Prechter on The Wave Principle: Part 3

(This is the final part 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. You can see the previous article in this series here.)

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 its 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 wave?

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.