WHICH ELLIOTT FIFTH WAVE IS BEING COMPLETED? -- DOW THEORY OVERLAPS WITH ELLIOTT WAVE -- THE DOW HAS COMPLETED A MAJOR DOWNSIDE TARGET -- WEEKLY RSI SHOWS BULLISH DIVERGENCE -- STOCKS MAY NEED ONE MORE DIP TO COMPLETE BOTTOM

WHICH FIFTH WAVE IS THE MARKET COMPLETING?... On Tuesday, I offered my view of the current Elliott Wave structure. I suggested that the last leg down starting in January appeared close to completing the entire Wave 3 that started last May. That would pave the way for a Wave 4 intermediate recovery which could reach the January high (a 38% retracement of the May/March decline). That was the scenario I outlined on Tuesday. That more positive short-term view, however, still leaves open the possibility of one more Wave 5 decline once the Wave 4 rally has been complete (bear markets usually have five waves). Chart 1 (courtesy of Arthur Hill) describes that scenario. As he points out, a move above the Wave 4 (January) high would argue for an alternate (and more bullish view). That alternate view is shown in the lower line.

Chart 1

ALTERNATE ELLIOTT READING... The lower line in Chart 1 presents an alternate Elliott Wave interpretation. Back in November and December, Arthur and I had suggested that the November low might have marked the end of major Wave 3 from the May peak (see red numbers). According to that earlier view, the November/January rally marked a major Wave 4 and the decline since January is a possible Wave 5. That more positive interpretation would suggest that the bear market is over. Of the two views, I lean toward the top chart. But I'm well aware of the alternate possibility in the lower chart. Here's the bottom line. The market appears to be at or close to completing a Wave 5. That argues for the likelihood of a substantial rally. How big a rally will depend on which Wave 5 it is. If it's the wave 5 from last May (upper chart), the likelihood is for an intermediate (bear market) rally. If it's Wave 5 from last October, the bear market is over. The key appears to be the January high. A bear market rally (upper chart) should stop at the January high. As Arthur writes, however, a close above the January high would argue for the more bullish view in the lower chart. Both views are bullish. One, however, is much more bullish than the other.

DOW THEORY DOWNSIDE TARGETS... One of our readers asked if there was overlap between Elliott Wave and Dow Theories. The answer is yes. One of the tenets of Dow Theory is that major bull and bear markets take place in three phases. Dow Theory, therefore, holds that a major bear market has three major downlegs (which correspond to Elliott waves 1, 3, and 5). The only difference between the two theories is that Dow Theory doesn't count the corrective Elliott waves 2 and 4. That makes them almost identical. That still doesn't resolve the question of whether or not the market has completed three major downlegs. That still depends on whether the November low qualifies as an important bottom. Here's something to think about however. One of the measuring techniques I learned a long time ago (based on Dow Theory) is to take the size of the first downleg and triple it. That would mean tripling the size of the first downleg from October 2008 to March 2009. The S&P 500 fell from 1576 to 1256 for a drop of 320 points (Chart 2). A doubling of that yielded an initial downside target of 936. A tripling of the first downleg meant a total drop of 960 points from its top for a major S&P 500 downside target of 616 (see Chart 2). This week's low came within 50 points of that target. [The S&P also came within 6 points of its 62% Fibonacci target at 660].The same measuring technique yields a major downside target for the Dow to 6506 as shown in Chart 3. That target was reached this week.

Chart 2

Chart 3

WEEKLY RSI DIVERGENCE... If I'm right about the market being in a fifth downwave, that makes some other technical signs more important. During a fifth wave, bullish divergences become much more important than at other times. Which brings us to the weekly S&P 500 bars in Chart 4. The solid blue line is the 14-week RSI oscillator. Notice the pattern of lower RSI peaks and troughs throughout the last two years. The red arrow shows a major negative divergence from the S&P at the October 2007 top. We're now seeing exactly the opposite. The RSI is showing a bullish divergence that started with the November bottom (blue line and arrow). Most of our other weekly indicators are showing a similar bullish divergence. That suggests to me that the market is ripe for an intermediate upturn.

Chart 4

MARKET MAY NEED ONE MORE DIP... The weight of technical evidence suggests that the market is close to a rally (which could test the January high). As I suggested on Tuesday, however, I remain concerned that the decline from the January top looks incomplete. I'd prefer to see a five-wave decline instead of the current three waves shown in Chart 5. The current bounce could be just a wave 4. At the risk of putting too fine a point on things, I'd prefer to see one more pullback that either touches a new low or retests the March low to complete a fifth downwave and set up an intermediate recovery. The key is the 800 level. Any move over that level (and its 50-day moving average) would signal that the bottom is in. Either way, it's not too soon to start turning a bit more positive.

Chart 5