On the fifth wave and an inflection point

MUMBAI: Is an Extended Fifth Wave upon us?

Talking Toffler?

No. Elliot Wave Theory.

Its proponents believe the Sensex and the Nifty are doing a Wave 5 X now. In more humane language, this could mean a darn good thing for investors — if they are right in the first place.

Bamboozled? Let’s take this gradually. Stock market traders using technical analysis as a primary tool try to forecast levels where bull markets commence or terminate.
While all schools of thought have their own hypotheses on the forecasting aspect of the charts, none has elaborated upon the subject as much as Elliot Wave Theory has.

The theory states that markets move in waves. Each bull phase consists of 5 waves. Waves 1, 3 and 5 are bullish or impulse waves and Waves 2 and 4 are corrective or down-waves. Various studies and tools are available to the Elliotician to forecast the price objectives / time periods before exhaustion occurs.

“So far so good, but this is where things get complicated,” points out Vijay Bhambwani, a technical analyst. “Waves sometimes extend and may also fail.”

In the current scenario, take a weekly chart of the Sensex / Nifty and you will see that the week ended May 2, 2003, marked the termination of a vicious bear hug. A vibrant bull market was under formation as Wave 1 unfolded. (See chart)

It lasted up to the first week of January 2004 and Wave 2 emerged.

Wave 3 was triggered after the vicious meltdown of May 17 and was confirmed in the week ended June 25, 2004. The same ended with a meltdown in the week ended May 12, 2006.

So far, Wave 3 was a textbook example of that wave type — longest in duration, most profitable and reliable of the entire pattern.

Wave 4 commenced and ended in the week ended on June 16, 2006 — the most vicious and bloody experience for a bull to be into. The gains made by Wave 3 were erased to the tune of 50% in 5 short weeks and there was blood on the streets.

“Wave 5 was born in those pessimistic days,” says Bhambwani.

Today, chartists say, we are seeing the extension of Wave 5. Such an extension is said to be salutary. Will it catapult the Sensex to 16,000 odd points?
“We’re getting into all possible extensions,” says Bhambwani.

The fall from 12671 (on May 12) to 8799 was about 3,800 points. After retreating, the Sensex again came back to its top in about five months.

The breakout from hereon shows possibilities of the Sensex gaining another 3,800 points more, and it would take around 8 months from the time it hit 12,671 for the second time.

That is, 8 months from October 13, 2006, which is mid-June 2007.

Ellioticians arrive at the eight months timeframe by multiplying 1.618 with the five months it took for the index to come back to 12671 levels.

Why 1.618? Some explanation is in order. In mathematics, there is a concept called the Fibonacci sequence, devised by Leonardo Fibonacci, the 13th century Italian mathematician.

According to him, the sum of any two adjacent numbers in a sequence forms the next higher number in the sequence.

Take the standard sequence 1,1,2,3,5,8,13,21.  Here, 1 plus 1 equals 2, 1 plus 2 equals 3, 2 plus 3 equals 5, 3 plus 5 equals 8 … this goes on till infinity.

What is to be noted here is that the ratio of any two consecutive numbers in the sequence is 1.618, or its inverse, .618.

The Georgia, US-based Elliot Wave International (EWI) says this is also known as the Golden Ratio or Golden Mean.

Nature, EWI said, uses the Golden Ratio in its most intimate building blocks and in its most advanced patterns, in forms as minuscule as atomic structure and DNA molecules to those as large as planetary orbits and galaxies.

“It is involved in such diverse phenomena as quasi crystal arrangements, planetary distances and periods, reflections of light beams on glass, the brain and nervous system, musical arrangement, and the structures of plants and animals. The stock market has the same mathematical base as do these phenomena,” says the organisation.
But within the chartists’ world, many don’t follow the Elliot Wave theory at all.

Like Sandeep Wagle, chief technical analyst of Angel Broking. He prefers the Dow Theory. He’s no less bullish for it.

“According to the Dow Theory, the Sensex will see the 14000-14500 levels in the next few months,” Wagle says.

Prem Daga, a technical analyst at Professional Investor, an investment advisory in Mumbai, concurs. “Based on Dow,” he says, “the Sensex will touch 14900 and the Nifty 4400, subject to their holding supports of 12612 and 3754 (the closing highs made by the indices in May), respectively.”

Now here come the caveats: R N Elliot, author of the eponymous theory, says Wave 5 is the most tricky one to ride.

Bhambwani says Robert Rougelot Pretcher and Robert C Beckman, in their seminal books on technical analysis, concur on this.

Wave 5, they say, is laced with the highest volatility. Many triangles and pincer formations are seen, confusing the traders into believing that the end of the rally was nigh.
These technical-analysis gurus say Wave 5 can typically measure up to Wave 1 in terms of duration (time ) and the exhaustion (top) of an extended Wave 5 can be approximated by multiplying Wave 1 top by 3.236 in terms of price objective.

Currently, the Wave 5 pattern on the Nifty is 20 weeks old, whereas Wave 1 lasted 33 weeks.

Wave 1 saw gains of 1095 points and Wave 5 has gained 1365 points as on Wednesday evening.

“In terms of time, watch the 3rd week of February as the possible time when the Wave 5 either signals an extension (deluding the players who are watching the fifth of the fifth wave) or witnesses an exhaustion,” says Bhambwani.

If you are having a hard time making up your mind and / or trading profits, take heart. Chartists reiterate Wave 5 is the most difficult one to trade.

Till then, wave and watch.