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Stock Market Is Trending Perfectly Within the Rules of Elliott Wave Theory


Here's why the method might be called the cornerstone of prudent risk management.

Over the past couple of weeks there has been a crash in confidence followed by a crash in fear, yet these extreme emotional swings have gone largely unnoticed for their potential foreshadowing of things to come.

The violent move in Treasury bills leading up to the default deadline was well known and easily explained by a lack of confidence in the safest and most liquid assets in the world. After the Congressional capitulation these securities quickly normalized, and many participants who don't trade hundreds of billions in cash simply laughed it off as a market that was overly paranoid.

The crash in fear was less well documented but perhaps more pronounced. On Wednesday, the 10-day historical volatility of the VIX (INDEXCBOE:VIX) index of implied volatility on S&P 500 (INDEXSP:.INX) options spiked to the highest level since this past spring, leading up to the massacre in the bond market.

On June 17 in The QE Carry Trade Is Imploding Right Under Everyone's Noses, I cited a brief research paper by Lake Hill Capital that recognized that, despite low spot VIX, volatility of volatility was spiking to what in the past had signaled a financial crisis.

The following is from Lake Hill Capital:
If we go back through history, we find that most of the high VIX environments are consistent with high periods of "vol of vol"- until now. Despite a cosmetically low VIX price, the current volatility of the VIX is suggestive of crisis.
I wasn't sure what was causing this spike in vol of vol, but had a hunch it was indicative of carry trades being unwound. I thought to myself, these guys were definitely onto something, and I wrote the following:

In analyzing this development in the context of realized volatility of the equity market for which the VIX is priced vs. the realized volatility of the market that finances carry trade positions, the move looks to be a function of financing costs.

Presumably a market that is short gamma and long inflation premiums was forced to lift volatility because inflation premiums collapsed, raising the cost of financing the trade. I believe this is a shot across the bow that leveraged positions are under pressure.

Volatility of Volatility

This past week there was a similar spike in the so-called vol of vol. It's happening again, only this time the spike occurred not because implied volatility was being lifted, but because it was being sold. Fear wasn't rising, it was crashing.

In fact, if you measure the 10-day volatility of the VIX as a ratio of the spot VIX, last week's spike is extremely rare. With equity prices jamming to new all-time highs, volatility premiums are getting crushed. Investors see a breakout and are eliminating downside protection.

S&P 500 Vs. VIX

Since the June 24 low in the S&P, I have been struggling to reconcile the market's technical pattern as corrective or impulsive. Elliott Wave gets a bad rap because many analysts incorrectly apply the concept, but I find it to be quite effective in mapping the market's trend, and more importantly, this risk of a change in trend.

There are two basic concepts in Elliott wave trend analysis. Markets impulse with the trend that Elliot counts in 5 waves (1-2-3-4-5) while markets correct against the trend counted in 3 waves (a-b-c). These impulsive and corrective trends take on many different patterns and can be found in varying degrees (eg, hourly, daily, weekly etc.). One idea that I have been monitoring is that the S&P is in the midst of a so-called ending diagonal triangle.

The following is from Elliott Wave Principal by A.J. Frost and Robert Prechter:
An ending diagonal is a special type of wave that occurs primarily in the fifth wave position at times when the preceding move has gone "too far too fast," as Elliott put it. In all cases, they are found at the termination points of larger patterns, indicating exhaustion of the larger movement. Ending diagonals take a wedge shape with two converging lines.

Each subwave, subdivides into a "three" which is otherwise a corrective wave phenomenon producing an overall count of 3-3-3-3-3. The fifth wave of a diagonal triangle often ends in a "throw-over," i.e. a brief break of the trendline connecting the end points of waves one and three. While volume tends to diminish as a diagonal triangle of a small degree progresses, the pattern always ends with a spike of relatively high volume when a throw-over occurs.

S&P 500 Working Count

Frost and Prechter label the waves inside an ending diagonal using numbers that are consistent with impulsive waves, however, because the waves are threes, I prefer to label with letters. The letter waves have distinct characteristics that I believe are indicative of the market's behavior inside a diagonal.

Frost and Prechter reserve the letters ABCDE for corrective triangles, but here I will apply them to the ending diagonal triangle. The "E wave" is thus the last leg higher in an ending diagonal. What's key here is that under Elliott Wave theory, each wave exhibits certain characteristics.

Once again, the following is taken from Elliott Wave Principal; it describes the "personality of an E wave" (I interject in brackets to conform to diagonal):
E waves in triangles appear to most market observers to be the dramatic kickoff of a new downtrend [uptrend] after a top [bottom] has been built. They almost always are accompanied by strongly supportive news [like a debt ceiling extension]. That, in conjunction with the tendency of E waves to stage a false breakdown [breakout] through the triangle boundary line, intensifies the bearish [bullish] conviction of market participants at precisely the time that they should be preparing for a move in the opposite direction.

A week ago last Friday after the market found support on the previous Wednesday (October 9), I began to suggest the final E wave higher was evolving. I tweeted to my followers the following observations on Friday October 11:
On Friday, the S&P not only saw a throw-over thrust through the upper parallel, it gapped above all previous price to a new all-time high just under 1750. This leg has not just been the most intense; it's up 6.0% in eight trading sessions for a 963% annualized return. Meanwhile implied volatility has collapsed while the vol of vol has exploded, suggesting protection buyers have capitulated. This move has e wave written all over it.

Despite the lack of earnings growth there is a lot of confidence in this multiple expansion-driven stock market rally. Bulls often say things like, valuations are cheap relative to history, or there is nothing else to buy and the Fed is going to remain easy; it's going higher so it must be the best investment. On the other hand, skepticism has been relegated to conspiracy theories like the idea that stocks are being manipulated by the central bank, the government, and computer algorithms. Both of these positions are misguided.

The stock market is trending perfectly within the rules of Elliott Wave. Ralph Nelson Elliott first published his Wave Principal in 1938 based on market psychology and emotion. These market conditions have not changed with quantitative easing or computer trading. These market conditions don't know valuation or opportunity cost. This market is subject to the same psychological and emotional conditions governing prices since the beginning of time: fear and greed.

Let me be clear: I am not telling you I know the pattern nor am I recommending a trade, but rather I am trying to highlight a risk. There are many ideas for the potential technical pattern, but the conditions are in place for an ending diagonal. Regardless of how it unfolds, you must understand that if we do reverse from this 1750 area and the lower parallel is violated, the market could be under significant selling pressure as momentum shifts to the downside.

As I said back in June when observing the spike in vol of vol in the context of a QE carry trade unwind, there were many markets that when analyzed separately were saying something different, yet when analyzed together were saying the same thing. The crash in T-bills and the crash in implied volatility are very different when analyzed separately, but when analyzed together they are the same. Despite the appearance of low volatility, participants are acting extremely anxious with itchy trigger fingers in jumpy markets. Money is scared in both directions and liquidity is thin on both sides.

Year-to-date into the May 22 high, the S&P 500 was up 21%, but since then is up only 3.4%. If this is an ending diagonal completing a trend that has gone "too far too fast," then stocks are going to see a material correction in order to work off the froth. Knowing this risk exists if and when it occurs will allow you to take advantage of the dislocation when others are panicking. It will make sense to you when others are emotional and confused. That is the essence of Elliott Wave theory applied, and the cornerstone of prudent risk management.

Twitter: @exantefactor
No positions in stocks mentioned.
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