Examining Elliott Wave Theory

Share this

There have always been a number of observers of the stockmarket who have believed that share prices move in clearly defined cycles or 'waves'. This is, in many cases, an extension of the work on economic and business cycles done by Nicholai Kondratiev (who was executed by Stalin for his pains) and Joseph Schumpeter.

Schumpeter is famous for coining the idea that capitalism was punctuated by periods of creative destruction - not unlike today, in fact.

But Ralph Elliott was one of those who attempted to fit theories like this to the stockmarket.

Born in 1871, Elliott was an interesting character. He was something of a 'company doctor', working mainly in the railway industry, and later had a brief stint as a public servant and became chief accountant for Nicaragua - at the time, a country bizarrely under the direct control of the US Marines.

He developed his 'wave theory' ideas while he was convalescing from serious illness and had the time to study the market in depth, devising a system that seemed to work well at predicting the direction of the index.

So Elliott occupies an important place in the history of technical analysis, the art of trying to predict future price movements from past ones. He has, like WD Gann and some other stockmarket gurus, his zealous adherents.

The grand scheme of things

Elliott's idea was to look at the pattern of cyclical behaviour in the stockmarket, drawing from a range of influences including Gann, astrology, number theory, and natural rhythms. His method, and that applied today by his adherents, is to take the current market and to try and fit its cyclical patterns into the great scheme of things.

He suggested that there was, in fact, a series of cycles each superimposed on the other, including the Kitchin wave, Juglar wave and Kondratiev wave - named after the economists that devised them, but also what he termed the 'grand super cycle' - a monster 250-year wave. Since stockmarkets have by and large risen since they were devised in the 18th century, the 250-year supercycle almost always suggests - in dramatic fashion - that the market is about to enter a prolonged crash.

Where Elliott's theories become topical in today's markets is that rather than believing that the waves in the stockmarket had, as many economists suggested, the expansion and contraction of credit, or the bunching of innovations, at their heart, what was really at work was simple human emotions - the instinct first to build something up, and later to demolish it. Credit cycles may play a part but there is something deeper at work.

Elliott Wave Theory proposes that wave patterns occur in groups of five. A cyclical upswing will have three upward movements split by two alternate and smaller downward ones. The same will be true in a downswing, with three sharp declines interspersed with smaller contrary movements. But each upward or downward movement will itself consist of the same five-move wave pattern, and within each of these smaller patterns the same thing will occur.

In Elliott's scheme of things, the grand supercycle is made up of series of supercycles (Kondratiev waves), with each of these comprising several cycles of around a decade, and each one of these containing several primary cycles (the so-called Kitchin waves). Underlying each primary wave is an intermediate wave, and underlying that a minor, minute, minuette and so-called sub-minuette wave. This means that, at the smallest level of the sub-minuette, the wave patterns are recurring every few hours while, at the supercycle stage, they recur only every 250 years.

To many familiar with the stockmarket, this seems an absurd proposition that somehow denies any sort of external human influence on the market from economic policymakers. One of the other problems with Elliott Wave theory is that each Elliott practitioner interprets the data in a slightly different way.

Peter says

Many Elliott wavers, not least Robert Prechter, an author who had done more than most to popularise Elliott's ideas, predicted a market crash and severe downwave beginning in 1998. And I have to admit that a personal decision of mine to reduce my pension fund exposure to the stockmarket and to buy bonds at around this time was influenced by reading one of Prechter's books.

Elliott wavers believe that this crash was postponed for a couple of years in the US by the influx of liquidity into the financial system at the time of LTCM crisis, which led directly to the stockmarket bubble in 2000.

So while there was a savage bear market in some parts of the stockmarket early in the millennium, prices recovered subsequently - until the subprime crisis came along. An Elliott Waver would comment now, to mix a metaphor, that the chickens are coming home to roost and that the day of reckoning can no longer be postponed.

The problem for many is that postponement of the apocalypse is a frequent occurrence. Can we really expect markets to behave in so predictable a fashion when policymakers have the experience of the mistakes of the past to draw on? On the other hand, the bearish would suggest that the egregious financial indiscipline of the last few years in the USA will have to be corrected, and the correction could take an awful long time.