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A Pattern Begins To Emerge

The good news is that the stock market's action over the last couple of days has made it easier to identify a technical structure after last week's free fall.

The bad news is that there appears to be more downside ahead for the market when the current rally is completed.

But even therein lies some good news: whatever bottom comes as a result of the next leg down has the potential to be a significant one.

We're watching two things here: Elliott waves and a chart pattern called a bear flag.

First, a little background on Elliot wave theory. There are two basic moves under Elliot theory: a five-wave "impulsive" move, or main trend; and a three-wave "corrective" move, or correction against that trend. There are other variations that aren't necessary for our purposes here.

And now onto a chart of the Dow since its May 22 peak (see below). The wave down from the May peak to early July was Wave 1 in a potential 5-wave move. The flat trading range until late August was Wave 2, or a correction against the main trend. And then came Wave 3; in Elliott terms, the third wave is the most powerful. Within that Wave 3, we can identify 3 completed smaller waves, labeled a-b-c. That makes the current wave a corrective wave d, with a wave e down yet to come to complete Wave 3 before we get a Wave 4 rally. Hope that's not too hard to follow.

That's one technical reason that the sell-off since the Dow broke 10,000 has been so powerful - in short, it was a 3 of 3, the third move of the third wave, the most powerful in Elliott terms.

Now onto what's been forming off the market's bottom on Friday morning. As we said in last night's Market Close, the Dow and S&P 500 appear to be forming bear flags off those lows (see charts below). A flag is a correction against the trend in a fast-moving market, and these patterns so far appear to fit that definition. Those bear flags give the market downside potential equal to that of the previous move ("c"), which was about 2000 points down in the Dow. Under Elliott terms, that projected "e" wave can't be bigger than the "c" wave, so a 2000-point move would likely be the maximum if those patterns break down. They could potentially break to the upside, which would be very bullish, but with several chances to do so that have already failed, the odds of that breakout occurring are diminishing.

Those bear flags could continue for a while longer, perhaps into cycle turns on October 2-3, and continue to climb higher, but another leg down appears to be in the cards, particularly if volume on this rally continues to diminish.

But the good news is that the next leg down could be the last for a while; a strong 6-week rally to complete a larger Wave 4 would be likely at that point. And for some stocks and indexes, this next leg down, the end of Wave 3, could potentially be a significant bottom, with the eventual Wave 5 consisting of a retest or minor new lows.

But that's getting into the much bigger picture. In the short-term, another leg down seems to be the likely bet, and it should produce a good buying opportunity.

A bit of stock market history is probably in order here. Major bear markets of 40% or greater have tended to occur about every 20 years throughout U.S. stock market history. It's been 27 years since we completed the last one. It would be well within the historical norm to have another one, and there are enough negatives in place for that to occur here. The volume of foreign money leaving U.S. markets alone could be enough to trigger that.

And don't forget that last week was the worst week for the stock market since 1933. In the intervening 68 years, there has been one crash (1987), two panics (1939 and 1946), and two bear markets of about 50% (1937 and 1973-1974), and none of them produced a week that bad. That's not an insignificant fact.

But even in the very worst bear markets - the 75%-89% Great Bears in 1857 and 1929 - the market rallied 50% after falling 45%-48%, and other major bear markets have tended to do the same. The next leg down has the potential to produce that kind of buying opportunity.

Will it be The Bottom? We don't need to know that. We'll just keep an eye on the charts to see what forms.

This too shall pass, as they say, and an economic recovery by the middle of next year is probably more likely than not. But until the signs are clear, it's probably wise to learn something about what was once the number one rule of investors: Preservation of capital.