In my post on the euro on 11 November, I outlined a model I use to analyse market action. It is completely different from that used by most pundits.
In that post, the euro had just suffered a sharp decline. The most common ‘explanation’ for this drop was a series of current events. As I said then, this is all post facto rationalisation and does nothing to help you secure a profitable trade. You would have needed this information before the event – and sadly, pundits are unable to provide that for you.
I believe markets are moved by changes in sentiment, and that the subsequent news flow is a result of these mood changes. These changes produce the swings in the charts that can often be analysed by the Elliott wave theory (EWT). One of its great benefits is that it can very often give high-confidence forecasts.
That is what we are looking for as traders – a reliable method that can forecast a move before the news emerges to justify it.
Why has the euro recovered?
Since that sharp decline in November, the market has recovered and gone on to make new highs for the move. For traders who still cling to the ‘news drives the markets’ model, I have one question: if the sharp decline was explained by the European Central Bank (ECB) rate cut and the plethora of US data supportive of the dollar, then why has the euro recovered since then and rallied to new highs?
Of course, you could say that new data has emerged to reverse the decline. But that is pure rationalisation and won’t help in making you money. Was this information available to you at the low? Of course not. According to this model, you needed that data before it was released to produce a profit – a logical impossibility.
No, the market rallied because the EW pattern was not complete. Let me show you what I mean.
This was the daily chart back in November:
Sentiment towards the eurozone had swung from one pole to the other in just a few months. But the crucial point is that the euro has traced out a three-wave A-B-C pattern to the 1.38 level, and these patterns are counter-trend.
Not only that, but the decline off the 1.38 high has a classic five motive waves down. This was the situation in November:
Note that my wave 5 occurred right after the ECB rate cut news. Conventional analysts would conclude that the euro would continue weaker as the news was getting more and more bearish.
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But I concluded that after the five waves down, there should be a rally and one with an A-B-C form. That would conform to the larger picture which has the market in a large scale downtrend.
So let’s see how the market has developed since then.
The ECB rate cut event was the low (my wave 5) and the rally since then is a clear A-B-C (so far). There is no other sensible interpretation for this rally. And note the B wave has itself an A-B-C form – an absolute textbook example, in fact.
Not only that, but the C wave terminated at the 38% retrace of the leg up from the 1.34 low. Remember, applying your Fibonacci tool to the most recent wave can give likely areas of support/resistance.
All I did was apply basic EWT to the decline off the 1.38 high to the rate cut low to forecast an A-B-C rally. I did not need any news! And this highlights one of the great benefits of using EWT – you can virtually ignore the news. Or rather, you can use the news to apply contrary analysis. That is its most valuable use.
Have we reached a turning point?
We are now in the final C wave of an A-B-C counter-trend rally. How does this fit into the bigger picture?
From the 2011 top, the market declined in five waves. The main trend is therefore down. And the C wave terminated at the precise Fibonacci 62% retrace at 1.38.
This is textbook action for a bear market. The conclusion is that all rallies are counter-trend and will be reversed at some point and that new lows are likely.
But have we reached a turning point today?
Here is the current hourly chart:
The C wave has carried to the exact Fibonacci 78% level following the US jobs data on Friday, which was interpreted as being dollar-bearish. This is because the consensus says that the Fed will start tapering this month.
Incidentally, note the A wave terminated right at the Fibonacci 50% level – a common turning point. If the current C wave terminates at this 78% level, the small negative-momentum divergence (red bar) will morph into something much larger.
One important event to watch is the upcoming Fed meeting on 17/18 December. This is when many expect the Fed to announce they will begin tapering their bond purchases, and by extension start to remove support for stocks. This means that many markets will remain nervous until then (and beyond). That includes the currencies.
The market could rally further and still retain the A-B-C form. That is always possible. But the 1.38 level represents strong resistance and it would take a huge effort to break above it. A dramatic Fed announcement next week could do it, but with the major trend down, rallies should be short-lived.• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:
• The essentials of tramline trading
• Advanced tramline trading
• An introduction to Elliott wave theory
• Advanced trading with Elliott waves
• Trading with Fibonacci levels
• Trading with 'momentum'
• Putting it all together
• Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here . If you have any queries regarding MoneyWeek Trader, please contact us here.
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