The Dow Jones and S&P 500 are diverging

Although my favourite stock index for trading is the Dow, I do keep a close eye on the S&P 500 (and the Nasdaq), because sometimes they display slightly differing Elliott wave patterns.

And this is exactly what has happened in the S&P since the 14 May highs. So today, I will tell you why this is such a significant development.

The Dow and S&P part ways

These were my initial Elliott wave labels for the Dow off the high in my 16 May post:

Dow Jones spread betting chart

The wave 3 appeared correct, because it was long and strong, which is the normal quality for a third wave. It is usually the strongest (in terms of momentum) of the three waves that move in the overall direction of trend.

I was then waiting for the wave 4 to top out before the market descended once again to a new low in the final fifth wave.

But the S&P chart offered a slightly different interpretation. Here is the hourly chart as of this morning:

S&P 500 spread betting chart

I have a shorter wave 3 and a long and strong fifth wave. These are called extended fifths and although not common, they do appear more often in the stock indexes than in any other type of market that I follow.

This is an acceptable way to label the big move down. At the wave 5 low, the selling had been overdone and the market started a normal relief rally.

This is a textbook rally

You should note the form of this rally – it is pure textbook.

First, it has an A-B-C form with wA equal in height to wC. This is a typical Fibonacci wave relationship between the corrective A and C waves. That is textbook behaviour and illustrates the equality rule of the A and C waves.

In fact, when you see this equality, it adds confidence to your interpretation that this is indeed a relief rally and to expect a resumption of the main down trend.

Second, wave C terminated precisely at the Fibonacci 62% retracement of the entire move down. This is the most common level where C waves turn around. And the hit was made on a pigtail, or spike, on the high bar. Again, all of this is straight out of the textbook.

And yesterday the market fell hard off the C wave high. So now I can place new Elliott wave labels for the larger pattern:

S&P 500 spread betting chart

My new wave 1 is the 15 May low and wave 2 is yesterday’s C wave high. To confirm this picture, I will need to see a new low below the wave 1 low – and out of the congestion zone.

Note the large congestion zone (marked in pink) whose upper limit was breached in the buying exhaustion thrust to the 1900 level. But that was a false breakout and the market soon plunged to test the lower limit of the zone. That is entirely normal behaviour.

And the upper limit of resistance was tested yesterday and was successful in turning the market back with force.

Why were investors flocking to the Dow?

How does this compare with the picture in the Dow? Here is the hourly chart as of this morning:

Dow Jones spread betting chart

The pattern is very similar, but the Dow has already made a new low below the wave 1 low. This means we are very likely already in the third wave down.

Note how much weaker the Dow is now compared with the S&P. The Dow C wave high terminated only at the Fibonacci 38% level compared with the higher 62% level in the S&P. And now we have a new low in the Dow and not in the S&P.

This is a turn-around from the recent pattern. The Dow has recently seen a flow of funds as investors seek solid dividend-paying companies in a flight from the riskier S&P shares. I believe this is a significant development.

Keeping an eye on the bigger picture

It is always a good idea to keep track of the bigger picture. Here is the daily Dow:

Dow Jones spread betting chart

I can draw a lovely wedge, and this morning the market is testing the lower line. A solid break of this line would confirm not only the top, but that we are in the third wave down, which should be long and strong.

This could get very interesting!