0 miles an hour. My father laughed at us and
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said, “No. In fact it can’t be done. Sixty miles an hour is a mile a minute.The car has already used up a minute traveling the first half-mile at 30miles an hour. To average 60 miles an hour the car would have to traverse the final half-mile in zero time. It would have to go at an infinitespeed.” I couldn’t accept his reasoning and I embarrassed myself by arguing for half the night that 90 miles an hour would still do the trick, buthe was right.This story leads us into a less complicated but similar question regarding stock prices. The question is this. The long-term average gain instocks (the S&P 500) since 1928 is just about 10.5%. Over the last 20years, the S&P 500 has averaged a gain of approximately 16% per year.Let me ask a similar question: If the stock market has averaged 16% peryear for the last 20 years, what does it have to earn over the next 20 yearsto average 10.5% over the full 40 years? Here, it is allowable to do thesimple calculation I had used that didn’t work with my father’s question.If we do the simple calculation, the market has to average 5% return peryear over the next 20 years to come in at its long-term average.Figure 7.1 dramatizes the idea behind this question by charting theprice of the S&P 500 since 1940. The trendline in the graph, drawn
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FIGURE 7.1 The stock market has gotten far ahead of its 70-year growth rate.It would be normal to adjust by going through a time correction, that is,marking time by making little price progress. What would look like a sidewaysmove on this long-term price chart, however, would really be composed ofrather lengthy bull and bear markets.
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against the bottom of the market after the Great Crash (not shown), risesat about 7% per year. When you include the reinvestment of dividendsof approximately 3.5% per year, this line represents a total return fromstocks (growth plus dividends) of 10.5%.From a certain perspective, what has happened in the market sinceMarch 2000 can be seen as natural. Investing is always a two-sidedproposition. In March 1982, I gave a talk on the long-term future of thestock market. I said that every generation usually has the opportunity toexperience the fantastic potential of stock investing, then gets carriedaway, overspeculates, and learns firsthand the negative side of stock investing. I said that this baby boom generation would probably be giventhe same opportunity. I believe the first part of this learning cycle is nowcomplete. It is time for the baby boom generation to learn firsthand, justas their parents did, the difficulties of stock investing, and then their investment education will be complete. The major lessons to be learnedare these.• Wealth comes with great difficulty and to only a few.• There is no magic formula; making money in the stock market requires constant vigilance and training.• When the future looks bright and everything seems too good, itprobably is. Similarly, when the future seems very bleak andeverything too bad, it also probably isn’t.
THE CURRENT ELLIOTT WAVE PATTERNAs I explained in Chapter 6, if you want to outline the future pattern forstock prices, there is no better template to lay down than the Elliottwave pattern. Many investors and analysts might disagree with me onthis point since the Elliott wave pattern doesn’t consider or address anyeconomic factors in its formulation and, as we’ve said, the long-termmovement of prices is caused by economics. That said, I still say there isstill no better tool to use when projecting the future course of stockprices than a basic Elliott wave pattern. The theory works because itpermits enough variation and stretching to allow for a number of different economic scenarios. For example, I might predict that a market advance will occur in two thrusting waves or sections, but there is no wayto know their size or duration; that would depend on the unfoldingeconomic situation. The basic pattern of two waves, however, should
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manifest—not three or four. This is all the projection intends to do—produce a broad outline of what to expect.When you use the Elliott wave theory, you must understand that anypattern projected must remain fluid. The number of Elliott wave variations demands that any pattern projection must be fluid and adjusted asthe real pattern unfolds over time. It is just a broad guideline to projectwith.Let’s begin by trying to determine how the Elliott wave count standsnow. You should always start from some point of high certainty. Thepoint of certainty I use is the 1982 bottom, which ended the 16-year correction and began, in my opinion, the long bull market we have been in.Figure 7.2 shows the S&P 500 since 1980, and I’ve indicated on thechart what I think the count is.The long bull market has been in play off the 1982 bottom now forclose to 20 years. I read the first movement from 1982 to 1984, which fi-
FIGURE 7.2 The hypothetical Elliott wave count on the market as of 2001.These counts must always remain fluid. The count shown indicates that themarket seems to have started into a major, wave 4 correction. I project that wave4 will be lengthy, forming an extended trading range. A final fifth wave (which Icall the final stampede) should follow once wave 4 completes.10,000
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nally broke through the Dow 1,000 barrier, as the first advancing wave(wave 1). Wave 2 was the short, six-month correction through the summer of 1984. Wave 3 carried all the way to the top of 1987, just beforethe crash. Wave 4 was not the 1987 crash—the 1987 crash started wave4. The 1987 crash was the first wave down (the A wave) of a longer-termABC correction, as shown in Figure 7.2. I believe the C wave of thiswave 4 finishes with the recession of 1990.Wave 5 has been in play since 1990; it is an extension. Wave 1 of thisfifth wave is the movement from 1990 to 1993. Wave 2 is simple and isthe correction of 1994. Wave 3 started in 1994, carried on for 6 years,and had extensions of its own. It finished in 2000. Since 2000, the market entered into the fourth-wave correction of the final fifth wave.The Fourth WaveThe stock market has started into a major fourth-wave correction. Although the Elliott wave theory does not directly detail the time length ofits waves (only their patterns), it does address the time length of somemovements under certain situations, particularly wave 4 corrections.One Elliott wave principle that gives some guidance concerning timeis called the rule of alternation. The rule of alternation addresses the correction waves, waves 2 and 4: If wave 2 is simple, wave 4 will be complexor vice versa. In our case, the 1994 wave 2 was very simple. Wave 3 wasthe extension move from 1994 to 2000. The rule of alternation impliesthat wave 4 should probably be complex—composed of a number ofmovements and stretched out in time. I believe that wave 4 will be a special type of correction, which Elliott and other wave theorists call a horizontal triangular correction.R.N. Elliott, in one of his Financial World articles, said the followingabout horizontal triangular corrections: “Triangular corrections are protracted trend hesitations. The main movement may have gone too farand too fast in relation to the slower economic processes, and prices proceed to mark time until the underlying forces catch up.”In a sense this Elliott wave interpretation is just telling us what wealready know about the market, that it has gone through a huge run-up fora long time without any extended correction. The stock marketboom was accompanied by constantly increasing public participation instock investing, ultimately culminating in broad technology and Internetspeculation of 1998 to 2000. The point emphasized here is that Elliott wave
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FIGURE 7.3 R.N. Elliott’s drawing of a fourth wave horizontal triangular correction.Notice that the wave 2 correction is small, so that the whole advance has been avery rapid 123. The market has gotten ahead of itself and now experiences aspecial type of correction beyond the normal ABC type. The horizontal correctionhas five movements in it instead of the normal three (the ABC), which lengthensthe correction. You can see from the shape of the waves that if the correctionlasted long enough it would form a long trading range market.
theory allows for this type of situation by detailing a special type of correction that could follow—a wave 4, horizontal triangular correction. Figure7.3 shows this type of correction, as taken from Elliott’s original diagrams.The Internal Structure of the Fourth WaveThe basic projection is that the market made a major top in 2000 as originally forecasted and has started in on an extended fourth wave correction. That correction will probably be a horizontal triangular correction,with the movements forming the correction being the market swingsthat make up the trading range market.Figure 7.4 shows some of the smaller waves in a fourth wave horizontal triangular correction. As already noted, the whole correction iscomposed of five movements. In my opinion, two or three of thesemovements will be large enough to be classified as bull or bear marketsin their own right. As diagrammed, in a horizontal triangle each one ofthe five movements breaks down into three smaller movements (ABCtype movements).
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FIGURE 7.4. The internal structure of a horizontal triangular correction as Elliottdrew it. Even though it is considered a correction, if each of these movements (1,2, 3, 4, and 5) is large and long enough, they could be considered bull and bearmarkets in their own right. Notice that each of the five movements of thecorrection break down into three submovements of smaller degree.
If this is the projection, then each sell-off (waves 1, 3, and 5) shouldbreak down into two distinct submovements. Likewise, each of the rallies(2 and 4) should break down into two distinct advancing waves. If onlyone advancing or declining wave is visible and obvious, then that wave isnot complete—more is to follow. Of course, certain cutoffs have to be established because this is just a projection; it must remain fluid. Just because I’m expecting a horizontal correction doesn’t mean that the marketwill produce it. Many other patterns and forms of corrections can happen, but of all of them, the horizontal correction seems the most likely.Contracting VolatilityIn Figure 7.4, notice that as the horizontal triangle forms, the up-anddown movements become smaller and smaller. In other words, the triangle becomes narrower as we move to the right. This points to anotherreason I’m expecting that the correction will be of this form: marketvolatility. It has been my experience, that after a speculative run-up likewe saw in the market from 1998 to 2000, with the bubble bursting in the
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technology and Internet sectors, it is usual for stock prices starting withhigh volatility to end a movement with very low volatility.Volatility is a measure of how much prices move up and down—whether they are active or muted. In the two years between 1998 and2000, the market manifested (as measured by the Nasdaq composite) avery high level of volatility, with record percentage changes for the advance immediately followed by record percentage changes in the decline. In a sense it was a huge index blow-off—the opposite of a sellingclimax.Do you remember our discussion of technical analysis and how a climax ends? Prices fall on huge volume and then reverse very quickly, rising on huge volume. This high volatility is soon followed by a market thatbegins to quiet down, eventually becoming almost lifeless. The oppositeof that, huge index blow-off, would produce the same phenomenon, except in reverse. The market would go up, with high volatility, but thenquickly reverse in a large market sell-off. Volatility would remain high fora while, but slowly, after the first sell-off, the subsequent price motionwould slowly die down as the correction carried forward and stabilized.Figure 7.5 shows such a market trend.Once the correction has run its course and the volatility dies, themarket should begin an advance to new highs. Theoretically, the blowoff is not the end of the whole move but a huge thrust that needs a majorcorrection before prices can resume their upward march.What all this means is that in the near future the stock market shouldbecome very boring. I don’t like to put it that way, but there really is noother way to say it. During this period, investors will start looking aroundfor alternative strategies in an effort to continue to increase their money.It is during this boring period that smart investors should start gettingthemselves ready for the final stampede—the final wave 5.The Time Scale of the Trading Range PeriodFigure 7.5 displays a schematic of the decreasing volatility that I’m expecting in the market. It should be a market where most investors become bored and disenchanted with stocks. They will be hoping for areturn of the good old speculative days, but that won’t happen. They willlook for excitement and get inactivity. How long should this tradingrange market last? This is a very difficult question to answer.In January 2000, I projected that the trading range would last fromtwo to four years. Back then, however, the correction hadn’t even started
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FIGURE 7.5 A schematic of the type of market to expect from the Nasdaqcomposite if it goes through a horizontal correction. As it is forming such apattern, the volatility of prices should contract like the coiling of a spring.
yet, so it was difficult to formulate a reliable answer to the how-longquestion since the way the correction would unfold was much less clear.Now that a major correction seems to have started, the form of the correction is easier to see and a time length easier to predict. A possibleguide is provided by considering the first 6 years of the 16-year (1966 to1982), trading range market.The long post-WWII bull market started in 1949, going all the way to1968 where it ended in a speculative flurry similar to but much less intense than the recent one. A number of indexes showed that the subsequent correction starting in 1968 carried forward for six years, ending in1974. Therefore, I think that a reasonable projection for the length of thecoming trading range market is 5 to 7 years. It would be normal for atrading range market of 5 to 7 years to follow a long bull market that haslasted, by many accounts, 18 years.
THE ECONOMIC “WHY”In the model presented in Chapter 2, the long-term movement in stockprices should reflect the changing economic picture. There is the fairvalue term that depends only on fundamentals—dividends and interestrates. It is only during price movements that last less than 9 months thattechnical considerations and market instabilities can dominate and the
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economic picture be set aside. If a trading range market is to last from 5to 7 years, there must be an economic reason for it, an economic or investment story behind such an occurrence.Simply put, the stock market has gotten way ahead of itself in itsspeculation phase, and the implied economic growth that these highprices require will not be realized during the next 10 years. We will haveeconomic growth, but it will be far less than is implied by current prices.Let’s look at current prices and what they imply.To start, let’s see what our stacking-the-money theory for fair valuecan illuminate. Consider an important financial ratio, the dividend yieldfor stocks, which is calculated by dividing dividends from the last 12months by price. The result is the yield on stocks, a comparable financialnumber in the stock market to yields on bonds. As shown in Figure 7.6,the current dividend rate on the S&P 500 is 1.3%—the lowest reading inhistory. But what does this dividend yield for stocks mean?Figure 7.7 is from chapter 3, where this idea was more fully explained. It shows, using the fair-value theory of stacking the money, howand why a low dividend yield (or the same thing—a high PE ratio) implies that Wall Street is expecting very high levels of growth in earningsand dividends.The low dividend yields result because the present dividend is tinycompared to the high stack (price) of all those huge expected dividends.In other words, the current price of stocks is built on a very high—in fact,a record high—expectation of earnings and dividends growth. If thisgrowth doesn’t materialize, we will know that current prices were toohigh and the expectations too extreme, and a major readjustment willoccur.We can do a very quick calculation to see what the current PE ratioof the S&P 500 is implying as far as expected earnings and dividendgrowth. In December 2001, the PE ratio of the S&P 500 was 31. The 10year treasury interest rate is 5%. From a well-known formula based onstacking the money, the current price of the S&P 500 is therefore implying an expected growth rate of 13% per year over the next 7 to 10years. If growth comes in at this high rate, stocks will have been fairlypriced. Thirteen percent is a pretty high rate of growth to achieve.Let’s be very clear: We can have very good continued earnings anddividend growth and still have a major market adjustment. Currentprices allow for almost no disappointment of any kind, and if anything
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FIGURE 7.6 Current dividend rates on the S&P 500. At any given moment, thedividend yield represents Wall Street’s expectations for earnings and dividendgrowth. The current ratio implies the highest expected growth in earnings anddividends in many years.
FIGURE 7.7 A low dividend yield implies that Wall Street is expecting highdividend (and earnings) growth in the future. The expectation of future growthallows investors to accept the low dividend yield today. If confidence in theexpected growth were ever shaken, a major price readjustment would occur.
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less than record-breaking numbers appear, there will be disappointment.In the speculative phase of the market, prices got ahead of themselves,and sooner or later, we must pay the piper. Growth can occur for only solong and expectations can rise to the moon, but eventually the price ofstock must be rooted in a fundamental basis (namely, D/I).Unfortunately, it always takes a while for investors to finally recognize that this is the new economic paradigm. It’s not as if someone ringsa bell and suddenly everyone recognizes what is happening. Usually, aconsistent erosion of expectation dashes the resurgences of hope alongthe way. When that happens enough times, there is a sudden change inthinking and reluctant but widespread acceptance that a less-than-rosyperiod has emerged. In today’s market, by the time that happens, we’llbe well into the major correction I’m predicting.
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Overvalued, Undervalued
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One of the errors I hear continually on Wall Street is the misuse of theterms overvalued and undervalued. People often say that stocks areovervalued or undervalued. When asked why they have that opinion,they usually refer to some ratio based on either the PE ratio or the dividend yield. I have no argument with looking at these ratios, but I do havea quarrel with associating these ratios with the terms overvalued andundervalued.For one thing, these are very powerful words. The word overvaluedimplies that the current price of a stock is higher than its true worth. Noone wants to be a sucker and pay more than something is worth, yet noone really knows exactly what something is worth. These ratios do notmeasure whether stocks are undervalued or overvalued; the PE ratioand dividend yields measure Wall Street’s expectation for the futuregrowth of earnings and dividends.For example, a record high PE ratio (low dividend yield) doesn’tmean that stocks are overvalued. It only means that Wall Street’s expectation for the growth of earnings and dividends over the next 5 or 6years is extremely high. If, after 5 years, earnings and dividends do growat the implied rate, then and only then can we look back and say thatprices were fairly valued. If over the next 5 years, earnings and dividends grow at less than the implied rate, then and only then can we saythat prices were overvalued. Only if earnings and dividends grow at
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more than the implied rate can we look back and say that prices were actually undervalued.I think we will find during the next 6 years that the earnings and dividends that this American economy can produce will grow at a lower ratethan prices are implying (through their dividend yields and PE ratios).That will be the reason the market ultimately forms and experiences atrading range market. In hindsight it will become clear that stock pricesjust got too far ahead of themselves during the speculative phase of an investment cycle.
THE FINAL STAMPEDEA careful look at Figure 7.2 shows that, according to my interpretation ofthe Elliott wave count, a final fifth advancing wave should follow thefourth wave (trading range) correction. This fifth wave should not be aminor Elliott wave movement but a bull market of considerable proportions. Since it is theoretically the final wave of the movement that startedin 1982, I call it the final stampede.At this time there is no way of using the Elliott wave theory to makea realistic projection about its character or nature. The only relevantcomment concerning the character and form of a fifth wave movementthat follows a horizontal correction is the following quote from TheWorks of R.N. Elliott.At the conclusion of a horizontal triangle, the market will resume thetrend that was interrupted by the triangle, and the direction of thattrend will be the same as that of triangular wave 2. The “break-out”from the horizontal triangle (in the direction of triangular wave 2) willusually be fast and represent the final wave of the main movement, andbe followed by reversal of the trend. The extent of the “break-out” willusually approximate the distance between the widest parts of the triangle. The diagrams [shown here] illustrate the “break-out” from horizontal triangles.
Therefore, according to Elliott, once the horizontal correction isover, the subsequent breakout (the final fifth wave) should be very fast.It also should go to new high prices, above previous highs, equal to thesize of the price range during the correction.
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I honestly don’t give much credence to a projection like this. For meit is too far out and too theoretical; it isn’t yet clear that the correctionwill be a horizontal one! The final fifth wave could be as short as 3 yearsor as long as 10. The economic picture will have to be considered verycarefully at that time to evaluate what form and structure the final fifthwave may take, but that is a problem for a later day.
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his chapter focuses on strategies intended primarily for an extended trading range market.
CautionWe will now look at several investment strategies based on backtesting, that is, taking historical numbers and testing how a contemporary strategy would have done in the past. In back-testing astrategy, you assume that today’s investment vehicles were availablein the past and that the results of these studies were possible. For thepurpose of the study, I assumed that we could have used the sameindex mutual funds, spiders, and today’s low commissions and narrow spreads (the difference between the bid and ask price), eventhough they were not available then. There is no implication thatanyone actually achieved these results or could have during the period of the study, these are simply theoretical calculations based oncertain assumptions. The hope is that if these strategies might haveproduced a positive result during the last sideways period, they maybe useful in the next.
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As I’ve already indicated, in coming years I’m expecting bull marketslasting from 1 to 2 years and encompassing 30% to 40% rises; these willbe followed by bear markets lasting 9 months to a year and decliningfrom 20% to 25%. There will be considerable up-and-down motion butlittle overall gain. It might seem strange to try to earn superior returns ifstock prices are essentially in a back-and-forth trading range. One obvious strategy is to try to buy at the bottom of the range and sell near thetop, but this, of course, depends on whether an investor can actually dothis.The last time the market experienced a long sideways trading rangewas from 1966 to 1982. The Dow Jones industrials hit 1,000 in 1966 andbounced between 700 and 1,000, making little progress for 16 years. Although I’m not expecting a sideways market so severe, this often-ignoredperiod can provide us with fertile ground for testing various strategiesthat might work well during another trading range market.No two markets are ever the same. We will assume, however, thatthe three feedback loops in the stock market model have created manyrecurring patterns and events over many market cycles. These similarpatterns might show up and be measurable if the market is approachedand studied in certain ways. This means that, although the economic picture is not anything like the 1970s, the forces that drive the feedbackloops—human emotion and reaction—are still the same today as theywere back then. We are looking for how this similarity manifests in stockprice movements. This chapter presents strategies, back-tested from1966 to 1982, that may be useful in the future.
TWO APPROACHES TO MARKET TIMINGThere are two general approaches to market timing (Figure 8.1). Thefirst approach tries to find the exact top or bottom of a price movement.It employs contrary opinion, interest rates, divergences, sector analysis,and price patterns to pinpoint the market top and bottom as closely aspossible, though reaching the Holy Grail of consistently finding the exacttop or bottom is obviously very difficult.The second approach to market timing doesn’t try to find tops or bottoms, but instead attempts to locate the moment when a new price trendhas established itself. It uses indicators that give signals after a top or bottom has been made. The idea is to let the market make top or bottom
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FIGURE 8.1 There are two categories of market indicators, defined by what theindicator is intending to accomplish. Some indicators try to locate exact tops andbottoms. The others try to identify and confirm a new price trend. When used inthe same time domain, these two categories almost always contradict eachother.
Two Categories of Technical ToolsType 1 – Defines when a new trendhas startedType 2 – Locates transition points(tops and bottoms)
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and then look for indications that the market has started a new pricetrend.You can usually classify an indicator into one of these two approaches. The first approach truly tries to predict the future. The finalresult is something like, “The indicators strongly predict that the marketwill stop going down now and start going up.” The second approach,rather than being predictive, confirms that a move has begun. Quiteoften, this confirming approach is characterized by the measurement ofa cutoff, meaning that prices have gone to a certain point that now provesthe trend has reversed and conditions have changed. This type of indicator could be a major price index breaking a trendline, the confirmationof two important indices breaking two similar trendlines, prices risingabove an established fixed percent, or a moving average turning up ordown.
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The Strongest Market SignalThe two approaches to market timing—predictive and confirming—almost always give conflicting signals when analyzing movements of the same time domain. That is okay because they are usedfor different purposes and have different goals. If contrary opinionsays that the market has reached bottom over the intermediateterm, the other approach—trending indicators for the intermediateterm—almost always indicates that the trend is still down.This is normal. Why? Because it is normal that investors becomevery bearish (furnishing us with buy signals using contrary opinion)as prices are plummeting and at their low. The large price dropmakes the trend indicators point down, but the predictive indicatorsare showing that the end of the decline has been reached andhigher prices are ahead.However, there are times when the two approaches do not giveconflicting signals, and these are very important to note. When predictive indicators such as contrary opinion strongly indicate higherprices, and the confirming indicators have already confirmed thestart of a slight uptrend, that is the strongest buy signal there is.There is nothing more reliable or important than when this unusualsituation happens.Why is this so? It is expected that, as prices move up, more andmore investors will become bullish. When, however, the bearish sentiment stays high or even moves higher as prices also move higher,that is not expected, and so it is the sign of a very strong stock market. At these moments, what is happening is that no one believes theupward price movement is real or that it will last. This skepticism isthe fuel needed to keep the movement going, usually for some time.The same holds true when both categories of indicators are confirming that prices are declining. If contrary opinion is extremelybullish and stock prices have already started down, so much so thattrend-following indicators are confirming the downtrend, there is nomore reliable or important sell indicator.
For example, back in the 1970s and early 1980s, the most reliableconfirmation of a new upward trend was when the advance-decline linerallied very strongly for 10 days. Here is what would happen: The mar-
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ket would look extremely weak after going through an intermediate decline. Then, seemingly out of nowhere and for no apparent reason, priceswould stage a violent rally. The rally would go straight up for about 10days with phenomenal breadth. Many investors, caught off guard andseeing the market apparently getting overbought, would wait for a pullback to buy. But the pullback seldom came. When this situation occurred, the best strategy was to simply buy into the overbought market,assuming that the rally was so strong any sell-off would be mild and temporary and the move would immediately carry forward. This strong initial showing in the advance-decline line was almost always confirmationthat the bottom had been made and that a new uptrend—likely to last forat least 6 months—had been established.There are three reasons that market technicians often espouse different opinions about the market. The first is that one technician is looking for an exact top and bottom while another is looking at the markettrend. The second is that they may be talking about two different timedomains, as mentioned in Chapter 2; the short-term trend may be upwhile the long-term trend is down. The third reason is simply that theymay truly have different opinions.Which Approach Is Best?I personally prefer the approach of the predicting indicators; I like thechallenge it presents and it suits my personality better. In truth, however,both predicting and confirming indicators are needed, and they areequally important. Let me show you why. Suppose that predictive indicators strongly show that the market is ready to start a major uptrend inprices. As an investor, you can do two things.