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The Correction Continues!

The stock market does not move in a random manner. It progresses in an intricate, but orderly process which is part of a universal rhythm including cycles, Fibonacci relationships, and fractal structural patterns. A few years ago, the Chaos Theory and the study of Dissipative/Replicative structures provided a greater understanding of the complex order in our physical universe which affects all of its aspects from the behavior of the smallest particles to giant galaxies.

In the 1920's and 30's, R.N. Elliott observed an orderly, repetitive, fractal process in the stock market which was governed by Fibonacci relationships, and in 1938, "The Wave Principle" was published. While there are severe limitations in applying this theory as an analytical tool, mostly because of individual interpretation, it can still provide some important clues about the behavior of the stock market.

The basic premise of the theory is that "the universe is ruled by law" and "The stock market exhibits the wave impulse common to all social-economic activity...It has its law, just as is true of all other things in the universe." Moves occur in repetitive patterns of 3 waves and 5 waves patterns, or a combination of the two, and this happens in an apparently infinite succession of "degrees", from very small to very large. That this is the case cannot be disputed and can be readily observed on one minute charts as well as on monthly charts where, when you put the two charts of comparable scales side by side without knowing which is which, you will not be able to tell them apart. The trick is to analyze the current pattern correctly in order to determine what this implies for the next pattern. The structural patterns are caused by a combination of cycles of various periodicity and Fibonacci relationships, both causing a reversal of price trends when completed.

Elliott did not include a study of cycles in his theory, perhaps assuming that they would show up in the structure itself. I believe that this was an important oversight, since cycles have predictive value and can be helpful timing tools. Robert Prechter, probably today's best known exponent of the Elliott Wave Theory, interpreted the market decline which started on 12/02/02 as the beginning of a massive wave III down. Had he realized that a 12-year cycle had just made its low in October, and that the beginning weakness was probably the bottoming process of the 120-week cycle, he might not have made that call.

That said, can we derive some benefits from the Elliott Wave Theory in interpreting today's market action?

Very definitely! The structural pattern which is developing currently still appears to be a corrective wave and not the beginning of a major reversal. So far, this looks like a 3-wave pattern with an incomplete 3rd wave. The pattern also suggests that a slightly lower low is likely. The daily stochastics oscillator is oversold and trying to turn up, while the daily MACD is beginning to show signs of positive divergence. Other positives this past week was that the DJ transportation index did not confirm the DJ industrial's break below it's 3/24 low, and that the breath indicators have stabilized.

How long this correction will last will very much depend on the cycles which are causing it. There are two potential sources of intermediate market weakness at this time. The most probable is the topping out of the 120-week cycle which has, in the past, done so in two distinct phases of approximately 60 weeks each, causing a low point approximately half-way through its total phase. If this is what is happening, then the current correction will soon come to an end and another short term up trend will begin which could even take prices to new highs for this move. It will be extremely important to gauge the market action after the current pattern is completed to determine if we are extending the long term up trend, extending the correction, or making a more significant top.

The second probability is that this is the bottoming action of the 10-year cycle. This could cause a more lengthy correction, although, as pointed out last week, this cycle has historically had an inconsistent effect on the market.

And then, there is a third and more serious possibility: the 4-year cycle is currently topping out and will cause a decline into its next low around October 2006. This is only a remote possibility at this time since market action does not yet suggest that this is taking place. But it must be kept in the back of our minds.

Because the very long term market action is primarily influenced by the 40-year cycle which is scheduled to make its low around 2014 (that cycle caused severe economic conditions on the early 1930s and again in 1974) as well as by the Kondratieff Wave which, according to Ian Gordon who is the editor of "The Long Wave Analyst" and one of today's recognized experts on this important cycle, is scheduled to make its low around 2010, one cannot feel very secure about the longer term prospects for the stock market. The decline into 2002 corrected many economic imbalances, but not all. And some have grown to even larger proportions since then. So it would appear that the worse is still ahead of us.

It is well known that economic fundamentals alone have consistently proven to be inadequate tools for market timing. The fundamental bears who are preaching gloom and doom will have to wait until the market is ready to accommodate their dire prognostications. By the same token, the fundamentalist bulls predicting an on-going bull market will also, at some point, be proven wrong long before they recognize that their prediction is no longer valid.

History seems to suggest that economic conditions are very much tied to major cycles. When these are in an up trend, the economy is good, and when they are in a down trend, then the economy suffers. The larger the cycle, the greater the suffering. This is why the 40-year cycle due to make its low about 2014 should raise all sorts of economic red flags. It was responsible for the depression of the early 30's, and the severe recession of 1974. What economic impact it will have this time around is anyone's guess, but it will not be positive.

However, we should not expect an immediate collapse of the economy and stock prices. This process might be delayed for a few more years, and the fractal nature of the stock market will probably give us a series of mini bull and bear markets until the cave bear finally comes out of its den and takes control. The market peaked in 1929, 5 years before the bottom of the 40-year cycle. It also made its recovery high in early 1973, just before the 40-year cycle bottomed. What is different, this time, is that the Kondratieff Wave is scheduled to make its low at about the same time as the major cycle, a condition which did not exist in 1934 and 1974. It is unclear what economic consequences this double whammy will have.

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