OPINION 

Corrective rules

Nicole Elliott

Whether you believe in technical analysis or not I think you will agree with one of its main tenets: that markets move in stages, periods of rising prices often alternating with declines. Depending on your time horizon, you will see and label these differently. A day trader might describe the market as bearish, with small bounces, if it closes lower on the session. Someone with a five-year horizon might describe stock indices over this timeframe as rallying very strongly with negligible pullbacks.

The key is that, regardless of rising or falling levels, trends can be either bullish or bearish with pauses, bounces or dips along the way; think of it as ebb and flow, high tide low tide, rather than positive versus negative. Occasionally there is also undertow, which is usually associated with an uneven playing field.

Cycle theory incorporates these concepts and adds a time overlay to the forecasts. For example the commodity super cycle is normally 20 years long. Bear markets often unravel at twice the speed of the rallies that preceded them. Elliott wave theorists are even more precise, postulating that bull phases move up in five distinct steps, while falling prices unravel in three large moves labelled A, B and C.

Many use Fibonacci ratios to describe - and limit - alternating price swings. Linked to the 'golden mean', it postulates that corrections will usually be either 38.2 per cent or 61.8 per cent of the previous trend; this is often rounded to 50 per cent as a rough and ready reckoner. Anything over a 78.6 per cent retracement can no longer be considered a correction. A move to a record low or high is always part of the impulsive swing.

With these simple rules in mind look at the four charts below and see if you can decide what is trend and countertrend. The FTSE 100 this year has seen its bull trend stall after struggling at the 6700-7000 area on umpteen occasions since 1999. We currently view this as potentially the start of a new bear trend and therefore the bounce from August's low is corrective, retracing just half of the drop from the record high.

 

FTSE 100 

 

Gold has been in a bear market since the record $1920 high in 2011 and although close to long-term support the latest squeeze higher is a drop in the ocean and clearly countertrend. It has also retraced half of this year's decline. Interestingly, July's low in turn was at the 50 per cent retracement level of the rally that started in 2001 and culminated a decade later; here the effect of one's time horizon is clear.

 

Gold

 

Sterling against the US dollar is a lot more complex, but one can clearly spot the pound's strengthening tendency against the euro. Since 2008 it has recovered almost all the catastrophic losses caused by the UK's perceived over-reliance on financial services as the banking crisis spiralled in 2007 and 2008. However, we are still well below peak at over 1.7000 when the euro was launched.

 

British pound/euro

 

Finally the yield on two-year British government paper (which is market-sensitive, unlike the Bank Rate). Since peaking in 1995, the trend has been decisively to lower interest rates. Having flirted with zero I would suggest that trends here are now negligible and/or irrelevant. A drop into negative territory cannot be ruled out and would certainly upset the apple cart.

 

Two-year Gilt 

 

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