(This is part 1 of a three-part explanation of the Wave Principle by Robert Prechter. This text is excerpted from one of EWI’s most popular titles, Prechter’s Perspective. See below to find out how to get a copy of the 270-page classic at a special cost.)

What is the Wave Principle?

The Wave Principle is, first and foremost, a detailed description of how markets behave. Now, there’s probably more that is not in that sentence than is in that sentence. For instance, a detailed description of how markets behave does not refer to what outside events are occurring, such as in the fields of economics, politics, or social trends. It’s strictly a study of how human beings behave collectively in the trading arena.

What specifically did Elliott discover?

Elliott’s most important discovery was that the patterns that develop in the stock market occur at all degrees of trend. The larger patterns are made up of components that are themselves composed of smaller ones. The same patterns on a smaller scale combine to create any one of those patterns on a larger scale. The larger pattern will combine with several others of the same degree to create an even larger pattern and so on. He described in detail exactly what those patterns look like. He identified 13 of them. Only recently has data been available for general stock prices back to the late 1700s, and the patterns are there as well.

How did he label the “degrees” of trend?

Elliott began by naming a particular structure with an arbitrary label, Primary degree, a term borrowed from Dow Theory. The next larger degree he called Cycle, and the next larger Supercycle. The lower degrees he named Intermediate, Minor, and so on. We therefore have a way to refer to the degrees of trend that we are talking about.

What was the biggest degree trend he talked about?

Grand Supercycle, which he guessed dated back to the founding of the United States. Since then, more detailed stock market data has confirmed that he was right. That’s not the biggest degree, though, as all waves are components of larger ones.

You once referred to the Wave Principle as the “purest form of technical analysis.” Why?

For a hundred years, investors have noticed that events external to the market often seem to have no effect on the market’s progress. With the knowledge that the market continuously unfolds in waves that are related to each other through form and ratio, we can see why there is little connection. The market has a life of its own. It is mass psychology that is registering. Changes in feelings show up directly as price changes in the barometer known as the DJIA, or the S&P 500, or any other index. The Wave Principle is a catalog of the ways that the crowd goes from the extreme point of pessimism at the bottom to the extreme point of optimism at the top. It is a description of the steps human beings go through when they are part of the investment crowd, to change their psychological orientation from bullish to bearish and back again. That description fits the movement of any market, as long as human beings are involved, rather than Martians, who may have a differently operating unconscious mind. Since people don’t change much, the path they follow in moving from extreme pessimism to extreme optimism and back again tends to be the same over and over and over, regardless of news and extraneous events.

What is the basic path?

Very simply, Elliott recognized that movement in the direction of the one larger trend subdivides into five waves. Movement against the trend subdivides into a three-wave pattern or some variation involving several three-wave patterns. In rising markets, true bull markets, the subdivisions occur in five waves up, an up-down-up-down-up sequence. Bear markets tend to occur in three wave sequences, down-up-down. Each one of those movements has a shape and a personality. As long as you can recognize the shapes that are occurring, you have a handle on what might happen next.

But the five-wave form does occur on the downside.

Yes, but only as a component of a larger three-wave pattern. The essence of the Wave Principle is that the moves in the direction of the one larger trend are five-wave structures, while moves against the one larger trend are three-wave structures. From that, you can tell what the underlying trend is and invest accordingly.

You just go on Elliott’s description alone. Does that mean you must act without knowing what’s causing the pattern?

On the contrary, I know what is causing the patterns: human nature as it relates to a person interacting with his fellows. When you ask what outside force is “causing” the patterns, you are asking the wrong question, so you are already on the wrong path. Elliott’s description of how markets behave forces you to a conclusion about cause and effect in social events. All of the causes most people assume to be operative are not, such as the latest political speeches or the latest numbers on the economy. They are simply results of the patterns of mass human psychology.

Is Elliott’s a mechanical system?

Not really. What we’re dealing with here is the behavior of people. If the tools you work with measure something other than the behavior of people, you’ll be removed from the reality of what’s going on. One of the biggest failures, in terms of approaching the stock market, is to assume that the market is mechanical in the sense that outside action causes market reaction, such as the idea that the market “responds” to Fed policy or the trade balance or political decisions. Others have tried to reduce it to a sum of periodic sine waves, but always find that it cannot be done, because the market is not a time-repetitive machine in its essence.

From the standpoint of theory, market behavior is tied to a mathematical law, but it is just not the same type of law found in the physical sciences. From the standpoint of practical application, the Wave Principle is tracking a living system, which is allowed variation in its forms, in fact, infinite variation, but limited by an essential form. Whereas a rigid system with numbers, strict mechanical numbers, never works.

Doesn’t infinite variation imply that anything goes?

Not at all. Trees vary infinitely, but they all look like trees, don’t they? And you can tell them apart from clouds, which also vary infinitely, and buildings as well. In fact, despite infinite variability, they are amazingly similar. The same is true of market patterns.

Does knowing Elliott guarantee profits?

Only the most trained and experienced market participants can act contrarily to their natural tendencies. I have yet to meet a man who invested or traded with a completely rational program based on reasonable probabilities without allowing his greed, his fear, his extraneous opinions or his irrelevant judgments to interfere. It is man’s emotional side, particularly his social dependency, that makes him think the way his fellows do, and when he does that, he loses money in the markets. At least using Elliott, you have a basis that makes winning possible.

Continue to Part II