the 1930s in a series of articles and books. Elliott’s theory was rediscovered
and popularized by Robert Prechter who, together with stock market
analyst A. J. Frost, published Elliott Wave Principle: Key to Stock Market
Profits in 1978. Elliott’s wave principle has intriguing similarities to Dow
Theory, not least of which is its proposition that stock market prices move
in waves. In contrast to Dow Theory, Elliott considered his wave patterns
to be as valid a predictive device over any time period in the market that is
observed, from the entire history of the market down to a chart setting out
market price movements over just a 5- or 10-minute period.
Elliott’s theory bases itself on the same principle as Newton’s Third
Law of Motion in Physics—that every action is followed by a reaction. In
the financial markets this can probably be reduced to its most basic level
in the assertion that what goes up must come down. The Elliott wave principle
also claims an underlying correlation with the Golden Ratio (1.618)
associated with the Fibonacci Sequence of numbers, publicized by the 13th
century Italian mathematician Leonardo da Pisa, known as Fibonacci, and
derived from earlier mathematical theories developed in India. The supposed
scientific and arithmetic underpinnings of Elliott’s theory lead to a
very rigid principle that holds that market moves follow a constant pattern
of five waves in the direction of the main trend, bull or bear, followed
by three corrective waves. The cycle in a bull market runs up, down, up,
down, up, followed by down, up, down. In a bear market the five/three pattern
is neatly reversed. The wave pattern that is exhibited here is said to
reflect the constant swings of investor psychology from optimism to pessimism
and back again. We are certainly believers in this type of pendulum
swing from optimism to pessimism, as well as its effect on markets even
if we prefer to classify these primary emotional drives as “greed and fear”
(see Chapter 4). In common with many critics of the Elliott wave principle,
while we feel comfortable with the desire to replace outright chaos
or even a “random walk” with patterns that can help predict future price
movement, it is the rigidity of the five/three pattern that we find unrealistic
and a little too suggestive of an almost religious predetermination—as so
much that is Fibonacci-related tends to be. We like to mix our acceptance
of the existence of patterns in the markets with a judicious recognition of
the equally important existence of the more chaotic nature of the effects of
human emotional drives.
KONDRATIEFF WAVE
For those who like their waves or cycles in both the economy and markets
to be even more long-term, there is the Kondratieff Wave that originated
with the ideas of Russian economist Nikolai Kondratieff (1892–1938). This
school of thought posits a very long cycle, between 50 and 60 years, affecting
modern capitalist economies. Ironically, Kondratieff himself helped
develop the first Soviet Five Year Plan. But his writings were considered
critical of certain aspects of the Soviet planned economy and he was sentenced
to death by Stalinist officials and executed in 1938 after a period of
imprisonment in the Gulag. In our view, the waves of such long duration
that Kondratieff identified are probably of little more than academic interest.
Clearly the relevance of so-called supercycles to anyone
pursuing a short-term trading strategy would be minimal to nonexistent.
WATER, WATER, EVERYWHERE, BUT NOT
A DROP TO DRINK
As our comments here show, we do not hitch our wagon to any particular
theory based on market waves. We are, however, completely supportive of
the concept that market movements contain patterns that recur over and
over again and thus can be indicative of future trends in the market. Where
these patterns run over the longer term, such as bull or bear markets, they
can be considered cycles. Where they are short-term, lasting days, hours,
minutes, or perhaps even just a few seconds, they are better thought of as
fluctuations. In any case, the important thing to keep in mind is that they
are always there, constantly recurring and providing runes for the market
observer, whether trader or investor to ponder. One of the problems that
we see with these patterns, aptly given oceanic, or perhaps more properly
littoral metaphorical names, is that they may provide some useful guidance
to the market observer in his quest to understand where the market is
coming from and maybe in which direction it is going. As a result, those
writers who stand behind one or other of the wave theories generally set
out to advise their readers the best times to buy and the best times to sell
stocks as an asset class, based on the patterns that they have discerned.
However, they generally leave this important question unanswered: If this
is a good time to buy stocks, which particular individual stock or stocks
should I buy?
With the acknowledgment that there are patterns, trends, cycles, and
fluctuations in every market, in the next two chapters we look at some
of the reasons that they work in this way. We also examine how we take
that extra leap to use recurring market fluctuations to select individual
stocks to buy and how we choose the specific times at which we make
our purchases.
Read More : The Elliot Wave Principle
