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Surfing the Indian Stock Markets with Elliot Wave Principle

Since early March of 2009, Indian stock markets have rebounded dramatically from the depths of Oct 2008. The present rally caught the attention because of its length and durability. Stocks rallied more than 30% from the lows and the much anticipated market correction didn’t happen. So, it was perceived that the bear market has ended and a new structural bull market is making its roots. However the global and domestic economic conditions continued to decline sharply in terms of exports and industrial production numbers. Till date there have been no signs of recovery in economy or corporate earnings. 
On May 16, 2009 the much awaited results of the general elections came out and to everybody’s surprise the Congress-led UPA government came back to power. There was anticipation that a stable pro-reforms government would solve all the evils and revive the economy soon. History was created on Dalal Street on May 18 2009, when the Sensex witnessed an unprecedented rise of more than 2000 points. There was a mad rush to buy the stocks as if there was no tomorrow left. Everybody argued that this is a complete game changer and now we are already in a new structural bull market. This is a clear evidence of mass ‘irrational exuberance’ as nothing can be changed in a day. Looking at the previous five-year bull market and the subsequent downfall, the Elliott wave principle gives an impression of a strong bear market rally, as this rally was not backed by any fundamental economic indicators but only by the irrational behavior of the masses in the Indian stock market.  
Elliott Wave Principle
Elliott contends that the irrational or crowd behavior trend can be found in the price trends of the stock markets and that the pattern is repetitive in nature. Markets are made of emotions and they are influenced by the irrational behavior of masses. Collective investor’s mass psychology swings from over-optimism to over-pessimism and back is the cause for peaks and bottoms in the market. The overriding forces for all markets, at all times, are psychological forces.
Elliott wave theory is based on the wave pattern-comprising of five upward bull pattern- and three downward bear pattern. The upward bull cycle comprising of three impulse waves, which give the upward direction and each of which followed is by two corrective waves. The bear phase comprises of two downward impulse waves and in between those two, one upward correcting wave intervening the bear trend. The timing and magnitude of these waves can be estimated using the Fibonacci sequence and golden ratios.
Every market movement represents the sum total of individual emotional instability and is ninety percent driven by emotions and psychology of masses. The remaining ten percent is driven by unforeseen risks which we call ‘Black Swan’ risk. Going by the basic patterns, trends and applying Fibonacci ratios, we can have maximum and minimum probable extensions to achieve the highest probability in predicting the movements.
 Figure 1: The basic wave patterns
Basic wave pattern

Source: Elliott wave international
Genesis of the present wave in India (Sensex)
The Present Wave cycle of bull and bear market has its roots of investor’s perception that prevailed in the post 9/11 attack in 2001. After completing one wave cycle comprising of the tech bull market (1998-2000) and a subsequent bear market (2000-2001), markets made its 10 year bottom. The only thing prevailed at that time was extreme pessimism and bearish perception. Even markets recovered and tried to scale new highs, but failed to sustain as the prevalent mass perception was hugely bearish. In fact, this negative bias and extreme pessimism of 2001-2002 gave way to the other extreme.      
A bull market will always start at the extreme end of pessimism. Because of the high extremes reversal are always drastic and surprising. The inflection point came in April 2003 and the market started booming defying the Iraq war reports and depressing guidelines from IT companies.
Figure 2: Present wave in Indian stock market (Sensex)

Source: BSE India
Surprising Wave 1: (3000-6000 a 100% rise)   
From April 2003, Sensex started rising negating the bearish bias prevalent at that time. There was a note of caution about the upward trend because of the three year long drawn memories of the tech crash. But the trend kept on moving upward, changing the perception of the people. The first impulse wave was a 100% increase from 3000 to 6000 completing the first leg of the bull market. That almost went above the previous tech boom levels making it a strong move. It took less than eight months to cover the ground it lost in three years.   
Suspicion Wave 2: (6000-4200 a 61.8% correction)
Wave 2 can be the first testing time for the anticipated long structural bull market as everyone was skeptical about the previous long surprise move of Wave 1. These testing events could be political, social or economical. Normally wave 2 should not retrace more than 61.8% (golden ratio). For Sensex the test came in the form of political risk in May 2004, when the congress party formed their government with the support of left parties. The market corrected nearly 61.8% to reach 4200. Everybody was scared and believed that the bear market got its grip. Again this quickly built up bearish sentiment only gave way for upward impulse wave 3.
Dominant Wave 3 (4200-12500 1.618 times the previous move)
Wave 3 is usually the largest and most powerful in the entire bull trend. Bullish anticipation psychology of people during the first wave period started yielding in this period by giving positive economic and corporate news. Indian economic growth numbers reached more than 7% and corporate earnings surprised everyone registering growth above expectations. The bullish trend was firmly enriched in the people’s mind. Sensex reached the new price territory of above 7000, which relived the previous tensions and misbelieves of people about this bull market. Rising prices and bullish perception dragged the attention of new people and new money started to flow into the market. During this period India registered the highest number of FIIs. Subsequently, the RBI stated easing the restriction on the capital inflows. This created money supply in the Indian financial system which in turn gave the stimulation to the economy as well as the stock prices. The Sensex reached a level of 12500, 1.618(again a golden ratio) times the previous impulse move of wave 1.
Typical Wave 4 (12500-8900 25% retracement)
As bullish trend was firmly established in people’s mind, wave 4 becomes the corrective one and second test for this bull trend. It typically retraces less than 38.5% (another golden ratio) of wave 3. The Sensex retraced to 8900 taking this as breather to the long bull market. Nobody was scared or suspected this bearish trend like in the earlier corrective wave 2.        
Crazy Wave 5 (9000-21000)
The previous setbacks of wave 2 and wave 4 completely relieved the fears of bear market, and everyone was of the belief that the bull trend will stay for ever. Companies started giving above-expected results and extremely optimistic earnings guidance. News turned out to be positive for markets and a crazy bullishness built up in the market. M&A activity reached its peak level creating a huge leverage and lot of companies came out with high priced IPO’s. This optimism brought new prospective investors into the market, from housewives to farmers and students to panwalas everybody was taking about stock markets and its predictions. Everyday, prices reached new highs and fortunes were created within a short span of time, making a crazy belief that the stock market is the only place to make money. Usually the fifth wave would be anywhere between 1 to 1.618 times the original move that would be around 18000-23550. But the Sensex cracked at around 21000 from Jan 2008.
Unusual Wave A:
Extreme bullish perception and over-optimism gave a reversal to the five year long bull market. The inflection point came as the much hyped IPO’s of Reliance Power and Future Capital nosedived. The fall came as a surprise because the perceptions of fundamental economic conditions and corporate earnings were bullish. Everyone thought it to be a usual correction and the bull market will resume soon. Negating the positive news of the financial situation, the market kept on moving downward and fell more than 30% from the peak. Generally negative news comes at this stage which would change the perception of the people and create panic among them. It came as real economic concerns of global credit crunch, which originated in the US, spread across the globe. This directed the process of de-leveraging, sucking out the liquidity in the financial system and eventually leading to the fundamental economic concerns in terms of global recession. The fall of large well established American investment banks washed-out business confidence and the internal bearish economic conditions created exhaustive panic selling, which took the Sensex to 9000.
Ongoing wave B: A breath taking rally
Having fallen so drastically from the top within a year and looking at the valuations, everybody felt that it is overdone and the bear market has finally ended. But the economic conditions did not show any improvement; in fact, they continued to deteriorate and all the economic indicators showing negative signs. But the market started moving upward from March 09 breaking all the technical levels. The present rise is perceived as the beginning for another strong structural bull market, and everybody’s perceptions changed that the economic conditions will improve from now onwards. Everyone turned bullish and the markets crazily going up and up. Technical Analysts jumped to say that we are already in new a structural bull market.
However, the wave principle says the other way round; the time taken for the bull trend and bear trend in complete wave cycle should follow a Fibonacci series and the ratio between them is the Golden Ratio. We had a bull market for five years (2003-2008) and this will follow a bear trend for a period of three years (5*61.8%), may be for 2008-2010. So, we may not going to see any fresh bull market till the end of 2010, and if any upward move comes, that should be seen as a corrective one in the whole downward trend.
Going by the daily technical analysis indicators, the markets have shown a good recovery breaking all the trend lines pointing towards a bullish trend. But the wave principle says that “Markets will be technically at their strongest after a sharp decline and technically at their weakest after a sharp advance”.
 If we do go by the conviction that the new government really makes drastic economic changes that will not take markets to new bull market, as the GDP theory says that there is no correlation between stock market returns and GDP growth rate. Historically, it is proven that strong economic conditions will not drive the stock market. Only people’s extreme perceptions and money supply will drive the stock markets.
Looking at the above reasons, it clearly shows that the present rally is a corrective bear market rally and  the Sensex has the clear strength to go up to 16500 (61.8% of wave A).              
The upcoming Wave C: Devastating one 
Bear markets find its bottom at the extreme pessimism of people and crazy perceptions that markets are not going to rebound and the trend will continue forever. That much of crazy behavior was not seen at the previous bottom instead everybody expected a new bull market. This means there is still air left in the optimism bubble created by the previous bull market. At the end of Wave B, fundamentals will not improve according to the peoples perceptions like in the previous bull market. That creates a suspicion among people about the sustainability of the short-term rally. Any strong negative news or any breakouts in the trend lines in Wave B will create a panic among the people leading to massive sell-off with the same psychology of people as we had seen at the time of wave 3 and 5 of the bullish trend, but with negative bias. The panic gets bigger and bigger; people go crazy in selling, hammering down Sensex below the previous bottom of Wave A. People believe that the downward trend is going to stay of forever; when the pessimism trend acceleration is huge, we will have a bottom (a top in the bear market) completing one full wave cycle.
The time taken to complete this entire bear cycle would be three years from the end of the previous bull market. However, the current upward trend to sustain and take us to another long standing bull market, it needs to cross over the previous high of 21000 in one leg by reversing the entire pessimism. This can be possible only when we get strong sustainable positive news which can change the entire bearish trend. But, the probability of such a thing happening is very less.
 Seeing the long-term bearish view staying out of this market is not recommended, instead investors should capitalize on the highly probable movements using different strategies for the changing trends. And be prepare for another big wave with a long standing bull market, which is going to start may be after 2010, having more magnitude than the previous bull market and lasting for about eight years (Fibonacci series number). 

Bhaskar Mutyala