and started to bounce from it
- the yen lost support yesterday - is that bullish equities or is the dollar strength bearish?
- then euro dropped smartly yesterday too - ditto my query above
- gold and silver are faltering and may confirm the more bearish count consistent with deflation
- other commodities haven't confirmed they can do another rally leg higher either
- the VIX remains above its own very significant Fibonacci retrace level as I've shown
- there are some indications from proprietary volume-measurements that can be early signal
- the McClellan charts I posted yesterday at UBTNB3 blogspot (and below) show divergence
- Tony Caldaro's OEW suggests that rally can falter (either pullback or more; we'll let his weekend update address any more detail on this)
- Merriman's cycles analysis suggests the rally can falter from here
- The banks and financials "breakout" is late to the party and can encounter significant chart resistance around $46-47 in the BKX chart, which it tested yesterday and drew back from
- I still like biotech and think it's just consolidating, but that won't be enough to draw the entire market with it - and it can have corrections and consolidations along the way too

So I know I've stated many times before that we should be alert, be cautious, etc. etc. blah blah blah, don't treat me like the kid that cried "wolf" too many times ... because the signals are now aligning more tightly than before. I do see enough strength in technical indicators that I think any deep move down can occur with positive divergence that helps boost for a very good rally afterward - so I'll tilt toward Tony Caldaro's view of looking for a larger-level rally later on. First things first though - gotta see if these signals blow the whistle on this rally in the days ahead!

The McClellan charts are courtesy of DecisionPoint.com (via Stockcharts.com) (both are included with links in the "other sites of interest" at the right side of the page here) - the markings on them (lines and circles) are my own annotations however.

I'm adding below Tony Caldaro's weekly chart of the Nasdaq Composite because as I was browsing his public charts via his charts list link http://stockcharts.com/def/servlet/Favorites.CServlet?obj=ID1606987, I was struck by the fact that this index is hitting resistance at its 89-week exponential moving average. Since I had passed along the point that the SPX just had its 13-week ema beginning to cross above its 34-week ema, which will support a bull market idea unless it's only a snap-back, it seems equally important to pass along that the broad COMPQ is at this important longer-term resistance level in its weekly chart. Not to mention chart resistance, round-number resistance at "2000", and apparently one of Tony's major pivot levels: