----- Oct 16, 2006 -----

Measured Corrections and Overbalancing of Price and Time

A funny thing happened in the stock market during the summer of 1987 that no one had seen in over 5 years. For the first time since the start of a great bull market that swept the Dow Jones Industrial Average 250% higher, the closing price of the cash S&P 500 sustained a cumulative net loss of more than 25 points.

A casual observer might have easily shrugged off the 26.23-point decline in the S&P from August 25 to September 21, 1987. After all, in absolute terms it registered a mere 6% greater than an earlier 24.83-point slide between October 1983 and July 1984, which represented the largest of three roughly equivalent prior stock market sell-offs including the corrections of September 1986 and spring 1987 (Table 1). In percentage terms, at –7.8%, it came in only a little above half of the 14.4% loss witnessed in 1983-84. Investors had more important things to worry about, like a new Fed Chairman and record trade deficit (sound familiar?). In any event, the Industrials responded with a then record 75-point gain in the session following the September 21, 1987 bottom. Ten days later, the S&P had retraced 70% of its overall loss and the brief late-summer bout of profit taking was all but forgotten.

Table 1

Overbalancing Price in the S&P 500 in 1987

Then stocks began to plummet at an accelerating pace. The Dow lost 6% one week, a gut-wrenching 9.5% the next. On October 19, 1987 all hell broke loose. The Dow crashed an unimaginable 508 points, or 22.6%, on “Black Monday.” The devastation rivaled the combined 23% meltdown witnessed on the previous two individual worst days ever, October 28 and October 29, 1929.

W.D. Gann’s Research on “Measured Corrections”

The legendary W.D. Gann advised that after a market establishes a final low and undergoes its first secondary reaction (correction) of importance to “watch for other reactions to run about the same. This is your yardstick, or measuring stick, for future movements.”

Trading with the main trend is the path of least resistance if you want to make big money . The best way to simultaneously minimize risk and maximize your potential return is to enter positions at the completion of corrections, or countertrend moves. Major trending markets always encounter significant corrections along the way. Historically, corrections are much more uniform than legs up in favor of the trend. These uniform corrections, like the near-identical ones in the stock market in 1983-84, 1986 and the spring of 1987, are often called “measured corrections.”

One of the simplest and most valuable techniques for entering a market is buying or selling approximate measured corrections. Over a span of 5 years throughout the 1982-87 example, each equivalent correction offered buying opportunities at its absolute low ticks. As demonstrated, it is important to watch the absolute number of points as well as percentage moves, because as a market pushes higher, the amount of points lost in a decline can increase but still fall well short of matching the percentage loss incurred at lower levels.

A historical review of any commodity going back through the years will convince you of the indisputable value of initiating positions based on measured corrections . This was one of W.D. Gann's rules for determining buy and sell levels based on price. "Buy when a reaction in price equals the previous reactions on the way up.”

Measured corrections assert the geometry of a continued bull market, affirming the inability of selling to "overbalance" the buying.

Anytime a market exceeds its largest point decline or longest time period of the corrections on the way up, its shifting momentum raises the specter that selling pressure will finally overwhelm buying pressure. In W.D. Gann's list of “Rules to Determine Selling Levels,” he states, “Sell when the first decline from the extreme highs exceeds in price and time the greatest correction in the preceding bull campaign.”

Conversely, you should “Buy when the first rally from the extreme bottom exceeds in price and time the greatest rally in the preceding bear campaign.”

Bull markets usually unfold in five to seven legs or waves, or “sections,” as Gann called them, with 3 or 4 in favor of the uptrend and 2 or 3 opposite the trend. The greatest profits most often come in the first and last section of a bull or bear market.

Gann said, “When the market has run out three or more sections in a bull campaign, go back over the record and find out what the greatest reaction has been in any section, whether 10, 15, 20, 30 cents, or more. Suppose wheat has been advancing for a long time and the greatest reaction in the Bull Market has been 10 cents and the market has reached the 3rd or 4th section of the campaign. The first time wheat breaks more than 10 points, or more than the greatest reaction, it is an indication that the main trend has changed or will change soon.”

Most major bear markets in stocks in the last century began with an overbalancing by the blue-chip averages, including the 89% Great Depression-era evisceration of the Dow between 1929 and 1932.

Gann instructed, “You should always figure the time from any top or high level to the next top or high point. Also figure the time from any low level to the next low level. Then figure the time from a low level to a high level, and the time from the last high level down to the low level. By doing this, you will know when Time Periods balance or come out about the same as a previous move. This is balancing of time. By knowing these dates and prices, it will help you to determine the duration of the next move.

“When a campaign has run only three or four sections and the TIME period of a reaction exceeds the greatest time of a previous reaction, consider that the main trend has changed. Remember that the most important thing is the time period, and when time overbalances or shows a change in trend, it is much more important than a percentage of prices.”

Bull and bear markets can run months or even years with the time periods of corrections equaling one another. Gann continued, “Go over the records and find the greatest time period from any minor top or the duration of a reaction in previous sections of the Bull Market. If you find that the greatest reaction has been about 4 weeks, the first time the market declines consecutively for 5 weeks or more is an indication that the main trend has changed and that wheat or (other) commodities will be short sales on a secondary rally."

Secondary Rallies

Regarding overbalancing of time, Gann stated, “This does not mean that a rally cannot take place after this definite signal of reversal has been given, as usually after the first signal of change in trend there is a secondary rally in a bull market. Time has to be allowed at the top for distribution to take place. Therefore, just because you get a definite indication that the main trend has changed, do not jump to the conclusion that you can sell short right at that time and there will be no rally. Always sell on rallies, if possible. However, there are times that you can sell at new low levels when bottoms are broken.”

When looking for buying levels, do just the opposite. “Buy when the first rally from the extreme bottom exceeds in price and time the greatest rally in the preceding bear campaign. After the first sharp advance, when the trend is changing from a bear market to a bull market, the commodity will have a secondary reaction and make (a) bottom.”

Watch For an Overbalancing in Gold and Crude Oil

As autumn dawns in 2006, a pair of key glamour commodities that since 2001 had led the charge higher in a newly chic natural resources sector suddenly find themselves under pressure and teetering on the brink of their own overbalancings.

Until the May 12, 2006 high, the largest percentage correction (-18%) of the over 5-year bull market in gold occurred when U.S. forces ousted Saddam Hussein from power in Iraq in early spring 2003. During a 1-month, 2-day sell-off in the metal from its May 2006 peak, gold overbalanced price with a whopping 26% decline (Figure 1). This was our first indication a final top could be in place. However, the longest time period of any correction since the bull market began in 2001 was 2 months and 20 days between March 11 and May 31, 2005. To overbalance time, we need only break the June 14, 2006 low at $542.27 basis the cash without first hitting a new high.

Meanwhile, as cash crude tests the $60/barrel area over 2 months after a 4 th breakout leg up into record territory, culminating in a July 14 top above $77, oil prices remain mired in their longest sell-off since falling 20% in 2 months and 19 days from the Hurricane Katrina-related spike high on August 30, 2005. So we haven’t yet overbalanced the most prolonged correction of the entire bull market, but we shouldn’t have to wait long to see if that will happen. If it does, the implications could be huge, because this would offer strong evidence of a developing bear market, and bear markets following breakout markets tend to be extreme.

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About the Author:

James Flanagan is the president and founder of Gann Global Financial. In 1978, while majoring in economics at Claremont McKenna College, he acquired his first book written by W.D. Gann, “How to Make Profits Trading in Commodities.” This set in motion his passion to validate the claims of this early pioneer of market psychology and technical analysis. In April 1990, he launched his first newsletter Past Present Futures which has been in continuous publication since that time. James Flanagan oversees all of the research and research development at gannglobal.com.