Economics: Elliot wave theory

The Elliott wave theory forecasts stock market prices by charting their movements through regular cycles. Mass psychology causes these cycles by swinging from optimism to pessimism in rhythmic waves.

Prices zigzag to new highs or lows, then turn and zigzag in the other direction. In a bull market, according to the theory, stocks move upward first. The second movement, a correction, trends downward. The third movement is upward, and the fourth corrects. After the fifth movement , the upward wave is over, and a downward trend begins. In the new wave, the first movement is down, the second up, and the third down.

Ralph Nelson Elliott published The Wave Principle in 1938. The book explains that seemingly chaotic price movements conceal order. They form regular cycles. It is hard to see these tacking movements in the market because within each long trend shorter trends zigzag in their own rhythms. Shorter trends increase the strength of the longer trend if they move with it, but weaken it if they move against it.

The theory posits waves of various degrees, lengths, from the subminuette, lasting minutes; to the grand supercycle, sometimes lasting centuries. Waves are useful in price prediction partly because each degree of wave predicts the movement of the slightly longer wave. If a minor wave moves in a five pattern, the intermediate wave will also move in a five pattern. Therefore, waves of any degree are leading indicators for longer waves.

So supporters of the theory say. Opponents say stock prices move randomly or in response to events like wars or earnings. Wave practitioners seem to disagree among themselves about where waves begin and end, as well. To critics, genuine believers in the Elliott wave theory see a pattern where none exists.

Robert Prechter, a market technician with a Yale psychology degree, uses the theory to make predictions. Syndicated financial columnist Eric Tyson believes that Prechter’s advice underperformed the market by about 25% annually between January 1985 and June 2009.

Elliott’s last book was Nature’s Laws-The Secret of the Universe. It expanded his stock market ideas to cover all human activity. Such sweeping claims impeach his theory, but many still believe in it, at least in part. Since it sometimes guides traders, knowledge of the theory is helpful to anyone trying to guess what other investors may do.

Prechter’s Elliott Today website

Tyson evaluation of Prechter’s advice