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Why 95% of Traders Fail

Robert Prechter Talks About Elliott Waves and His New Book

InvestorEducation / Elliott Wave Theory Apr 23, 2017 - 04:05 AM GMT



Avi Gilburt of conducted a thoughtful interview with Bob Prechter recently. We thought you'd like to see it.

1. How did you come across Elliott wave analysis?

My dad subscribed to Richard Russell's Dow Theory Letters, and he would occasionally forward his copies to me. In 1968, Russell began writing about A.J. Frost's Elliott wave work. He published wave interpretations for the Dow off and on through late 1974, when he called the end of the bear market. During that time, I began charting gold and gold stocks, labeling the waves. After I became a professional technician at Merrill Lynch in 1975, I went on a search for Elliott's original books, which were published in ring binders. The Library of Congress didn't have them. Finally I found copies on microfilm in the New York Public Library. It was a thrill coming across those listings on library cards. In 1980, I republished Elliott's original books and articles in what is now called R.N. Elliott's Masterworks. Later I published all of Bolton's, Frost's and Russell's Elliott wave writings along with bios and notes.

2a. This question is simply asking for your perspective on how markets have changed -- if at all -- over the decades in which you have been analyzing Elliott waves.

Markets have changed in superficial ways but not in any essential way. They still trace out Elliott waves. But that doesn't mean it has been easy. Wave V from 1974 has been unusually large in both price and time relative to waves I and III. The closest thing to it in the record is the 1932-1937 rise, in which wave five lasted 15 times as long as wave one. Also, from 1987 to 2007, pullbacks were shallow and skewed upward in the Dow and S&P, which threw me off.

Some analysts credit the Fed's inflating for these market attributes. But even as the Fed was expanding the money supply at a record rate, the 2007-2009 drop in the Dow was deeper than one would have expected for wave C of a Primary-degree flat. So, that causal argument is spurious. Here in 2017, even the Dow/PPI is at an all-time high. I chalk it all up to Grand-Supercycle-degree optimism. That's why we have record credit expansion, too, along with cooperation among members of the Federal Reserve Board and political support for the Fed. All that will change when mood turns negative.

2b. With the advent and proliferation of computer-executed trading, what effect do you feel they have had upon Elliott wave analysis, other than the speed at which trading is now effectuated?

Virtually none. People build their errors of thinking into their programs.

3a. We have analyzed thousands of charts on multiple timeframes and have found a few rules and/or guidelines that MAY be a bit too strict. For example, the rule that states "Waves 1, 2, 3, 4 and 5 of an ending diagonal always subdivide into zigzags" seems to be a bit too stringent as a hard rule, as we believe we have found examples when an Ending Diagonal does not subdivide in this manner. So, are there any plans to update any of the rules within the standard EW structure now that we have decades of further real world example of chart patterns?

An Elliott wave group in Russia asked if diagonals can occasionally have a third wave longer than wave one. The answer is pretty much the same:

I believe it likely that strict rules apply to the inferred Elliott waves of shared mood. But there are no categorical imperatives pertaining to records of the actions people take to express their moods. Market prices are imperfect reflections of market mood, because they record only people's actions. Waves at small degrees -- intraday -- are especially imperfect because some individual trading actions can be either forced or impeded by circumstances. Until we can probe people's brains to record waves of social mood directly, we are stuck with this imperfection. If you read the paragraph on page 86 of Elliott Wave Principle titled "A Summary of Rules and Guidelines for Waves," you can see that I explicitly stated this point in the book.

Figure 1-18 in that book, which was published in 1978, shows a long third wave in a contracting diagonal, and waves two and four don't even overlap. I decided as soon as it ended that a diagonal was the best count, since the subdivisions were three waves, the shape was a wedge, and it was the fifth wave of a decline. Sure enough, the market reversed after it was over.

Until we have a statistical answer to the question of when to allow this or that variation, the best answer is a practical one, and here is mine: The only time an analyst should allow an imperfection in a wave is retrospectively when all other aspects of the wave demand it. Suppose you see a wedge-shaped fifth wave with 4-1 overlap and three-wave subdivisions, but wave 3 is longer than wave 1, or one of the waves subdivides into a five. If your next alternative is even less compatible with the model, then label the wave a diagonal.

One should never bet that a developing diagonal will break from the standard form. It will lead you to trouble 9 times out of 10. But once the wave ends, a diagonal with a quirk may be better than any alternative. That is how to use rules. There is no purist solution for this issue; there is only the best solution.

3b. Along these lines, I have seen many analysts attempt to modify Elliott's original structure, but none with any degree of success. If there were any aspect of Elliott's structure to be its weakest link, where would you see the potential for such modification to find success in the future?

You're right. I have seen two attempts by others to change Elliott's fundamental observations, and I have not adopted either of them, because I don't see them dominating prices.

I have suggested three variations on forms: the leading diagonal (in which the odd-numbered waves can subdivide into five), the expanding diagonal and the skewed triangle. I remain skeptical about the legitimacy of all three of these forms. I suspect the patterns I described are more likely artifacts of imperfect mood recording than legitimate formations.

On the other hand, over the years I and my colleagues have made a number of valuable observations about wave forms that Elliott never noticed. Some have become well known, others not. They are:

  1. Wave three is most often the extended wave.
  2. Peak acceleration occurs at the structural center of each wave, i.e. in wave 3 of 3 of 3.
  3. In the stock market, fifth waves are always weaker than third waves.
  4. B waves of contracting triangles often reach a new price extreme.
  5. Even so, E waves of triangles in the wave four position always end within the territory of the preceding third wave.
  6. Double flats are somewhere between rare and non-existent, I've seen flat-X-triangle serve as double three.
  7. The barrier triangle is a more useful idea than the idea of independent ascending and descending triangles.
  8. Zigzags often adhere to channels.
  9. In zigzags, A waves tend to be steeper than C waves.
  10. In flats, C waves tend to be steeper than A waves.

Then there is the whole discussion of wave personalities that I put in Elliott Wave Principle.

4a. While we use various technical indicators to support or show the weakness in any wave count, my favorite has been the MACD. Do you have any favorites that have been most useful to you over the years?

Nearly all momentum indicators provide the same basic information. There are hundreds of them, because they are easy to construct, especially with computers. I don't chart rates of change anymore because I can tell what they look like just by looking at prices. But momentum analysis is not simple. In the stock market, slowing momentum nearly always precedes reversals, but slowing momentum does not mean a reversal must follow. The 1985 and 1989-1994 periods are classic examples. In each case, the market slowed its rise -- looking terminal from a momentum standpoint -- and then accelerated. In the first case, I knew wave 3 of 3 was dead ahead, so I was really bullish. The second one threw me off. The most consistently useful momentum indicator is breadth. If I had to rely on only one momentum indicator, that would be it.

4b. Do you have any specific time frames in charts that, in your experience, have provided the most insight into a specific market or commodity?

No. Markets are fractals. Nothing quantitative is meaningful or useful.

5a. As I am sure you are well aware, there is a debate amongst various schools of thought as to what is more important -- price or time. Can you please give us insight into your perspective on this debate?

What matters most is form. Form involves both price and time, although arguably price is the more definitive component.

5b. I am sure you have seen much time cycles analysis in your career. In my experience, I have not really seen any that have been better than 50/50. I am just wondering why you think we are unable to develop the same accuracy percentages in timing models as we do in pricing models using Elliott Wave?

I think the reason for your observation is that cycles are not the essence of markets. They are artifacts of the fractal form. They appear for a while and then disappear. Usually by the time someone recognizes a cycle and bets on it, it is poised to vanish. As you say, the success rate is about 50/50, so I don't rely on them anymore.

I think Fibonacci ratios between the prices and durations of related waves are meaningful. I wrote a book about Fibonacci relationships called Beautiful Pictures.

6a. I have personally noted how I view socionomics as the ground-breaking work which will eventually lead market analysis into the future. But, I also understand how old habits are hard to break, and most still desperately cling to the old Newtonian-based exogenous-causation theories of market analysis. What sort of reception has the socionomic theory been receiving from the world of academia?

It has had wisps of success. We have had several academic papers published, and another was accepted by a journal last week. A ranking member of the Academy of Behavioral Finance and Economics commented to me that the term socionomics was becoming part of the lexicon, which was encouraging to hear. Several professors at mid-level universities are including it in their courses, and several top professors have been kind enough to provide a good word for the book. But most economists don't know socionomics exists, and most of them would dismiss it if they did. Socionomic theory explains why such a reaction is, generally speaking, imperative: People are built better to participate in waves of social mood than to analyze them. So, it's very hard to get the word out. People like you, who do pure market analysis, have been the quickest to get it.

6b. As new studies into the socionomic aspects of financial markets are performed all the time, are there any other resources for us to follow to gain continuing insight into this perspective?

Thanks for asking. The Socionomics Institute puts out tons of interesting material. The website is full of studies, articles, events and videos. People who like this field should become a member. Learn how to start your membership now.

6c. What are your top three arguments to present to those who do not believe in socionomics but still hold fast to the old exogenous-causation theories?

It took 800 pages in The Socionomic Theory of Finance to present arguments. But I can make three brief statements:

  1. Events and conditions that are often labeled "fundamentals" have no predictability with respect to the behavior of financial markets, so they cannot be causal. (See Chapters 1, 2 and 22.)
  2. Financial markets differ in numerous fundamental ways from economic markets, implying that their behaviors spring from different causes. The key difference is that in economic markets the context is one of relative certainty with respect to one's own personal values, which allows for rational decision-making, whereas in financial markets the context is one of pervasive uncertainty with respect to others' future actions, which prompts people to herd. (See Chapters 12 and 13.)
  3. Postulating unconscious waves of social mood as a hidden variable explains a persistently compatible relationship among myriad social actions, from popular musical tastes to changes in the economy to political actions to women's fashions to trends in the stock market. (See Chapters 8 and 10.)

7a. What do you think will set off the next bear market in stocks?

Triggers are a popular notion, borrowed from the physical sciences. But I don’t think there are any such things in financial markets. Waves of social mood create trends in the stock market, and economic and political events lag them. Because people do not perceive their moods, tops and bottoms in markets sneak right past them. At the top, people will love the market, and events and conditions will provide them with ample bases for rationalizing being heavily invested.

7b. How are conditions going to change from what we have now?

The increasingly positive trend in social mood over the past eight years has been manifesting in rising stock and property prices, expanding credit, buoyant pop music, lots of animated fairy tales and adventure movies, suppression of scandals, an improving economy and—despite much opinion—fairly moderate politics. In the next wave of negative mood, we should see the opposite: declining stock and property prices, contracting debt, angry and somber music, more intense horror movies, eruption of scandals, a contracting economy and political upheaval. That’s been the pattern of history. It’s all relative, though, and it’s never a permanent condition. Just as people give up on the future, its brightness will return. The financial contraction during the negative mood trend of 2006-2011 was the second worst in 150 years, yet thanks to the return of positive mood many people have already forgotten about it. Investors again embrace stocks, ETFs, real estate, mortgage debt, auto-loan debt and all kinds of risky investments that they swore off just a few years ago.

The trick to maintaining personal prosperity is to avoid popular investments at the turns. It’s not easy to do, but at minimum you need a fractal perspective on social trends as opposed to a linear one.

8. Are you involved in any other projects?

I've got two compendiums due out in book form in late spring: Socionomic Studies of Society and Culture -- which will have our best work relating socionomic causality to trends in movies, music, TV, cars, skyscrapers, roller coasters and other fun stuff--and Socionomic Causality in Politics, which may not be as fun, but it's important.

Another project we have going is computerizing Elliott wave analysis. It's a complex task, but we know what we're doing, and we're getting it right.

On the business side, I have cut back. I'm down to about two speeches a year and pretty much retired from doing media. I'm still involved in macro business matters, but I have a great team handing the rest. I do the occasional Q&A, so allow me to say thanks for the opportunity.

The Socionomic Theory of Finance presents the 13-year-long work of Robert Prechter, plus 21 contributions from 12 other scholars, writers, researchers and analysts. The book challenges convention and offers an entirely new theory of finance and macroeconomics.

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This article was syndicated by Elliott Wave International and was originally published under the headline Robert Prechter Talks About Elliott Waves and His New Book. EWI is the world's largest market forecasting firm. Its staff of full-time analysts led by Chartered Market Technician Robert Prechter provides 24-hour-a-day market analysis to institutional and private investors around the world.

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