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This
is part 3 of a three-part explanation of the Wave Principle by Robert
Prechter.
Have
you ever had a sure thing — a case where the market absolutely had to
go up or down?
All Elliott can do is
order the probabilities, and they are never 100%. But there have
definitely been times when my own mind felt that the probability was
100%. I get so excited I can barely contain myself when that happens.
I’m usually right then, but not always!
Keep in mind
that while one can never say that a certain event must happen, there
are times when one can say that a particular market event is
impossible. There’s always an alternate count, but there are certain
things that can’t happen under Elliott. And that is a very useful
fact.
The
calls you made on stocks, bonds and gold helped you to establish
yourself as a media presence in the 1980s. But one response to the
record is to say that the Wave Principle is not behind your success.
Some say it is gut feel or instinct, rather than the method. In other
words, it’s not the theory, it’s the theorist. You’ve always
insisted that it is the Wave Principle. How can you be sure it’s
giving you the edge and not the other way around?
Gut feel and instinct
will get you clobbered in the market. The market is the collective
gut, which means you have to be counter-instinctual to beat it. The
only way to do that is with a method that takes that reality into
account.
Looking
in more detail at an Elliott wave, what is the progression that takes
place over the course of an "impulse," which is Elliott’s
term for the classic five-wave pattern?
If you watch any of
these wave structures, whether over the last 40 weeks, 40 years or 40
minutes, you see the same progression recurring. After a market
reaches its low, so-called strong hands — people who have been
around a long time, do some buying. Psychology has passed its low
point. News remains scary because it is the tangible result of the
prior downtrend in psychology. That is the first wave up.
Then the
second wave, the correction of the first move, takes place. The vast
majority of investors are convinced that wave 1 was merely a bounce in
the previous bear market and that wave 2 is the beginning of the next
phase of decline. Usually, the fears that were around at the actual
bottom recur at the bottom of wave 2. Again, news is very dark, but
the prices are ahead of news. They do not fall to a new low.
From that
base, wave 3 begins, which is the middle portion of the larger
advance, and that third wave is almost always accompanied by
increasingly positive news and "fundamentals." Those better
fundamentals are the result of the increase in optimism, and they
reinforce the psychological upturn. That is why wave 3, as Elliott
noted, is most often the longest, strongest and broadest in the
sequence. Every day, there is reason to be optimistic. All of those
people who thought during waves 1 and 2 that the long-term trend was
down finally become convinced that the long-term trend is up.
That change
persists all the way to the top of wave 3. Then comes wave 4, which is
a correction of that long third. Most people have finally become
convinced by the top of wave 3 that the long-term trend is up. Wave 4
is a surprising disappointment.
From the
fourth wave correction low, the market stages the final wave up. The
fifth wave is generally easy to recognize because the psychology tends
to be more speculative and euphoric, while at the same time, the
internal strength, or momentum, of the market is not as strong as it
was during wave 3. The psychology goes through its final binge in the
fifth wave. That’s when, figuratively speaking, the last guy puts
his last nickel in, and that’s the end of the sequence.
Let’s
examine one of these waves — the fifth wave — since, by your wave
count, the Dow Jones Industrial Average has been in a fifth wave of
Grand Supercycle, Supercycle and Cycle degree for the better part of
many people’s lives. What is the profile?
The market is usually
quite selective and rotational in a fifth, creating a weak upward
trend or even a sideways trend in the advance-decline line. You will
often see huge rises in certain individual issues, while many lag
significantly. Usually in fifth waves, the general speculation is
concentrated most heavily in the blue chip sector. You also generally
see the market attracting new players, unsophisticated players who
have been watching the bull market year after year and finally became
convinced that they should be involved.
That is one
reason why the market, or at least large segments of the market,
become extremely overvalued. It is attracting new players who have no
concept of value and are just willing to buy because they think
someone else will be buying from them tomorrow. In other words, it’s
an engine that is running on increasingly available fuel — which is
more people with money — with its forward movement as it own end.
The situation creates a speculative bubble, a chasing of paper value
for quick profit. Often it is a craze that sinks very deeply into the
society. We had this style of advance in the 1920s, for instance.
In this most
recent fifth wave, mechanisms were put in place that fostered terrific
speculation. There was the development of the stock index futures
market and the very intricate options markets, with options on stocks,
options on futures indexes, and so forth. There has been increased
media coverage as well. In fact, it’s an incalculable increase.
Television, for instance, didn’t report on business or markets prior
to the 1981 launch of Financial News Network, which is now CNBC. It
has been so successful that more all-business news networks are about
to be launched. It’s a great major top signal.
In
following in Elliott’s footsteps, you moved out onto some relatively
unexplored intellectual terrain. Your idea that history reflects the
Wave Principle is one of them. Your identification of cultural trends as
reflective of the overall mood is another. Regardless of the subfield
you discuss, though, you reiterate that "mass psychology is
structured," and that Elliott identified the structure. After
witnessing this movement in the stock market data and its apparent
constancy, both you and Elliott have concluded that collective human
sociology is not random, but travels a path as if following a law of
nature, like gravity or thermodynamics. If this is true, then science,
the study of nature, should supply some corroborating testimony. Is
there anything going on in science to support you on this?
During the past 20 years,
several scientists have reintroduced the idea of the fractal geometry
of nature. The recent work has been pioneered by Benoit Mandelbrot.
His computer studies revealed that many processes in nature, while at
first appearing chaotic, are actually very structured, but in ways
most people have never considered. The component structures are not
simple geometric forms like circles and squares; they may be very
jagged constructs. But the components of the jagged pattern are jagged
to the same degree as the larger pattern itself. If you take a stalk
of broccoli as a common example, and you break off a piece near the
top, the piece you break off looks exactly like a stalk of broccoli.
If you break off a smaller piece from it, it also looks exactly like a
stalk of broccoli — just smaller. The components take the shape of
the whole. What’s exciting to me is that Elliott noticed the same
thing about stock market prices half a century before Mandelbrot.
From
an Elliott wave perspective, there are also differences within the same
market. Advances and declines, bull and bear markets, take different
shapes. Is this also true of the psychology in bull and bear markets?
The problem with
declines is that they can follow a lot more paths, because there are
numerous corrective patterns. At the start of a bear market, all you
have are hints. You have little certainty about which one of the
shapes is going to take place. All you can say is it is going to be
rough for a while. Bob Farrell says that a bear market goes from
caution to concern to capitulation. In most patterns, that’s true,
but in contracting triangles, it goes the opposite way: capitulation,
concern, then caution, or at least complete disregard.
Bear markets
tend to bring bad news in one form or another, regardless of their
shape. Triangles, for instance, are seemingly moderate sideways
patterns. Yet there is almost always a scary event or point of focus
in wave e, the last wave, that keeps you out of the next advance. In a
large bear market, wave e of an upward triangle correction usually
features a bullish event that gets you to buy just before the rug is
pulled. However, the worst news — the news that turns out making the
history books — usually awaits the end of a large bear market. Bull
markets do it again, only the other way around. They save the best
news for last. Just look at the amazing world news of the past six
years: Communists giving up power, old enemies signing peace pacts,
the implications of the computer revolution.
In
real time, the Wave Principle is a lot more complicated than it sounds
when you simply describe the types of waves. Dealing with corrections is
particularly difficult. What makes it so much more difficult to pinpoint
your position in a corrective wave than an impulse waves?
Five-stage movements
are generally uniform, with very few exceptions to the rule. When
prices are moving with the trend, they are moving very freely, and you
get the full five-wave structure. In that case, analysis is not that
much harder than it sounds on paper. But when the short-term trend is
fighting the intermediate-term trend, it is going against the tide.
Corrective processes by their very nature are fighting the larger flow
of price movement. When the market is fighting the flow, it can only
go so far. It never develops the five waves. In 10 years of studying
the market, I’ve never seen an exception.
Is
this also why there are several different ways that corrections can
unfold?
Corrections are the
point at which the out-flowing river meets the incoming tide. The
jumble that results is far less uniform than the river’s flow or the
tidal force. As a result, knowing exactly which of the corrective
patterns has begun is impossible at the outset. The analyst knows that
moves against the larger trend never develop into full five waves, but
he does not know precisely which non-five wave structure it will be.
Nevertheless, R.N. Elliott’s compilation of the list of countertrend
patterns is the product of brilliance. Though there are a number of
them, he described them clearly, and that is of substantial value in
practical application.
Is
there a simple guideline that a novice can follow to help him weather
corrective Elliott Wave patterns?
Sure. During these
periods in which Elliott Wave analysis is the most difficult, do
nothing. It is not necessary to forecast all the time unless you are
in the business, like I am. So just wait for the pattern to clear and
then take action.
Some
analysts get annoyed at this. They say, "That’s the problem with
the Wave Principle. It doesn’t work in bear markets."
Well, tough break!
Bear markets are what they are. If someone objects to what the market
is, then he is arguing with nature and the reality of markets.
"Less predictable" does not mean impossible, indecipherable,
disorderly or random, either. You can form some useful opinions about
corrections. The ultimate price goal of a fourth wave correction, for
instance, can be forecast with more accuracy than most impulses.
What’s more, it is the Wave Principle that tells the analyst when to
expect less predictability. So your overheard "objection" is
not a problem with the Wave Principle, much less a revelation of where
the Wave Principle cannot be applied. That the Wave Principle
recognizes the differences in market behavior is one of its greatest
strengths.
What
about those who say investing with impulse waves, or in the direction of
the trend, isn’t that hard anyway?
Tell that to 83% of
the professional money managers who under-performed the Standard &
Poor’s or the Dow Jones Industrial Average for three years in the
heart of the bull market of the 1980s. Tell it to the 98% of money
managers who got killed in the last downward impulse in 1973-1974.
Tell that to the 99% of the public who lose money in their investments
over the long run. I, for one, recognize the fact that successful
investing is extremely difficult. Anyone who tells you it is not is
headed for a fall.
Can
Elliott save you from a fall?
It can save you from
a catastrophic loss. It is one of the few concepts I know that allows
the investor to get out of a losing position with a small loss for an
objective reason. The alternatives are to ride it out or simply get
out because an arbitrary "stop" level has been reached,
which nine times out of ten gets you out just before the big gains are
due.
Part 1
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2 Back
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