ELLIOTT WAVE PRINCIPLE - BASICS

 

Even though I am a strong believer in a buy and hold strategy for the long term investor, I think investors who are more active in markets could look to ride the market cycles for greater profits. I have found the Elliott wave principle quite useful in predicting these cycles.

As anyone who has been in the stock markets long enough, knows fully well that markets follow cycles of boom and bust. Ralph N.Elliott, an American who worked in Mexico as a wireless operator, observed these cyclical movements of stock markets, by observing historical data of the indices while convalescing from a long illness in the 1930'. He postulated a principle that markets move in clearly identified waves over periods of time ranging from a couple of centuries down to movements in hours and minutes. Each wave can be subdivided into its component waves and each sub wave can be further subdivided and so on. This science is now known as fractals. Accordingly waves are classified from the "Grand Super Cycle" being the largest to the "Sub Minuette" being the smallest practically measurable wave.

As per the Elliott wave principle, an uptrend comprises of 5 waves, 3 up and 2 down. Each up wave is followed by a down wave. Up waves or impulse waves are labelled as Waves 1,3 and 5 and down waves or corrective waves are labelled as waves 2 and 4. Waves 1,3,5 comprise of 5 component waves each and waves 2, 4 comprise of 3 component waves each. At the completion of wave 5 a new market high is achieved. This is followed by a cycle of severe destruction comprising of 3 waves, which seek to erase most of the gains of the previous bull market. These three waves are labelled as A,B and C. Waves A and C, which are down waves each comprise of 5 component waves because the trend is now down. Wave B, which is an up wave comprises of 3 component waves.

The task before an investor is to identify the stage in the above cycles, which the market is presently in. Once this is correctly done, the investor can decide how the market is going to behave in the future and act accordingly. This can be particularly beneficial for longer term investors to decide when to liquidate their holdings or when not to enter the markets, so that they do not have to suffer the agony of seeing their portfolios diminish in value such as at the present moment. Also it prevents longer term investors from selling prematurely and thus not being able to capture the full extent of the bull run.

A drawback of this principle is that it calls for a lot of judgement on the part of the investor and has no rigid rules to go by. In fact this method is so flexible that different analysts can have different opinions on the present stage in the markets. But since markets do not follow any rules it seems only justified that any system which aims to predict market movements, similarly do not lend themselves to the rigidity of rules, but have an inherent flexibility to account for the vagaries of the markets. Therein lies the beauty of the Elliott Wave Principle, as it attempts to forecast market trends while at the same time is open to account for erratic market movements caused by sudden news flows, which cause a temporary aberration in the wave patterns.

MY TRADING SYSTEM

As you might have figured from my blog, I am basically a fundamental investor, though I reserve a small portion of my portfolio for trading (not day trading though, my typical investment period for a trade is about 30 days). My oservations on my trading experience are as follows.
1. It does make the whole process more exciting.
2. I use traditional charting methods like candlestick patterns, price patterns, moving avgs etc.
3. I am a long only trader. So no shorts & no F&O.
4. You can make money trading, but I don't know the sustainability of such returns since my fundamental investments have been over some time while I started trading only recently. However my trading returns till now have been positive.
5. Taking small losses and executing strict stop losses are the key to success. Easier said than done though.
6. I generally trade on the same stocks I hold in my fundamental portfolio. Thus I can save on STCG tax.
7. Whatever profits I make on trading I withdraw from the market. In case of losses I do not replenish my lost capital, but trade on the reduced capital.
8. I am not a compulsive trader. I buy whenever I feel comfortable and maintain inactivity if I get a bad feeling about the markets.
9. I generally try to guess the direction of the markets over a period of 2 -4 weeks and go long if I feel good about it. For instance I recently bought some Infosys. I already hold it in my long term portfolio. My logic is that Q1 results are expected to be good, and markets do not seem to have discounted this at current prices. So I am looking at an upside of about 15 % in about 2 weeks, while if it does not perform I will have some more of a good stock in my portfolio.

GARP INVESTING

GARP (Growth At a Reasonable Price) investing is an offshoot of the growth investing principles propounded by Philip Fisher and T Rowe Price. It involves identifying rapidly growing companies that are available for low PE multiples. If an investor gets it right, this strategy could yield multi baggers in due course of time because of two factors. One, the growth of the company and its per share earnings would increase over a period. Two, because it shows sustained growth over many years, its price to earnings ratio would get rerated.

One of the leading practitioners of this investment style, Peter Lynch, often looked at businesses which manufactured products that he liked and used. An aspect of his investment style involved going to shopping malls with his family to check out the brands that were doing the best sales. Then he would research the companies that owned these brands and come up with options for investment.

An important aspect of GARP investing is the PEG ratio. This is the ratio of the PE multiple of the company to its average growth rate in EPS over a period of 3-5 years. For small companies that are growing rapidly, a PEG of 1 is considered suitable for investment in the Indian context. Here rapid growth rates are seen in a variety of businesses and an investor can find many companies quoting at PEG of 1 and below. Are all these companies good buys on the basis of GARP? To determine that, an investor needs to look at the sustainability of that growth. For example a company growing at 25 % per annum for the past three years and quoting at a PE ratio of 15 may be a buying candidate if an investor can satisfy himself that the business can sustain growth rates of at least 15% if not 25 % over the next few years.

How does an investor ascertain that? Therein lies the art element in investing. He looks at the business prospects of the industry in which the company is operating, the brands it owns, how well its products are doing in the markets, its loyalty among buyers, service track record, capacity additions it has planned and the quality of its management.

A risk in employing GARP investing is that high growth and low PE businesses are available mostly in the small and midcap space. By nature these companies do not have the staying power to overcome prolonged adverse market cycles. This risk can be mitigated to an extent by selecting companies which have been around for some length of time and have demonstrated their ability to weather difficult conditions. Large cap companies can be considered buying opportunities at a PEG of 1.25.

Let's try and apply this methodology to the BSE Sensex. The Sensex is expected to deliver earnings of 970 for FY 08-09. In the past the Sensex earnings have been growing at 25 % per annum. Since a slowdown is expected due to inflation, crude prices and other factors, let us assume that the Sensex will grow at 15 % in future. Since India is among the top five markets in terms of market cap in Asia, it is analogous to a large cap company. Therefore, it deserves a PEG of 1.25.

Price/Earnings/Growth = 1.25

Price (Sensex) = 1.25 x Growth x Earnings
= 1.25 x 15 x 970
= 18180
So, when various analysts say that India at a PE of 17 is expensive compared to other emerging countries, they fail to take the growth rates into account. PEG normalises the PE ratios by adjusting for growth.
Brazil's GDP growth rates for the past 6 years are given below:
2003 1 %
2004 -0.2 %
2005 5.1 %
2006 2.3 %
2007 3.7 %
2008 4.5 %
Average GDP growth over 6 years = 2.73 %
The PE ratio of Bovespa was 16.8 as on 31.05.08.
Brazil being a commodity driven economy, these growth rates are in an era of high commodity prices. Even in such conditions adverse to it India has clocked a GDP growth of 8 % over 6 years. What would happen if commodity prices were to correct, as is widely expected? Therein lies the genesis of my arguments that long term investors should buy Indian stocks at present levels.

WHAT ANALYSTS PREDICT & WHAT ACTUALLY HAPPENS

I would like to highlight an interesting post on rediff where three different analysts employing different prediction methods predict their levels for the sensex in the coming year. The predictions were made on Jan 7 2008. They went something like this:

1. Milind Karandikar - using Neowave theory - Sensex between 27000 to 39000 in the 1st half of 2008,

2.Devangshu Datta - using technical analysis - Nifty between 6600 to 7000 in six to eight months with a bottom of 5600 to 6100. Really?

3.Mukul Pal - using Elliott wave - Sensex not extending beyond 24000 in 2008. The closest of the lot, but still wrong by a long long way.

I would like to ask these gentlemen their views in the present context, but they have chosen to not display their respective e-mail id. They would probably be bearish now, taking refuge in some jargon or some hedging terms which they have been careful to qualify their projections with. Readers may judge the value of the predictions for themselves by reading the article here.Its very easy and popular to simply extrapolate the current trend and on that basis come up with fancy figures. The real test of an analyst is if he can go against the mood on the street AND end up being right. In that respect I admire people like Gul Tekchandani and Ramesh Damani who had the conviction to go against the popular mood and point out the risks, when markets were at their peaks. Some like Morgan Stanley have been screaming from the roof tops about overvaluations since the index was at 8000 and are delighted that their call has been proved right finally with the index at 21000! Some call, guys. Even a stopped clock is right twice in a day.