Pattern recognition is the foundation of Elliott wave analysis. Newcomers to the method with a background in fundamental analysis -- those who make forecasts by watching economic news, world events and central bank actions -- are often stunned to find out that you can forecast markets simply by studying a chart.
Here's a good example. One of the Elliott wave chart patterns is a "contracting triangle." It's a sideways, corrective move comprised of five overlapping waves labeled A-B-C-D-E. This diagram shows them both in bull and bear markets:
Triangles often appear in specific positions within a wave pattern: wave 4 and wave B. Once a triangle ends, prices resume in the direction of the preceding larger trend.
Armed with this knowledge, let's look at what unfolded on Monday, January 17. China's Shanghai Composite stock index lost 3%; analysts attributed the sharp one-day decline to a recent Chinese government decision to raise reserves at China's banks. But from an Elliott wave perspective, that wasn't the real reason behind the sharp stock decline.
On Sunday, January 16 -- the day before the Shanghai Composite fell 3% -- Elliott Wave International's Asian-Pacific Short Term Update posted this chart and forecast:
[China – Shanghai Composite Index]
We’re anticipating a sharp break in coming days in the Shanghai Composite index. Prices may find short-term support at the 2700 level...
Notice the suggested support level in this January 16 forecast: 2700. Guess where the Shanghai Composite finished trading the following day? 2,706.66! This is what prices looked like at the close on January 17: