Prechter on The Wave Principle: This is an explanation of the Wave Principle by Robert Prechter. This text is excerpted from one of EWI’s most popular titles, Prechter’s Perspective.
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.
Most people are more interested in how the Wave Principle works than why it works. Is there any one thing people need to remember to make it work for them?
The key to Elliott Wave patterns is that the market goes three steps forward for every two steps back. If you do not get scared by the two steps back, and if you are not euphorically confident after the third step forward, you’re light-years ahead of the pack. Even then, I would add that it is one easy thing to recognize that the Wave Principle governs stock prices, while it is quite another to predict the next wave, and still another to profit from the exercise. There is no substitute for experience, so that you can learn what you feel and when you feel it, with respect to market behavior.
Jack Frost has described the Wave Principle as something that has to be seen to be believed. What does he mean by that?
The principle is complicated to express in words. With the Wave Principle, you are dealing with a phenomenon that reveals itself visually. Try describing the concept and variations of “tree” in detail to someone who’s never seen one and you’ll see that it can be a complex task. Saying, “Look! There’s one,” is a lot easier. The human brain is very good at recognizing a pattern visually. If a computer must be programmed to recognize shapes in the sky, it would be difficult to teach it the difference between a cloud and bird and an airplane. Once you have that programmed, of course, a blimp floats by and the computer is in trouble. The human brain works differently, however, and is extremely efficient at pattern recognition. If you draw out the Principle, it is much more quickly grasped. Then when you compare actual market pictures with the model, you can accept the truth more readily. It is at the perceptual level that it is best presented, then, not the conceptual.
Can you really teach it?
Sure. Video is an excellent approach, for instance. A lot of people have learned how to apply it that way. Some have trouble at first, but then say “Once I saw your video tape, I understood it all.”
What are the Wave Principle’s key strengths?
Frost liked to say, “Its most striking characteristics are its generality and its accuracy.” Its generality gives market perspective most of the time, and its accuracy in pointing out changes in direction is almost unbelievable at times.
Why does the Wave Principle work so well?
Because it is 100% technical. No armchair theorizing from economics and politics is required.
What are its biggest shortcomings?
There is one main weakness, and this accounts for just about all the problems. There are eleven different patterns for corrections. When a correction starts, it is impossible to tell in advance which pattern has begun, so you do not know how it is going to unfold. Therefore, the best that you can do is apply some of Elliott’s observations as guidelines in making an intelligent guess as to what it is. Another problem is that corrections can do what Elliott called “double” or “triple” — that is, repeat several times. Triple corrections are the largest formations possible, so at least there is a limit. These repetitions can be frustrating because they can last decades. For example, we had a 16-year sideways correction in the Dow Jones Industrial Average from 1966 to 1982. A.J. Frost and I thought it was over in 1974, and the market was ready for another bull wave. To be sure, most stocks rose from that point forward, but the Dow went sideways for another eight years in a doubling of the time element, which caused some frustrations before the next bull wave finally began on August 12, 1982.
It sounds like a chess game. The number of possibilities, and therefore the probabilities of success, vary at certain junctures.
Chess provides an excellent analogy. The market can do whatever it wants, except that it will always do it in an Elliott Wave structure. Similarly, your opponent can move chess pieces wherever he wants, except that he must follow basic rules. On the other side of the board, you still have a lot of hard thinking to do despite your absolute knowledge that pieces must move according to those rules.
Are there situations where the Wave Principle does not hold true?
No, it always holds true. But of course, it is one thing to say the markets will follow the Wave Principle and another thing entirely to forecast the future based on that knowledge. It is always a question of probabilities. Once you have hands-on experience with it, once you understand all the rules and guidelines, it is a lot like becoming Sherlock Holmes. There are many possible outcomes, but guidelines force you along certain paths of thinking. You finally reach a point where the evidence becomes overwhelming for a certain conclusion.
Have you ever had a case where you thought the probability of a certain outcome was high, say 90%, but the market went otherwise from your expectation? What did you do then?
Of course it happens. But you should never be wrong for long relative to the degree that you are trying to assess. One of the terrific things about the approach is that it’s price that tips you off. With other approaches, price can go a long way before the reason behind your opinion changes, if it ever does. No matter how difficult the pattern is to read sometimes, it always resolves satisfactorily into a classic pattern.
Can you illustrate how knowledge of “wave structure” comes into play when trading?
For instance, the bottom of the fourth wave, which is a pullback, cannot overlap the peak of the first rally. If it does, then it’s not a fourth wave. The fourth wave is still ahead of you, and the third wave is subdividing. Knowing this tenet can keep you out of a lot of trouble that an armchair wave counter would encounter. Another very basic tenet is that wave three is never the shortest. It is usually the longest. Wave three is the recognition stage when most people get aboard.
But if there is always a correct pattern, and it is only a matter of seeing it, why aren’t accuracy levels higher than the 40%, 50%, 60% or even the 80% ratios of hits to misses?
First, just because R.N. Elliott discerned that the market follows rules as in a chess game doesn’t mean you can predict the market’s next move. All you can give are probabilities. But the psychological difficulties are at least an equal impediment. Hamilton Bolton once said that the hardest thing he had to learn when using Elliott was to believe what he saw. Despite all I know, I have fallen prey to that problem more than once. The fact that even perfect analysis only results in the best probability provides the uncertainty that feeds the psychological unease. As Frost is fond of saying, “The market always leaves its options open.” So when you combine human weakness with a game of probability, the result is many errors in judgment. Nevertheless, I must stress that the ratio of success with Elliott is better than that with other approaches, and that is the only rational basis for judging its value. Besides, the inestimable value of the Wave Principle is not so much that it provides a high percentage of correct “calls” on the market, but that it always gives the investor a sense of perspective.
Is it possible that the system merely takes into account every possible pattern and thus allows the practitioner to force things into a satisfactory wave count retrospectively — but not prospectively?
No, for two reasons. First, if that were true, then there would be no record of success such as the Wave Principle has over the decades. There are numerological approaches to the market, ones based on fantasy that may as well be dealing with a random walk, and they produce worthless results, as they should. As Paul Montgomery likes to say, a good test of a theory is whether it can predict. Second, there are many non-Elliott patterns that the market could trace out if it were a random walk; but it has never done it. I have never seen a market unfold in other than an Elliott Wave pattern.
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.