One day the equity bears will be proved correct and we will get the long awaited correction. But has anyone really thought what the decline will look like? Or do you plan to react to it as it unfolds?
Reacting may seem like the only option, but a word of warning: when equities correct the 2009 bull market the majority of traders will lose money. There will be a lot of false bottoms, vicious short squeezes and eye watering drops. Even the bears will probably miss the good old days when the markets were a little more safe and predictable.
No-one can say for sure what the correction will look like, but it is possible to have reasonable expectations based on historical precedence and cycles. Should we all build bunkers and buy ammunition (I have read comments from investors doing exactly this), or should we buy the first 100 point S&P500 dip and keep adding on further declines?
As with many of my articles, I use Elliott Wave to identify and label the stages of trends, and fractal theory to provide a guide to what future price action may look like. A quick guide on Elliott Wave can be found here, and there are free resources on the web for further reading.
Correcting the trend
An expectation for any correction is a break in the trend channel. This will confirm the bull market (or at least this part of it) from the 2009 lows is over.
The S&P500 (SPY) has a well defined channel currently around 2000. I'll be out of longs way before we reach this point (I have a 2370-2400 target), but when the correction gets underway, it is important to know where the channel is. The expectation is for a bounce, but only to set up the eventual break.
Another expectation is for the correction to be larger than either wave 2 (the 2011 drop) or wave 4 (the 2015-2016 drop). Since wave 4 is the smaller of the two, we would therefore expect a minimum correction of 326 points.
Hardly anything too scary, but this is only a guide for the minimum. What is the maximum?!
To answer that question we need to know where we are in the long term trend.
The Grand Supercycle
The Grand Supercycle 'is the longest period, or wave, in the growth of a financial market as described by the Elliott Wave Principle, originally discovered and formulated by Ralph Nelson Elliott.' It is broken into 5 smaller waves, each called a supercycle.
There are different theories as to when the grand supercycle started and what position today's market is in the trend. Some websites sell equity data going all the way back to 1693, and using this data we could say the south sea bubble was the end of the first wave.
What is for sure is the 1929 crash was hugely significant and we started a new wave at the 1932 low.
Whether or not to include data from the south sea bubble is currently not important; what we need to know is when or where the 1932 trend is likely to complete. The correction of this cycle will dwarf previous declines this century and spell global disaster. Equity bears should be careful what they wish for.
So the important question to answer now is: will the completion of the 2009 rally also complete the cycle starting in 1932, or could we expect higher?
The 1932 supercycle
Given the time span and percentage change in the Dow Jones Industrial Average (DIA) since 1932, there is a surprisingly clean trend, with everything you would expect from an Elliott Wave trend sequence:
- Waves (NYSE:I) and (NASDAQ:III) are equal in size, each with a +2400% rise
- Wave is the most aggressive and powerful
- Waves and are clearly contained within channels
- Waves and are clearly subdivided into 5 smaller waves
This all makes it likely that we are currently in wave (NYSE:V), the last in the sequence.
It is interesting to compare the chart above to the first chart of the S&P500. It doesn't matter how long the duration, the same stages of the trend are present.
This fractal repetition gives us added confidence that we are indeed in wave in the 1932 supercycle.
However, it is clearly much smaller than the waves preceding it, which both spanned 2400% and many decades. The expectation is for each wave to be proportional in time and size, and the current wave is nowhere near. Therefore it is very likely that the current 7 year rally from the 2009 lows is only the beginning. When the rally completes it will constitute the first wave (wave I) in a large 5 wave sequence spanning decades.
In other words, the next correction (wave II) is not going to be a 1929 style crash. It may be sharp and feel like the world is ending, but it is only clearing the way for another rally and prices will not go below the 2009 low.
So far we have a minimum correction of 326 points, and a maximum correction taking us to the 2009 lows. I'm not sure about you, but I look for a bit more accuracy.
Unfortunately we cannot deal in absolutes, only probabilities. The most probable size for a wave II retrace is 61.8% of wave I. Let's say the S&P500 does in fact turn at the 2370 target, a 61.8% Fibonacci retrace would therefore take us to 1317. Quite a drop by any stretch of the imagination.
Again we can look at historical precedents, and what happened in similar positions in the trend. The fractal nature of the markets gives us plenty of examples, but perhaps the closest in terms of structure is shown below.
The final stages of the great 1945-1968 rally can provide a guide to the final stages of the current rally. It supports the idea already presented; the correction will eventually retrace 61.8% of the rally from the 2009 lows, and this retrace will be followed by a large rally.
This is my expectation. I'd be interested to hear yours in the comments section.
When the rally from the 2009 lows eventually completes we will be faced with many difficult decisions. The narrative will be scary and we will have to stay focused during irrational price moves.
I don't plan on moving into a bunker with a stash of gold and ammunition. Nor do I plan on responding to every short term reversal and media headline. Whatever shape or form the correction takes, the market will have done something similar before. History doesn't repeat itself, but it often rhymes.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.