- 1997: Volume 6, No. 6 International Corner: Targeting Reversal Points in the U.K. Equity Market

Forecasting future movements in financial markets, using technical analysis, can involve a number of different approaches. One way is by the use of techniques that follow the trend of the market. This might involve a simple moving average system or perhaps drawing channels, which contain past price action, in the hope that this trend will continue into the future. Another method involves the recognition of commonly recurring price patterns, such as flags, triangles, head and shoulder tops and bottoms, drift patterns etc that lead to some predictable future move in the market once the formation is complete.

Because price patterns such as these occur quite often across a wide range of financial markets, it can be implied that markets are, in essence, cyclical. As such, a third area of technical analysis involves methods that attempt to identify the dominant cycles in a market, both short- and long-term.

Although all of these different approaches have merit, it is important to realize that their effectiveness depends crucially on the nature of the market, when it is analized. For example, using trend following techniques in a market that is moving sideways is of little use. Likewise, trying to predict tops in a market using cycles can be a notoriously difficult and frustrating exercise since topping formations, very often, can take a long time to form.

One theory that attempts to provide an all encompassing explanation of financial market behavior is the Elliott Wave. Although this approach is not new, having first been discovered over 50 years ago, it had a new lease on life in the 1980s when its chief proponent used it with great success to anticipate well in advance the bull market of that decade. Since then, it has fallen from grace, perhaps because it is difficult to interpret and as such can be used to justify almost any future scenario that is desired. Nevertheless, if used thoughtfully, it can be of great use, particularly in targeting potential reversal points in a market. This article looks at this theory, as applied to the U.K. stock market, and shows how it was used to anticipate, in advance, the sharp correction that took place in October of this year.

The basic principle, as is widely known, is that prices trace out sequences of five moves, in the direction of the main trend with countertrend moves occurring in three waves. Since this basic principle is assumed to apply to whatever timeframe is under consideration, with smaller degree price movements, be they hourly, daily etc., forming part of larger price patterns, this can lead to a good deal of uncertainty as to interpretation. It is often best to begin counting from a previous important low or high. The chart in figure one shows the long-term progression of the FTSE-100 Index since the beginning of 1990. On it is labeled the best interpretation of the market, in terms of the Elliott Wave, following the important Gulf War low in late 1990. As can be seen, there is a clear five wave advance in prices, from this point, which should be followed by a decline which corrects this move. Although this structure seems relatively clear, even with the simplest patterns there are, very often, other ways to interpret past moves which may imply a completely different future outcome. For example, why couldn't the extended advance from 1994 be part of a third wave, which are often the strongest of the three impulse waves in a five wave structure. After all, in terms of points travelled, this move is clearly the largest.

Figure 1

Often, when helping to decide between different alternatives, it is important to consider the status of supporting indicators. Not only do third waves often travel the furthest distance, but almost always they are technically the strongest. In the stockmarket, this means that they will display participation across a broad range of individual shares.

The chart in figure two shows the behaviour of the advance/decline line over the same time period. On it is highlighted its performance during each of the three impulse moves. As should be clear, the strongest move in this measure took place between late 1992 and year-end 1993. This strongly suggests that the third wave, on the FTSE-100 Index, was in progress during this time period. In fact, the most recent peak in the advance/decline line occurred in the middle of 1996. This means that the supposedly large rise in the stock market this year has almost entirely been confined to the blue chip stocks.

Figure 2

Once it became probable that the market was in the final impulse move, the crucial question was at what level would it terminate? Very often, in a five wave sequence, there is a price relationship between the three impulse moves. When the fifth wave is extended, in both price and time, as is the case here, then the most common relationship is that the fifth move will be equal in length to the net travel from the beginning of the first wave to the end of the third wave. Slightly complicating the issue is that there are two possible points to measure from. The first is the price low in the FTSE-100 Index at 2845, in June of 1994. The second uses the 2959 low, in early March of 1995, which is when the advance/ decline line made its low and as such represents the point when the downward pressure on the market ended. Putting all this together, the index rose just over 79 percent (3539/ 1974) from the beginning of wave one to the end of wave three. If we add this percentage move onto the two possible measuring points, detailed above, the target level for the possible ending of wave five is either 5100 or 5305. This same analysis allowed me to postulate, several weeks in advance, that this area was highly likely to provide strong resistance for the index, which enabled clients to reduce their positions accordingly. In early October of this year, the FTSE-100 Index registered an intra-day high of 5367, slightly over one percent above the upper end of the projected range. By the end of the month, the index had fallen over 20 percent from this high to its spike low of 4388 (Figure three).

Figure 3

Although this analysis is primarily of use to investors, given the nature of the time frame involved, short-term traders were able to use this analysis to their advantage. In early August of 1997, the FTSE-100 Index came within five points of the 5100 level before dropping six percent in little over a week. The main difficulty then was deciding whether the index had peaked at the lower level or whether it would still manage to move up again and test the higher target. The inability of the market to break down in mid-September provided some clues to this and by the end of the month the index has risen to the higher level, allowing traders to reinstate short positions. Since the index was then in a make or break situation, a close above 5400 would almost certainly have negated the above analysis. This allowed traders to use a relatively tight stop. Those who were disciplined enough to play for the bigger picture were rewarded with a large profit by the end of the month.

Paul White, of Trend Analysis Ltd, is a technical analyst specializing in world equity markets. Based in the U.K., Trend Analysis publishes independent technical analysis on a wide range of financial markets. Contact Paul White by phone at +44 (0) 181 441 9067 or e-mail vp31@dial.pipex.com.