How Elliott Wave Analysis Helps and Harms Investors

If you look at your graduation class you’ll probably find that some of the biggest oddballs or nerds have landed the best jobs. Elliott Wave Theory (EWT) is the oddball of technical analysis, but has produced some spectacular results … spectacularly good and spectacularly bad. Here’s how to make EWT work.

The right dose is important, because it’s possible to have too much of a good thing.

Take for example mold. Mold can be dangerous so we try to stay away from it. In small doses though, mold can be all right, even tasty.

If you like Gorgonzola, Blue Cheese, or Roquefort cheese you are basically eating moldy cheese that contains Roquefortine, a mold dangerous in large quantities.

Like Gorgonzola, Blue Cheese or Roquefort, Elliott Wave analysis can be healthy (for your portfolio) in controlled quantities. Like moldy cheese, Elliott Wave analysis may also be an acquired taste.

The Technical Analysis Oddball

Elliott Wave Theory (EWT or Elliott Wave analysis) is the oddball of technical indicators. Some love it, others hate it.

But investing is supposed to be about results not emotions. So regardless of emotional bias, serious investors should take an objective look at EWT.

EWT – The Good, The Bad and The Ugly

I’ve been exposed to EWT for about 10 years and have seen EWT at its best and worst. Here are the top 4 most important facts you should know about EWT:

1) EWT is interpretative. Five different Elliotticians (that’s how followers of EWT call themselves) may have 5 different interpretations of the market’s current whereabouts and next move. Some Elliotticians (example below) know just enough to be dangerous, literally.

2) At certain inflection points the correct interpretation of EWT can be invaluable. It will provide insight no other form of analysis can (see example below).

3) Never use EWT as a stand-alone indicator. I always use EWT (when I use it) in combination with technical support/resistance levels, sentiment and seasonality.

4) EWT has been effective in spotting major market bottoms (with the help of EWT I’ve been able to get my subscribers back into the market in March 2009, October 2011, and June 2012), but rather ineffective in spotting tops.

EWT – The Good

As mentioned above, there’s a time to use EWT and there’s a time to ignore EWT.

One of the more recent times I referred to EWT was via the August 18 Profit Radar Report, which featured the S&P 500 chart below. At the time, EWT strongly suggested that with or without a minor new low, stocks are gearing up for a large rally with a target at 1,685 – 1,706 (open chart gaps) or higher.

Trend lines suggested that the S&P 500 will run out of gas (at least temporarily) at 1,735 (September 18 Profit Radar Report).

Partially based on EWT, subscribers to the Profit Radar Report were advised to go long on August 29 when the S&P 500 triggered a buy signal at 1,642.

EWT – The Bad and The Ugly

EWT is largely based on crowd behavior and social mood, which in turn affects the money flow. However, in recent years the Federal Reserve decided to ‘spike’ the money flow and throw EWT a curveball.

We’ll never know how much the Fed’s easy money policy affects EWT, but we know that since late 2009 some Elliotticians have stubbornly predicted a market crash.

Among them is the world’s largest (according to their claim) independent financial market forecasting firm, Elliott Wave International (EWI). EWI’s message has been the same for years. Below are just a few of EWI’s market crash calls:

August 2010: “Stocks are ready to resume the ongoing bear market. The next phase of selling should be broad-based.”

November 2011: “Short-term positive seasonal biases are now dissipating and an across-the-board decline should draw financial markets lower.”

September 2012: “The stock market’s countertrend rally from June stretched to an extreme. This weak technical condition should lead to an accelerated decline.”

July 2013: “U.S. stock indexes are in the very early stages of a multi-year decline.”

Interpretation Spoils Profits

As mentioned earlier, EWT is subject to interpretation. Just because one Elliottician’s (or company’s) interpretation is wrong doesn’t mean EWT is useless.

The last time the Profit Radar Report looked at EWT was on September 8. At the time the S&P 500 (NYSEArca: SPY) was trading at 1,655 and many Elliotticians thought that the market had topped for good.

In contrast, the Profit Radar Report (on September 8) focused attention on a bullish EWT option: “There is one (normally) rare exception that allows for new highs even after a completed 5-wave reversal. In fact, the 5-wave reversals in 2010, 2011, and 2012 all led to new highs. Bullish seasonality starting in October supports this outcome.”

Some Elliotticians are still fishing for a major market top and they may well be right.

However, the S&P 500 (NYSEArca: IVV), Dow Jones, and Nasdaq (Nasdaq: ^IXIC) erased their bearish divergences visible a few weeks ago and seasonality and various breadth measures suggest higher prices later on this year.

The odds of a major market top have dropped a bit, but there will no doubt be time when EWT will provide valuable clues.

Regardless of the next EWT signal, I’ll continue to evaluate the dozens of indicators that make up my forecasting dashboard and share my most valuable findings via the Profit Radar Report.

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @iSPYETF

 

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Is this Gold Rally Real or ‘Fool’s Gold?’

A novice wouldn’t be able to distinguish fool’s gold from real gold. Even gold experts have trouble telling the difference. Miners have come up with the acid test to avoid getting fooled.

Most metals tend to bubble or fizzle when they come into contact with acid, precious metals don’t. Placing a small drop of a strong acid, such as nitric acid, onto the metals surface quickly and unmistakable differentiates real gold from fool’s gold.

Is this gold rally the real deal or is it a fool’s gold rally?

The results of this analysis won’t be as conclusive as the acid test for gold (nothing ever is in investing), but there are some worthwhile indicators to consider.

CBOE Gold Volatility Index

The April 28, 2013 Profit Radar Report examined a pattern in the CBOE Gold Volatility Index to ascertain if the April low at 1,321 was here to stay.

The CBOE Gold Volatility Index is basically a VIX for gold as the VIX methodology is applied to options on the SPDR Gold Shares (NYSEArca: GLD).

An update chart of GLD plotted against the Gold VIX is shown below. Major gold lows in 2010 and 2011 occurred against positive gold VIX divergences, where gold prices dropped to a new low, but the Gold VIX didn’t.

Such divergences are nothing new. I’ve used similar divergences between the S&P 500 (SNP: ^GSPC) and the VIX (Chicago Options: ^VIX) to nail major stock market lows in March 2009, October 2011, and June 2012. See S&P500 Forecasting History for more details.

There was no such divergence in April 2013 when gold (NYSEArca: IAU) dropped as low as 1,321. This suggested new lows and the April 23 Profit Radar Report stated that: “A new low would be the best buying opportunity.”

We got that new low on June 28, but it didn’t have all the hallmarks of a lasting bottom. We were long for parts of the rally from the June low, but never committed fully.

Our focus was on the iShares Silver Trust (NYSEArca: SLV) where we just closed out a very nice trade. We went long gold again with Thursday’s move above 1,345 (GLD trigger was 130.15).

The move above 1,345 is bullish, but gold has already reached your initial up side target around 1,365 (see resistance lines in chart below).

If gold can move above resistance here, it is likely to extend its rally and move to our second target. Otherwise watch out.

Gold prices have a huge effect on gold miners (NYSEArca: GDX). One unique valuation metric – which correctly predicted the 2001 and 2008 low for mining stocks – just flashed a rare signal. Read more about the Gold Miner’s Signal here: By One Measure Gold Miners Are as Cheap as Ever.

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow him on Twitter @ iSPYETF or sign up for the Free Newsletter.

Contrarian Alert: Mutual Funds Are Buying This Rally – Should You Sell?

Most licensed and bonded professionals are considered authorities in their field. Usually you do as they say. Almost the opposite is true for financial pros, mutual fund managers. It often pays to do the opposite of mutual fund managers.

I’m not a craftsman, so if a pipe springs a leak I call a plumber. To get the job done right you call a pro. Unfortunately, the same principle doesn’t always apply to investing.

Often the opinions of the investment pros – mutual fund managers – work better as a contrarian indicator than an actual authority. That’s what makes the recent mutual fund manager survey interesting.
Each week the National Association of Active Investment Managers (NAAIM) surveys money managers to see how aggressively they are positioned, long or short.
The positions can range from leveraged bullish (200% net long) to leveraged bearish (200% net short).
The average mutual fund manager is currently 87.5% net long, that means that for every $100 under management, $87.5 are invested in stocks.
That’s not an all-time high, but as the middle portion of the chart below shows, fund managers are not often that bullish.
The chart plots the S&P 500 (SNP: ^GSPC) against two facets of the NAAIM survey. The vertical red lines highlight the correlation between extreme readings and the S&P 500 (NYSEArca: IVV).
Another interesting data point is the ‘last bear standing’ portion of the NAAIM survey. The most bearish manager polled, on average, is leveraged short (negative 110%). The most bearish manager right now is 15% long.
Rare as those bullish readings are, they are not as bearish for the S&P 500 (NYSEArca: SPY) as we’d expect from a contrarian sentiment indicator.
Some extremes led to corrections (October 2007, April 2010, February 2011), but in other instances (January 2007, September 2009, December 2010, January 2013) stocks just kept on trucking. Although on most occasions eventual corrections erased all or most of the gains accrued since the extremes were registered.
Another indicator that provides a sneak peek at what mutual fund managers are thinking are mutual fund cash levels. Just like a fire needs wood to burn, stocks need cash to rally.
How much cash is left to drive stock prices up further?
The detailed mutual fund cash level analysis featured here provides interesting inside with a twist.

Weekly ETF SPY: Russell 2000 ETF – IWM

Risk is rising when leaders turn into laggards. After outperforming the S&P 500 for years, the Russell 2000 failed to confirm the S&P’s new all-time high on April 10. The stock market in general peaked the next day. Here’s an updated look at the Russell 2000 and the Russell 2000 ETF.

We’ve been using the Russell 2000 Index as a ‘thermometer’ to see if the market is getting overheated. How can any one index work as a thermometer?

As rallies or bull markets mature, investors typically find fewer and fewer stocks at a price tag that justifies buying. Mature rallies are therefore accompanied by selective buying.

Selective buying is just a fancy expression for some indexes beginning to lag and underperform. High beta indexes, like small caps, are usually the first to be left in the dust.

That’s exactly what happened in early April, particularly on April 10. The S&P 500 rallied to new all-time highs. The Russell 2000 did not.

The April 10, Profit Radar Report pointed out just that: “The stock market has arrived at a point where selective buying is cautioning of a looming high. Upcoming resistance levels and divergence spreads (i.e. Nasdaq-100 compared to Nasdaq Composite, DJIA compared to DJA, and S&P 500 compared to Russell 2000) provide a low-risk opportunity to go short.”

In other words, there is a low-risk opportunity to go short as long as the Russell 2000 remains below its all-time high (recorded on March 15).

The purple bar in the chart below highlights the difference between the April 10 and March 15 highs, seven points. The risk of going short on April 11 was seven points. So far the Russell 2000 has fallen as much as 48 points. This is a risk/reward ratio of almost 7:1 in your favor.

On Thursday the Russell 2000 closed right above important triple support. Although RSI (bottom of chart) did not yet confirm the new price low, it failed to provide an obvious bullish RSI divergence. This suggests that any bounce at current support will lead to at least one more leg down.

A move below 890 should minimally lead to a test of 868, possibly lower.

The second chart shows the same support levels for the iShares Russell 2000 Index ETF (IWM). IWM already closed below the two ascending trend lines. Once price drops below support it turns into resistance (that’s why the trend lines are colored red).

IWM may foreshadow what’s next for the Russell 2000, but when it comes to trading/investing, I base my technical analysis on the purest representation of the respective asset. The purest representation of the Russell 2000 is the Russell 2000 Index, not the Russell 2000 ETF.

Nutshell summary for IWM: Based on trend line support for the Russell 2000 Index, small caps are likely to find support around current prices, but should ultimately move lower before embarking on a more sizeable rally again.

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Follow up on prior ETF SPY Picks:

click here for links to prior ETF SPY Picks

April 12: GDX broke through support with a vengeance. A new low is likely before we’ll see a significant rally.

April 5: XRT closed below trend line support and registered a failed bullish percentR low-risk entry (lingo for: the up trend is likely broken). XRT is still trading above support at 68.70.

March 22: AAPL’s break above trend channel was a fake out break out. The March 31, Profit Radar Report stated that: “Apple failed to bounce from parallel channel support (on the log scale chart) and closed below. Our stop-loss was triggered and the option of much lower prices is now on the table. I’d like to see further confirmation, but the potential target for Apple may be as low as 353. Support at 425 – 405 could soften or halt the decline.”

March 15: XLF trades as high as 14.65, which was right in the 18.52 – 19.66 resistance cluster that was likely to halt XLF’s rally.

March 7: The Nasdaq-100 (corresponding ETF: QQQ) had two open chart gaps: 2,806 and 2,860. Although it seemed unlikely at the time, the Nasdaq-100 closed the gap at 2,860 on April 10 before declining well over 100 points.

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Early Indicators Show 87.5% Odds That 2013 Will End Higher

Investing is a game of probabilities and the beginning of each new year hosts a number of pretty good barometers with decent track records. Two combined indicators put the odds of a positive 2013 at 87.5%.

The S&P 500 is about to reach a key inflection point. How it reacts there will probably set the tone for the first 6 months of 2013. Once the S&P reaches this “fork in the road,” I expect it to turn down.

Regardless of ones bias, you can’t be blind to other indicators and two of them are quite bullish.

Santa Claus Rally (SCR)

The SCR covers the last 5 trading days of the old year and 2 first trading days of the new year. The 2012/13 SCR delivered a 2.0% gain for the S&P 500, a 1.5% gain for the Dow Jones and 2.6% pop for the Nasdaq.

Since 1950, a positive SCR for the S&P 500 has resulted in full year gains 62.8% of the time.

First 5 January Days (F5D)

A lousy performance during the first 5 trading days of the year is often viewed as an early warning signal for the entire year. It doesn’t like look the F5D will be waving any red flags this year. Unless the S&P closes below 1,426.19 today, the F5D will be positive.

Used as a barometer, the first 5 days have correctly predicted the full year outcome (up or down) 62.8%.

Santa Claus Rally + First 5 Days

What happens when we combine the SCR and F5D barometers? Since 1950 the SCR and F5D have been up 21 of 24 years for a success ratio of 87.5%.

Based on this, the odds for 2013 ending up in the green is 87.5%.

Once again, I don’t buy those odds, at least not yet. I am waiting for the results of another indicator, one with a 92.3% accuracy ratio. I’m also waiting how the S&P 500 reacts at its fork in the road point.

The results of the 92.3% accurate indicator and the level for the S&P 500 inflection point will revealed by the Profit Radar Report.