Elliott Wave Principle : Chapter 7

Chapter 7

Other Approaches to the Stock Market & Their Relationship to The Wave Principle 

7.1 Other Approaches to the Stock Market & Their Relationship to The Wave Principle

Dow Theory

According to Charles H. Dow, the primary trend of the market is the broad, all-engulfing "tide," which is interrupted by "waves," or secondary reactions and rallies. Movements of smaller size are the "ripples" on the waves. The latter are generally unimportant unless a line (defined as a sideways structure lasting at least three weeks and occurring within a price range of five percent) is formed. The main tools of the theory are the Transportation Average (formerly the Rail Average) and the Industrial Average. The leading exponents of Dow’s theory, William Peter Hamilton, Robert Rhea, Richard Russell and E. George Schaefer, rounded out Dow’s theory but never altered its basic tenets.

As Charles Dow once observed, stakes can be driven into the sands of the seashore as the waters ebb and flow to mark the direction of the tide in much the same way as charts are used to show how prices are moving. Out of experience came the fundamental Dow Theory tenet that since both averages are part of the same ocean, the tidal action of one average must move in unison with the other to be authentic. Thus, a movement to a new extreme in an established trend by one average alone is a new high or new low that is said to lack "confirmation" by the other average.

The Elliott Wave Principle has points in common with Dow Theory. During advancing impulse waves, the market should be a “healthy” one, with breadth and the other averages confirming the action. When corrective and ending waves are in progress, divergences, or non-confirmations, are likely. Dow’s followers also recognized three psychological “phases” of a market advance. Naturally, since both methods describe reality, the Dow Theorists’ brief descriptions of these phases conform to the personalities of Elliott’s waves 1, 3 and 5 as we outlined them in Chapter 2.

Figure 7-1

The Wave Principle validates much of Dow Theory, but of course Dow Theory does not validate the Wave Principle since Elliott’s concept of wave action has a mathematical base, needs only one market average for interpretation, and unfolds according to a specific structure. Both approaches, however, are based on empirical observations and complement each other in theory and practice. Often, for instance, wave counts for the averages will forewarn the Dow Theorist of an upcoming non-confirmation. If, as Figure 7-1 shows, the Industrial Average has completed four waves of a primary swing and part of a fifth, while the Transportation Average is rallying in wave B of a zigzag correction, a non-confirmation is inevitable. In fact, this type of development has helped the authors more than once. As an example, in May 1977, when the Transportation Average was climbing to new highs, the preceding five-wave decline in the Industrials during January and February signaled loud and clear that any rally in that index would be doomed to create a non-confirmation.

On the other side of the coin, a Dow Theory non-confirmation can often alert the Elliott analyst to examine his count to see whether or not a reversal should be the expected event. Thus, knowledge of one approach can assist in the application of the other. Since Dow Theory is the grandfather of the Wave Principle, it deserves respect for its historical significance as well as its consistent record of performance over the years.

The “Kondratieff Wave” Economic Cycle

The fifty- to sixty- (averaging fifty-four) year cycle of catastrophe and renewal had been known and observed by the Mayas of Central America and independently by the ancient Israelites. The modern expression of this cycle is the “long wave” of economic and social trends observed in the 1920s by Nikolai Kondratieff, a Russian economist. Kondratieff documented, with the limited data available, that economic cycles of modern capitalist countries tend to repeat a cycle of expansion and contraction lasting a bit over half a century. These cycles correspond in size to Super cycle degree (and occasionally Cycle degree when an extension is involved) waves under the Wave Principle.

Figure 7-2, courtesy of The Media General Financial Weekly, shows the idealized concept of Kondratieff cycles from the 1780s to the year 2000 and their relationship to wholesale prices. Notice that within the Grand Super cycle wave shown in Figure 5-4, the beginning of wave (I) to the deep low of wave a of (II) in 1842 roughly tracks one Kondratieff cycle, the extended wave (III) and wave (IV) track most of two Kondratieffs, and our current Super cycle wave (V) will last throughout most of one Kondratieff.

Figure 7-2

* The April 6, 1983 Special Report (see Figure A-8 in the Appendix) recognized that the last contraction ended later than depicted in this standard illustration, in 1949, pushing all forecast dates forward accordingly

Kondratieff noted that “trough” wars, i.e., wars near the bottom of the cycle, usually occur at a time when the economy stands to benefit from the price stimulation generated by a war economy, resulting in economic recovery and an advance in prices. “Peak” wars, on the other hand, usually occur when recovery is well advanced and, as the government pays for the war by the usual means of inflating the money supply, prices rise sharply. After the economic peak, a primary recession occurs, which is then followed by a disinflationary “plateau” of about ten years’ duration in which relatively stable and prosperous times return. The end of this period is followed by several years of deflation and a severe depression.

The first Kondratieff cycle for the U.S. began at the trough that accompanied the Revolutionary War, peaked with the War of 1812, and was followed by a plateau period called the “Era of Good Feeling,” which preceded the depression of the 1830s and ’40s. As James Shuman and David Rosenau describe in their book, The Kondratieff Wave, the second and third cycles unfolded economically and sociologically in a surprisingly similar manner, with the second plateau accompanying the “Reconstruction” period after the Civil War and the third aptly referred to as the “Roaring Twenties,” which followed World War I. The plateau periods generally supported good stock markets, especially the plateau period of the 1920s. The roaring stock market of that time was followed ultimately by collapse, the Great Depression and general deflation until about 1942.

As we interpret the Kondratieff cycle, we have now reached another plateau, having had a trough war (World War II), a peak war (Vietnam) and a primary recession (1974-75). This plateau should again be accompanied by relatively prosperous times and a strong bull market in stocks. According to a reading of this cycle, the economy should collapse in the mid-1980s and be followed by three or four years of severe depression and a long period of deflation through to the trough year 2000 A.D. This scenario fits ours like a glove and would correspond to our fifth Cycle wave advance and the next Super cycle decline, as we discussed in Chapter 5 and further outline in the last chapter.

7.2 Cycles

The “cycle” approach to the stock market has become quite fashionable in recent years as investors search for tools to help them deal with a volatile, net-sideways trend. This approach has a great deal of validity, and in the hands of an artful analyst can be an excellent approach to market analysis. However, in our opinion, while it can make money in the stock market as can many other technical tools, the “cycle” approach does not reflect the true essence of the law behind the progression of markets.

Unfortunately, just as the Elliott Wave Principle in conjunction with Dow Theory and one or two related methods spawned a large public following for the “all bull markets have three legs” thesis, cycle theories have recently spawned a rigid adherence to the “four-year cycle” idea by many analysts and investors. Some comments seem appropriate. First, the existence of any cycle does not mean that moves to new highs within the second half of the cycle are impossible. The measurement is always low to low, regardless of intervening market action. Second, while the four-year cycle has been visible for the postwar period (about thirty years), evidence of its existence prior to that time is spotty and irregular, revealing a history that will allow for its contraction, expansion, shift or disappearance at any time.

For those who have found success using a cyclic approach, we feel that the Wave Principle can be a useful tool in predicting changes in the lengths of cycles, which seem to fade in and out of existence at times, usually with little or no warning. Note, for instance, that the four-year cycle has been quite visible in most of the current Super cycle’s sub waves II, III and IV but was muddled and distorted in wave I, the 1932-1937 bull market, and prior to that time. If we remember that the two shorter waves in a five-wave bull move tend to be quite similar, we can deduce that the current Cycle Wave V should more closely resemble wave I (1932-37) than any other wave in this sequence, since wave III from 1942 to 1966 was the extended wave and will be dissimilar to the two other motive waves. The current wave V, then, should be a simpler structure with shorter cycle lengths and could provide for the sudden contraction of the popular four-year cycle to more like three and a half years. In other words, within waves, cycles may tend toward time constancy. When the next wave begins, however, the analyst should be on the alert for changes in periodicity. Since we believe that the debacle currently predicted for 1978 and 1979 by the cycle theorists on the basis of the four- and nine-year cycles will not occur, we would like to present the following quotation from “Elliott’s Wave Principle — A Reappraisal” by Charles J. Collins, published in 1954 by Bolton, Tremblay & Co.:

Elliott alone among the cycle theorists (despite the fact he died in 1947, while others lived) provided a basic background of cycle theory compatible with what actually happened in the postwar period (at least to date).

According to orthodox cycle approaches, the years 1951- 1953 were to produce somewhat of a holocaust in the securities and commodity markets, with depression centering in this period. That the pattern did not work out as anticipated is probably a good thing, as it is quite doubtful if the free world could have survived a decline which was scheduled to be almost as devastating as 1929-32.

In our opinion, the analyst could go on indefinitely in his attempt to verify fixed cycle periodicities, with negligible results. The Wave Principle reveals that the market reflects more the properties of a spiral than a circle, more the properties of nature than of a machine.

Figure 7-3

The Decennial Pattern

Figure 7-3 is a chart, courtesy of Edson Gould and Anametrics, Inc., of the “decennial pattern,” as averaged out over the past seven decades in the stock market. In other words, this chart is a reproduction of the DJIA action, since its inception, for the composite decade, years one through ten. The tendency toward similar market action in each year of the decade is well documented and is referred to as the “decennial pattern.” Our approach, however, gives this observation a new and startling meaning. Look for yourself: a perfect Elliott wave.

News

While most financial news writers explain market action by current events, there is seldom any worthwhile connection. Most days contain a plethora of both good and bad news, which is usually selectively scrutinized to come up with a plausible explanation for the movement of the market. In Nature’s Law, Elliott commented on the value of news as follows:

At best, news is the tardy recognition of forces that have already been at work for some time and is startling only to those unaware of the trend. The futility in relying on anyone’s ability to interpret the value of any single news item in terms of the stock market has long been recognized by experienced and successful traders. No single news item or series of developments can be regarded as the underlying cause of any sustained trend. In fact, over a long period of time the same events have had widely different effects because trend conditions were dissimilar. This statement can be verified by casual study of the 45-year record of the Dow Jones Industrial Average.

During that period, kings have been assassinated, there have been wars, rumors of wars, booms, panics, bankruptcies, New Era, New Deal, “trust busting,” and all sorts of historic and emotional developments. Yet all bull markets acted in the same way, and likewise all bear markets evinced similar characteristics that controlled and measured the response of the market to any type of news as well as the extent and proportions of the component segments of the trend as a whole. These characteristics can be appraised and used to forecast future action of the market, regardless of news.

There are times when something totally unexpected happens, such as earthquakes. Nevertheless, regardless of the degree of surprise, it seems safe to conclude that any such development is discounted very quickly and without reversing the indicated trend under way before the event. Those who regard news as the cause of market trends would probably have better luck gambling at race tracks than in relying on their ability to guess correctly the significance of outstanding news items. Therefore, the only way to “see the forest clearly” is to take a position above the surrounding trees.

Elliott recognized that not news, but something else forms the patterns evident in the market. Generally speaking, the important analytical question is not the news per se, but the importance the market places or appears to place on the news. In periods of increasing optimism, the market’s apparent reaction to an item of news is often different from what it would have been if the market were in a downtrend. It is easy to label the progression of Elliott waves on a historical price chart, but it is impossible to pick out, say, the occurrences of war, the most dramatic of human activities, on the basis of recorded stock market action. The psychology of the market in relation to the news, then, is sometimes useful, especially when the market acts contrarily to what one would “normally” expect.

Our studies suggest not simply that news tends to lag the market but that it nevertheless follows exactly the same progression. During waves 1 and 2 of a bull market, the front page of the newspaper reports news that engenders fear and gloom. The fundamental situation generally seems its worst as wave 2 of the market’s new advance bottoms out. Favorable fundamentals return in wave 3 and peak temporarily in the early part of wave 4. They return partway through wave 5, and like the technical aspects of wave 5, are less impressive than those present during wave 3 (see “Wave Personality” in Chapter 3). At the market’s peak, the fundamental background remains rosy, or even improves, yet the market turns down despite it. Negative fundamentals then begin to wax again after the correction is well under way. The news, or “fundamentals,” then, are offset from the market temporally by a wave or two. This parallel progression of events is a sign of unity in human affairs and tends to confirm the Wave Principle as an integral part of the human experience.

Technicians argue, in an understandable attempt to account for the time lag, that the market “discounts the future,” i.e., actually guesses correctly in advance changes in the social condition. This theory is initially enticing because in preceding economic developments and even socio-political events, the market appears to sense changes before they occur. However, the idea that investors are clairvoyant is somewhat fanciful. It is almost certain that in fact people’s emotional states and trends, as reflected by market prices, cause them to behave in ways that ultimately affect economic statistics and politics, i.e., produce “news.” To sum up our view, then, the market, for forecasting purposes, is the news.

Random Walk Theory

Random Walk theory has been developed by statisticians in the academic world. The theory holds that stock prices move randomly and not in accord with predictable patterns of behavior. On this basis, stock market analysis is pointless as nothing can be gained from studying trends, patterns, or the inherent strength or weakness of individual securities.

Amateurs, no matter how successful they are in other fields, usually find it difficult to understand the strange, “unreasonable,” sometimes drastic, seemingly random ways of the market. Academics are intelligent people, and to explain their own inability to predict market behavior, some of them simply assert that prediction is impossible. Many facts contradict this conclusion, and not all of them are at the abstract level. For instance, the mere existence of very successful professional traders who make hundreds, or even thousands, of trading decisions a year flatly disproves the Random Walk idea, as does the existence of portfolio managers and analysts who manage to pilot brilliant careers over a professional lifetime. Statistically speaking, these performances prove that the forces animating the market’s progression are not random or due solely to chance. The market has a nature, and some people perceive enough about that nature to attain success. A very short-term trader who makes tens of decisions a week and makes money each week has accomplished something far less probable (in a random world) than tossing a coin fifty times in a row with the coin falling “heads” each time. David Bergamini, in Mathematics, stated,

Tossing a coin is an exercise in probability theory which everyone has tried. Calling either heads or tails is a fair bet because the chance of either result is one half. No one expects a coin to fall heads once in every two tosses, but in a large number of tosses, the results tend to even out. For a coin to fall heads fifty consecutive times would take a million men tossing coins ten times a minute for forty hours a week, and then it would only happen once every nine centuries.

An indication of how far the Random Walk theory is removed from reality is the chart of the first 89 days of trading on the New York Stock Exchange after the 740 low on March 1, 1978, as shown in Figure 2-16 and discussed therewith. As demonstrated there and in the chart of the Super cycle in Figure 5-5, action on the NYSE does not create a formless jumble wandering without rhyme or reason. Hour after hour, day after day and year after year, the DJIA’s price changes create a succession of waves dividing and subdividing into patterns that perfectly fit Elliott’s basic tenets as he laid them out forty years ago. Thus, as the reader of this book may witness, the Elliott Wave Principle challenges the Random Walk theory at every turn.

7.3 Technical Analysis

The Elliott Wave Principle not only supports the validity of chart analysis, but it can help the technician decide which formations are most likely of real significance. As does the Wave Principle, technical analysis (as described by Robert D. Edwards and John Magee in their book, Technical Analysis of Stock Trends) recognizes the “triangle” formation as generally an intra-trend phenomenon. The concept of a “wedge” is the same as that for Elliott’s diagonal and has the same implications. Flags and pennants are zigzags and triangles. “Rectangles” are usually double or triple threes. “Double tops” are generally caused by flats, “double bottoms” by truncated fifths.

The famous “head and shoulders” pattern can be discerned in a normal Elliott top (see Figure 7-4), while a head and shoulders pattern that “doesn’t work out” might involve an expanded flat correction under Elliott (see Figure 7-5). Note that in both patterns, the decreasing volume that usually accompanies a head and shoulders formation is a characteristic fully compatible with the Wave Principle. In Figure 7-4, wave 3 will have the heaviest volume, wave 5 somewhat lighter, and wave B usually lighter still when the wave is of Intermediate degree or lower. In Figure 7-5, the impulse wave will have the highest volume, wave B usually somewhat less, and wave four of C the least.

Figure 7-4

Trend lines and trend channels are used similarly in both approaches. Support and resistance phenomena are evident in normal wave progression and in the limits of bear markets (the congestion of wave four is support for a subsequent decline). High volume and volatility (gaps) are recognized characteristics of “breakouts,” which generally accompany third waves, whose personality, as discussed in Chapter 2, fills the bill.

Figure 7-5

Despite this compatibility, after years of working with the Wave Principle we find that applying classical technical analysis to stock market averages gives us the feeling that we are restricting ourselves to the use of stone tools in an age of modern technology.

The technical analytic tools known as “indicators” are often extremely useful in judging and confirming the momentum status of the market or the psychological background that usually accompanies waves of each type. Indicators of investor psychology, such as those that track short selling, option transactions and market opinion polls, reach extreme levels at the end of C waves, second waves and fifth waves. Momentum indicators reveal an ebbing of the market’s power (i.e., speed of price change, breadth and in lower degrees, volume) in fifth waves and in B waves in expanded flats, creating “momentum divergences.” Since the utility of an individual indicator can change or evaporate over time due to changes in market mechanics, we strongly suggest their use as tools to aid in correctly counting Elliott waves but would not rely on them so strongly as to ignore wave counts of obvious portent. Indeed, the associated guidelines within the Wave Principle at times have suggested a market environment that made the temporary alteration or impotence of some market indicators predictable.

The “Economic Analysis” Approach

Currently extremely popular with institutional fund managers and advisors is the method of trying to predict the stock market by forecasting changes in the economy using interest rate trends, typical postwar business cycle behavior, rates of inflation and other measures. In our opinion, attempts to forecast the market without listening to the market itself are doomed to fail. If anything, the market is a far more reliable predictor of the economy than vice versa. Moreover, taking a historical perspective, we feel strongly that while various economic conditions may be related to the stock market in certain ways during one period of time, those relationships are subject to change seemingly without notice. For example, sometimes a recession begins near the start of a bear market, and sometimes one does not occur until the end. Another changing relationship is the occurrence of inflation or deflation, each of which has appeared bullish for the stock market in some cases and bearish for the stock market in others. Similarly, tight money fears have kept many fund managers out of the 1978 market to date, just as the lack of such fears kept them invested during the 1962 collapse. Falling interest rates often accompany bull markets but also accompany the very worst market declines, such as that of 1929-1932.

While Elliott claimed that the Wave Principle was manifest in all areas of human endeavor, even in the frequency of patent applications, for instance, the late Hamilton Bolton specifically asserted that the Wave Principle was useful in telegraphing changes in monetary trends as far back as 1919. Walter E. White, in his work, “Elliott Waves in the Stock Market,” also finds wave analysis useful in interpreting the trends of monetary figures, as this excerpt indicates:

The rate of inflation has been a very important influence on stock market prices during recent years. If percentage changes (from one year earlier) in the consumer price index are plotted, the rate of inflation from 1965 to late 1974 appears as an Elliott 1-2-3-4-5 wave. A different cycle of inflation than in previous postwar business cycles has developed since 1970 and the future cyclical development is unknown. The waves are useful, however, in suggesting turning points, as in late 1974.

Elliott wave concepts are useful in the determination of turning points in many different series of economic data. For instance, net free banking reserves, which White said “tend to precede turning points in the stock market,” were essentially negative for about eight years from 1966 to 1974. The termination of a five-wave decline in late 1974 suggested a major buying point.

As testimony to the utility of wave analysis in the money markets, we present in Figure 7-6 a wave count for the price of a long term U.S. Treasury bond, the 8 and 3/8 of the year 2000. Even in this brief nine-month price pattern, we see a reflection of the Elliott process. On this chart, we have three examples of alternation, as each second wave alternates with each fourth, one being a zigzag, the other a flat. The upper trend line contains all rallies. The fifth wave constitutes an extension, which itself is contained within a trend channel. At the current stage of interpretation, the best bond market rally in almost a year is due quite soon.

Figure 7-6

Thus, while monetary phenomena may relate to stock prices in a complex way, our experience is that price movements always create an Elliott pattern. Apparently, what influences investors in managing their portfolios is likely influencing bankers, businessmen and politicians as well. It is difficult to separate cause from effect when the interactions of forces at all levels of activity are so numerous and intertwined. Elliott waves, as a reflection of the mass psyche, extend their influence over all categories of human behavior.

Exogenous Forces