Understanding corrections

An overused and misunderstood term 'correction' has many wealth creation nuances built into it.

A correction is a reality for stock market participants. It's discussed, debated analysed and forgotten when the uptrend resumes. But the term 'correction' is highly misunderstood in the market. And it's the technician who can define it correctly, and an Elliottician could do it better in terms of degree.

What is a correction? First and foremost, corrections are not unidirectional ie they don't just happen on the downside. There are upside corrections and downside corrections. So a correction purely defined is a correction of the trend. And a trend can be up and down.

Masses generally have a propensity to direction; they consider upsides as certainty and downside as uncertainty. A trader or a technician on the other hand knows that there is always a bull run going in some asset class as there can never be a market without a bull run. Unfortunately, owing to their homework, threshold level and asset bias, investors look at an asset at a time, which generally is the asset already in a bull trend.

Hence corrections are downwards for an equity player, which is in a bull trend. While corrections will be upwards for someone trading cotton or sugar considering the secular trend of multi-years is down for many commodities. But the definition does not just end here.

There is a degree connected to every correction. Charles Dow defined three degrees viz primary (more than nine months), intermediate (multi-months) and minor (less than three weeks). Elliott on the other hand extended the degrees taking it three levels higher and three levels lower viz cycle (few years), super cycle (decade), grand supercycle (many decades) on the higher side and minute (few weeks), minuette (few days) and subminuette (intra-day).

Now this might look a bit complex but only a degree defines how low or high a correction can go. And every trend starting a one minute trend has three legs up, which are separated by two corrections or two legs down. And after the three trend legs get over, we have a correction larger than the previous two corrections after which markets move to a higher degree and the process starts again subdividing higher on both scale and time.

Markets can move in corrections for years while a small investor may never understand or notice it. For example many agro commodities like wheat, coffee, sugar and cocoa have come out of more than two decades of correction of more than cycle degree. This is one of the reasons we never felt the harshness of food and agro prices as they were in a correction and not in a trend.

So if you don't understand the degree, you don't even know if it's a trend or a counter trend (correction). And you will have no comprehension of the fact that a countertrend is a part of a trend and a trend could be the part of a higher degree correction. It's only when you understand the degree can you say how long the correction can last or how deep it will be.

For a simple investor the Indian rupee must be in a strengthening trend, but for an Elliottician who studies degrees of multi-years and decades, the rupee is moving in a counter trend against the multi-year weakening against the dollar that pushed the currency from Rs 17 to the dollar in 1990 till Rs 55 in 2002.

Trends and countertrend work on all assets, and even on the Sensex. We may try to convince ourselves that the Sensex is in a unilateral move to 36,000 or 40,000, it will be wishful thinking, far away from reality. Before that happens, we will have corrections correcting the existing trend. So a seven year trend needs at least a nine-month trend down or sideways to correct.

And if markets get into a corrective of over a year, all prayers will come to a naught as the trend will seize in its path and remain till the time it decays, corrects and wastes the time it has to rebuild or reconstruct. This is why we keep saying that markets have life; they also need energy and strength to move up. It's not some rocket with unlimited fuel. The market is as human as all of us, just that it's an extension of many humans, a complete society.

Though corrections bring in chaos, there is no order or trend without them. And hence, understanding a correction is as important as wealth creation. Investors who understand corrections and their extent are better prepared than ones who see every dip as a correction and every rise as perfect. If only it was that easy.

Correctives not only come with degree but also have a form linked with them. A corrective could be sharp or sideways. It was between these two types that Elliott classified 13 forms. And even if you start seeing them, which is easy, it is the believing part which is tough; believing that markets work on mass psychology patterns and fractals and not on economic valuations.

We are in an ongoing primary (more than nine months) five wave up (final leg of three legs up), which is a part of the Super Cycle degree of more than 30 years. The current move up should complete sometime this year for the Sensex. This means that every correction that happens should not last for more than multiple weeks after which the trend up should continue.

Any dip that started from the recent top near 21,000 should not move below 19,000-18,000. After that the final leg up also called as the fifth wave of intermediate (multiple months) should begin taking markets to new highs. Whether this turns out right is of course connected with the skill and experience of watching and understanding corrections and labelling them degree by degree. It's definitely more risky then calling every dip a correction. But then risk has a return side too. Let's see how low this correction takes us.

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The writer is CEO, Orpheus Capitals, a global alternative research company.