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How a Bull Market Starts: An Analysis According to Elliott Wave Theory

A bull market is a market situation in which prices are generally rising and investors generally have positive expectations. This type of market is usually characterized by a five-wave movement, and Elliott Wave Theory explains how these movements develop. Let's examine the beginning and development of the bull market step by step.

Wave 1: First Ascension

According to Elliott Wave Theory, the first wave is usually not evident in the beginning. When the first wave of a new bull market begins, fundamental news is usually negative. The previous downtrend still appears to be going strong. The economy generally looks weak as fundamental analysts continue to lower their earnings estimates. Sentiment polls are significantly down, put options are popular, and implied volatility in the options market is high. Trading volume may increase slightly as prices rise, but not enough to attract the attention of many technical analysts.

Wave 2: Correction

The second wave corrects the gains of the first wave, but never moves beyond the starting point of the first wave. Usually, the news is still bad. As prices retest previous lows, the downtrend quickly strengthens again, reminding the majority that the bear market is still deeply entrenched. However, some positive signs begin to emerge: Volume should be lower during the second wave than during the first wave, prices generally do not reclaim more than 61.8% of the gains of the first wave, and prices often fall in a three-wave pattern.

Wave 3: Strong Rising

The third wave is usually the largest and strongest wave of the trend. The news is now positive and fundamental analysts begin to raise their earnings estimates. Prices rise rapidly, corrections are short-lived and superficial. At the beginning of the third wave, the news may still be bearish and many market players are still negative; but in the middle of the third wave the "crowd" usually joins the new uptrend. The third wave usually extends the first wave by 1.618:1. As the third wave rally gains momentum, the peak of the first wave is breached, at which point stop orders come into play. Gaps occur depending on the number of stop orders. Gaps are a good indicator that the third wave is ongoing. Once stop orders are in place, the third wave rally attracts traders' attention.

Wave 4: Correction and Preparation

The fourth wave is usually clearly corrective. Prices trend sideways for a long period of time, and the fourth wave usually retraces less than the 38.2% of the third wave. The volume is considerably lower than in the third wave. This could be a pullback buying opportunity for those who understand the potential for wave 5. Still, fourth waves often disappoint due to the lack of progress in the larger trend.

Wave 5: Final Rising

The fifth wave is the last move in the direction of the dominant trend. The news is almost universally positive and everyone is optimistic. Unfortunately, this is often when many average investors buy right before the peak. Volume is generally lower than in the third wave and many momentum indicators begin to diverge (prices reach a new high, while indicators do not reach a new high). At the end of a major bull market, bears may become a laughing stock (remember how the stock market reacted to peak predictions in 2000). The fifth wave does not contain the great enthusiasm and power seen in the third wave. The fifth wave rise is driven by a small group of traders. Prices rise above the peak of the third wave, but the rate of strength or momentum within the fifth wave is very small compared to the rise of the third wave.

These wave movements play a critical role in understanding the onset and development of a bull market. Elliott Wave Theory can help investors predict market cycles and develop strategies accordingly.

via: elliottwave-forecast