Lessons for the Bear Market: Harmonic Trading Strategy

THE 2008 BEAR MARKET

The ability of the Industrials to rally to new all-time highs was remarkable. The multiyear uptrend of the 1990s was clearly over. It seemed as if a new multidecade trend was beginning. Surely, the 2000 bear market represented a significant historic correction—enough to possibly justify a new bull market. Despite such rationalizations, the 2008 bear market did provide early signals of a significant decline at hand. Specifically, the price action reversed sharply from the prior year’s peak. In fact, the index lost nearly 15–20% of its value before anyone really knew what was unfolding.

From a Harmonic Trading perspective, the index established a distinct Bullish 5-0 structure on the weekly chart that possessed a smaller Bullish AB=CD. The initial points of the pattern were well defined. As the price action declined in the final leg of the setup, it became apparent that this structure was the make-or-break support of the prior multiyear rally (see Figure 1.15). Although I was not actively operating my advisory service, I was compelled to outline these developments in a report on my website.

FIGURE 1.15

In a report in July 2008, I wrote:

“The Dow Jones Industrial Average has sustained remarkable damage the past 12 months. Although the index recently declined sharply—nearly 10 percent in 30 days, the trend is still clearly down. Remarkably though, the index has formed an exact 5-0 pattern on the weekly chart. The distinct structure clearly points to a critical technical test in the coming months at slightly lower levels.… With the prevalence of the weekly Bullish 5-0 pattern and the AB=CD pattern, there are several substantial technical events about to unfold. Following this short-term bounce, I expect a complete test of the entire Potential Reversal Zone (PRZ) at the 10,400 range.… Back in March, I outlined the entire scenario for the Dow Jones Industrial Average at a group presentation in Atlanta. In particular, I was addressing the numerous Harmonic levels at the 11,600 are.… As I stated in my presentation in March, I was very concerned and still am about the long-term state of the Dow Jones Industrial Average. More importantly, a failure beyond the mid-10,000 area would essentially trigger a massive continuation and an eventual retest of the entire 2003 low. For now, it is important to focus on the current action and impending roll over of the recent rally. The eventual test of the mid-10,000 area will dictate the long-term action.  It is critical to prepare for this impending technical action and upcoming test of this substantial harmonic support zone. Until then, it is important to stay with predominant trend, which is still down.”

FIGURE 1.16

Figure 1.17 shows how the price action failed this projected support in dramatic fashion and actually exceeded the 2003 low. Although the 5-0 pattern failed, the decisive breakdown was a clear continuation of the predominant trend. Not to mention, the extreme warning sign of the sharp sell off at the pattern’s completion contributed to the bearish trend.

FIGURE 1.17

The index has rallied from these lows, but it is still bound by the respective multidecade limits of support and resistance. For the Industrials, the lows of the 2000 and 2008 bear markets—approximately in the 7000 area—possess incredible significance for the next decade and beyond. Regardless of the end result, more than anything the volatile action of the past decade has mandated a greater attention to the market’s behavior and a greater readiness to capitalize on both sides of the market.

DOW JONES INDUSTRIAL AVERAGE CONCLUSION

More than any other index, the Dow Jones Industrials required a bit of discretion and confirmation to decipher the long-term trend. For example, in the 2000 bear market, the price action failed to completely test the 6700–6800 area. Despite falling shy, it is important to note that this prediction was accurate within the context of the time period. At a minimum, the harmonic measurement techniques provided a reliable ballpark area that effectively identified the long-term potential support for this multiyear bear market. Also, the actual low was approximately 400 points above—or less than 10% of the entire move—from the projected target. Most important, this target was identified nearly 18 months prior to its realization.

From a harmonic perspective, this was not an ideal conclusion to the multiyear bear market. It would have been a perfect situation if the index would have reversed from the completion point of the long-term Bullish AB=CD. But it did not. Similar to this discretion, the failure of the 5-0 pattern in 2008 was not an ideal situation. However, these events still pinpointed the critical areas to examine for market turning points. Did Harmonic Trading techniques fail to provide the correct conclusion in these situations? I don’t think so. In real trading situations, there has to be some degree of flexibility in the overall market analysis to allow for the variations that may arise from the model situation. Although the market failed to react ideally, the performance of Harmonic Trading measurement techniques throughout this period was extremely accurate. At both the all-time peak and the bear market lows for the index, the approach warned of the impending changes about to unfold in the predominant trend.

THE LESSONS FROM THE BEAR MARKETS OF 2000 AND 2010

The experiences of the past two decades have facilitated an evolution of the entire Harmonic Trading approach. I realized that the patterns were not ultimate buy or sell signals in their own right. Although I always stressed the principle that harmonic patterns are first and foremost “signposts of potential future price action,” the overwhelming failure of the bullish patterns during the multiyear bear markets in particular required a broader perspective to interpret what the market was really indicating at this time. Specifically, the failure of harmonic patterns was to be regarded more than I had in the past. This was a difficult admission for me because in a way it devalued the significance and potential for the patterns themselves to comprise a stand-alone trading methodology. Regardless, a more comprehensive interpretation of harmonic price action was required to recognize the market’s signals and to determine the overall direction of the primary trend.

Without a doubt, I learned a great deal during this time. In the long run, this was an important evolutionary process that was essential to the advancement of the Harmonic Trading approach. These lessons refocused my attention on price action in the completion area of harmonic patterns, especially with respect to the predominant trend. Furthermore, this strategic adjustment led to new strategies that expanded the technical tools employed within the Harmonic Trading arsenal.

It’s Not the Pattern’s Fault…

The structural significance of harmonic patterns has been debated in recent years. I encountered some criticism in those early years regarding the effectiveness of patterns. For example, some maintained that since the monster bullish setups failed from 2000–2002—especially the NASDAQ Composite—Harmonic Trading failed to work. No! In fact, the numerous bullish pattern failures were screaming that the predominant trend in many of these equity markets would remain bearish for quite some time. Again in 2008, the index violated a significant weekly setup—the critical Bullish 5-0 pattern—which underscored the extent of the damage at hand. Therefore, I would have to argue that the system did not fail. Throughout these bear declines, the demonstrative price action signaled their overwhelming continuation, as most of the significant bullish patterns on daily and even weekly time frames yielded little to no support at these harmonic zones. In short, my point is that the bear markets of 2000 and 2008 represented a unique test of the Harmonic Trading strategies as an effective methodology. But, these difficulties inspired a more integrative approach that has expanded the application of the basic interpretations immensely.

A Feel for the Markets

In The Harmonic Trader, I discussed the importance of developing a feel for the markets, especially as it relates to harmonic price behavior. Developing this “intuitive feel” for the markets is where the lines of the art and the science of trading merge. Again, despite the fact that incredibly harmonic price action helped to determine the overall market positions, these conclusions still fall under the “artistic side” of trading. I prefer to call these types of decisions “educated assessments.” Regardless, this situation truly manifests the “feel for price action” that is required to successfully navigate the financial markets.

One of my favorite classic books on the markets—How to Make the Stock Market Make Money for You by Ted Warren—aptly describes this feel as a technical “know how” to be successful:

“Learn to recognize the variety of bases, consolidations, trends, false ceilings, false support levels, false starts, and shakeouts. There are internal changes which take place, all of which have an important bearing on the future action of a stock. If you can detect these formations, you will acquire the ‘know-how’ in forecasting stock price movements.”

(How to Make the Stock Market Make Money for You [Grants Pass, OR: The Ted Warren Company, 1966] 66).

I believe that the “feel for the markets” must always be based upon the established principles and technical rules that define the Harmonic Trading approach. Throughout my experience operating an advisory service based exclusively on this approach, my decisions were always based upon the application of the standard harmonic measurement techniques. This adherence to a “strict constructionist” view of the Harmonic Trading rules is the primary reason I was able to anticipate the critical changes and stay with the predominant trend throughout this era for all three major U.S. indices. Furthermore, this experience permanently validated the effectiveness and importance of these techniques to determine probable future price action in the financial markets.

Now What—Long-Term Harmonic Projections

Elliott Wave Principle by Alfred Frost and Robert Prechter was a revolutionary technical book for its time. In addition to integrating price structures with Fibonacci ratios and outlining precise wave counts, the book presented some remarkable future projections for the markets. The book was written during a period of time when the markets were still languishing in an extended long-term sideways range. After crashing in 1974, the markets experienced a volatile few years, as equities failed to recover. Despite the unfavorable conditions of their time, Frost and Prechter presented some bold predictions for the next decade. At the very end of the book (in their third edition), they called for an all-time target of 4000 on the Dow Jones Industrial Average by 1990. In fact, on page 188, they outlined their case:

“…based on Elliott’s channeling methods, to the upper channel line, wage in this case cuts through the price action in the 3500-4000 range in the latter half of the 1980s…therefore, one point to be watching for a possible market peak is five years from 1982, or 1987. Coincidentally, as we pointed out in the text, 1987 happens to be a Fibonacci 13 years from the corrections low point in 1974, 21 years from the peak of wave 3 in 1966, and 55 years from the start of wave want in 1932. To complete the picture, 1987 is a perfect date for the Dow to hit its 3686 target sense to reach at the Dow would have to burst briefly through its upper channel line in a ‘throw-over,’ which is typical of exhaustion moves (such as the 1929 peak). Based upon a 1.618 time multiple to Wave I and upon equality to the 1920s fifth cycle wave, and a year wave V would point to 1990 as the next most likely year for a peak.”

The interesting aspect regarding this study was that Frost and Prechter were utilizing prior measurement techniques to project future targets. Although Harmonic Trading does not discuss wave counts, similar comparative measurement techniques from the past can be employed to determine critical future price levels. Surprisingly, their predictions were accurate as the Dow Jones Industrial Average crashed in 1987 and managed to test the 3000 level by 1990—a mere 15% shy of their long-term target.

It must have been alarming to hear someone predict that the Dow Jones Industrial Average would more than triple from the current level in 1983—the date of the market report from their third edition. In fact, the 3500–4000 area represented a critical technical level where the index consolidated briefly before accelerating sharply in a historic breakout. Similar to Harmonic Trading, their prediction was based upon the analysis of specific price waves that established their technical measurement methods. This type of analysis was unprecedented for the time, yet the methodology held its own throughout the following years, and remains to be a reliable framework to analyze price action. Although the price levels from this Elliott Wave study have been vastly exceeded in the years since, the effectiveness of such techniques to gauge critical long-term technical areas in advance is impressive.

In much the same manner, I believe Harmonic Trading techniques will continue to hold their own as an effective methodology to analyze price action. Regardless of the time frame—either long-term multiyear price projections or intra-day short-term analysis—harmonic measurement techniques offer an effective means to decipher market movements in a similar fashion as Elliott Wave.

HARMONIC PROJECTIONS—THE YEAR 2025

It’s the year 2025 and the Dow Jones Industrial Average is trading at 36,000! Am I kidding? Partially. However, the analogous prediction of Frost and Prechter’s decade forecast related to current levels would equate to over a 300% gain or a Dow Jones Industrial Average reading of approximately 25,000 points from current levels of 10,000. Although the relative market position is different than that of the early 1980s when Frost and Prechter made their historic prediction, such long-term forecasts must be based upon cogent measurement tools and thorough technical reasoning. I am not making a prediction that this will occur. Rather, I am merely speculating along the same lines as the Prechter forecast.

In that vein, I present a similar analysis within the context of the Harmonic Trading approach. Historically, the markets have responded to long-term technical levels as defined by respective substantial harmonic retracement and projection ratios of prior price history. The incredibly harmonic long-term price action in both the bear market of 2000 and 2008 exemplified the ability of these measurements to provide an effective framework of critical technical levels to consider.

STANDARD & POOR’S 500 (^SPX): WEEKLY

HISTORIC HARMONIC PROJECTIONS

Although this may seem oversimplified, the progression of harmonic ratios serves as a general framework to analyze future long-term price action (see Figure 1.18). For the S&P 500, the price action recovered following both the bear market of 2000 and 2008. Although the index has retraced 50% of the prior decline since the 2009 low as of this writing date, the all-time historic 0.886 bearish retracement will serve as the true historic test. Eventually, the index will test new highs. But, the price action at the long-term 0.886 retracements in cases like these has frequently provided a great deal of indication of whether it will happen sooner or later. Aside from the all-time 0.886 retracement as resistance, the index has established historic support since the bear market low of 2003 and 2009 that completes in the 700 area. This type of long- term price action could be manifesting a stable recovery like many prior historic cases—namely the 1929–1934 and the 1987–1992 markets.

FIGURE 1.18

As long as this multiyear uptrend is maintained, I truly believe that the index will retest historic resistance at the long-term 0.886 retracement level above 1500. This is attainable within the context of the 2025 scenario. Again, this framework depends upon steadily maintaining the uptrend support from the recent bear market low.

NASDAQ Composite ($COMPQ): Weekly

Historic Harmonic Projections

This long-term chart of the NASDAQ Composite, shown in Figure 1.19, is strikingly similar to the price action in the Dow Jones Industrial Average following the Crash of 1929. If these are similar situations, it will likely take the same 25 years for the NASDAQ to recover all of its losses as the Industrials did following the Crash of 1929. One indication of this is the fact that the NASDAQ has failed to exceed the minimum 38.2% bear market retracement in the past decade.

FIGURE 1.19

The most interesting long-term harmonic level for the NASDAQ is the 0.886 retracement at 4675. This essentially represents a 100% gain from current levels, but it just might be the year 2025 or later before it is realized!

DOW JONES INDUSTRIAL AVERAGE (^DJI): WEEKLY

HISTORIC HARMONIC PROJECTIONS

The Dow Jones Industrial Average possesses the best chance of testing the long-term harmonic resistance levels. Having already recovered half of the 2008 losses, the index has established substantial multiyear support in the 7000 area (see Figure 1.20).

FIGURE 1.20

The most significant harmonic level within the next few years for the index is the 0.886 retest above of the prior all-time high. Given the volatility of the last decade, 14,000–15,000 is possible. If the next ten years are anything like the last, an even higher target is not as far-fetched as it might seem. Given the year 2025, the Dow Jones Industrial Average would need to triple from current levels. Although such speculation can be interesting, this does not excuse complacency, as the 80% washout in the NASDAQ demonstrated. However, it is important to be mindful that such long-term levels have provided reliable technical projections in the past. Furthermore, future harmonic areas will help to decipher the progress of the predominant trend.

MARKETS REVIEW CONCLUSION

Before we continue with the new concepts within the Harmonic Trading approach, I believe that this review was an essential foundation to lead into the new material. I’m proud of the advisory service that I provided for so many years. The ability to accurately assess such volatile price action over the course of that time proved that these techniques are truly effective in deciphering price action in the financial markets. In addition, I believe that these market reports represent accurate case studies, further substantiating the Harmonic Trading approach.

Over the course of the past two decades, there have been many advancements in the basic approach of Harmonic Trading. New patterns, new ratios, and unprecedented measurement techniques have evolved directly from the lessons learned from the experience of providing this advisory service. I believe that the new techniques presented in this book substantially increase the arsenal of technical tools within the Harmonic Trading approach, and enhance the ability of existing strategies to effectively decipher price action and define profitable opportunities.

In conclusion, it’s important to understand the state of the major indices relative to any other market that you might be trading. It is essential to have a solid understanding regarding the state of the predominant trend and to be able to determine the potential critical turning points in the markets. In essence, the ability to understand and to interpret “the big picture” of the overall technical condition of any market is an essential aspect of successful trading. With the tools within the Harmonic Trading approach, it is possible to decipher the relative state of price action within any market. But it is essential to consistently analyze all markets within the framework of the Harmonic Trading methodology, as this will provide the clearest of signals regarding the state of future potential price action.