Prechter Q & A: Using Elliott Waves to Get a Feeling About Investors' Feelings

Robert Prechter is considered the leading authority on Elliott Wave Theory, a form of analysis underpinned by a belief that the collective mood of investors, not news or economic and corporate fundamentals, determines market movements and even the fundamentals themselves. A conventional Wall Streeter might argue that the credit mess ignited the recent bear market, for instance, while an Elliott Waver would say that the bubbly mindset of a few years ago led to the loans-for-everyone policy at banks that set the stage for all the woes that followed.

Ralph Nelson Elliott, the Depression-era accountant who developed the theory, believed that changes in sentiment occur in regular patterns, causing markets to travel impulsively in five waves in the direction of a trend and to correct those moves in three less clear, less forceful waves. Each wave forms part of a wave that is larger and longer-lasting and can be divided into waves that are smaller and more fleeting. By knowing where a market is within a wave, Elliott said, it's possible to profitably forecast price movements.

Prechter, president of Elliott Wave International, made a name for himself - and for Elliott - by foretelling the great bull market of the 1980s when his peers were still uniformly bearish and then calling a top just ahead of the 1987 crash. He also encouraged subscribers to his newsletters, including Elliott Wave Theorist and Elliott Wave Financial Forecast, to bail out before the 2000 tech bubble burst and again before the credit crunch struck last year. In those cases, however, he turned bearish way too early. He never quite got back into stocks with both fists after the bottom in the late 1980s either. Critics cite shortcomings like that as evidence of basic flaws in the theory. They find it too subjective, a sort of Rorschach inkblot test that allows analysts to detect patterns that conform to their preexisting views.

Wave patterns do seem to be in the eye of the beholder, but I'm still a fan of Prechter and the theory, especially the big idea behind it. Much of the rationale offered for market action alludes to investor sentiment without directly acknowledging its role: Fear of X sent stocks down yesterday, while hope for the same X sent them higher today. For Elliott Wavers, the X is beside the point. All that matters is the mood swings. The theory helps explain such stumpers as how and why the long-term trend in the stock market shifts before changes in the economy and earnings instead of in response to them. The public is merely undergoing an attitude adjustment that affects both; it shows up in the market first because buying and selling stocks is fast and easy.

Here is the first part of a Q&A with Prechter focusing on the basics of Elliott Wave Theory. Some of his responses have been condensed to conserve space and to make his views more accessible to novice investors. A second installment, highlighting the workings of the theory and what the wave patterns tell him is in store for investors, will be posted next week.

Buy low, sell high. Sounds easy enough. Why do so many investors, including experienced, highly paid pros, do the opposite and fail to beat the market by wide margins? They're not even taking a random walk - more like turning into every dark alley they stroll by.
Waves of social mood regulate investors' aggregate behavior. As people feel increasingly optimistic, they buy stocks, and when they feel increasingly pessimistic, they sell them. This is why indicators of market psychology show bearishness at bottoms and bullishness at tops. It's not that the market's action is making them feel this way; it's that their feelings are causing the market's action. This is a much better explanation than random walk, for two reasons: It explains why even pros are wrong in the aggregate over a full cycle, and it explains why some exceptional people can beat the markets; they have learned to invest against their natural emotional states.

The inability to make sense of the markets seems to persist despite the availability of more information than ever. How come?
People . . . think news should move the market around, but it doesn't. News is a report of the social actions taken in response to waves of social mood. So people who dig through the news for causes are actually studying results. Analyzing waves of social mood at least gives you a look at the present, not the past, and if you use our Elliott wave model, you can often get a peek at the future, too.

Are you saying that macroeconomic and corporate fundamentals like earnings and management strategy have no influence on prices? Do you really think that Apple's long-term outperformance has nothing to do with Steve Jobs being a genius?
Aggregate trends of stock prices are regulated entirely by Elliott waves of social mood, but where the money goes in terms of individual stocks is another matter. Management, genius and luck all have something to do with individual corporate success. But I would also caution that corporate success is hardly the only determinant of stock prices. For example, it cannot explain the run-up in what proved to be ultimately valueless Internet stocks in late 1999-early 2000. That was almost entirely due to herding. At other times, investors sell shares of perfectly good companies because they are scared or simply need the money.

As markets fell in sync last year, some Wall Street began heralding "the end of diversification," but you had been forecasting a bear market in everything for quite some time. Has the rule about building a diversified, balanced portfolio been revoked or just suspended?
One of [our] forecasts was that all traditional investments - real estate, stocks, commodities and many bonds - would go down together, a lot. This is a very rare event. When credit pyramids collapse, this is one of the results, and the wave structure said it was about time to happen. Diversifying across many markets was all the rage, right at the wrong time. This is perfectly normal, because markets are ironic and paradoxical. People always adopt strategies after they have proved useful over many years or decades, and that's usually about when they are due to stop working. So the kind of diversification that advisors were recommending became the road to huge losses.

I don't know what a "balanced portfolio" is. I think it means that the advisor has no idea what's coming, so he balances the items according to his lack of knowledge. People always try to escape having a market opinion, but it can't be done.

If you were building a portfolio with the aim of funding a comfortable retirement or meeting some other long-term goal, what would you put in it? And you can't say 100 percent Treasury bills, because that's no fun.
First we need to redefine "fun." Many of our subscribers have told us of their feelings as they held onto their money while others were suffering terrible losses day after day. They are deeply appreciative. Losing half your money is not fun. Also, speculators are welcome to ride the waves up and down. Those 17 months of decline were the best ride for short sellers in my experience, and I was there for the 1973-1974 bear market. [But] trading is just not advisable for most people, because financial markets are a probabilistic world, and in environments of uncertainty, the herding impulse is so strong that few can overcome it.