on The Wave Principle: Part
(This is part 1 of a three-part explanation of the Wave Principle by Robert
Prechter. This text is excerpted
from one of EWIs most popular titles, Prechters
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the Wave Principle?
Wave Principle is, first and foremost, a detailed description of how
markets behave. Now, theres 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. Its strictly a study of how human beings behave
collectively in the trading arena.
specifically did Elliott discover?
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.
he label the degrees of trend?
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.
the biggest degree trend he talked about?
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. Thats not the biggest degree,
though, as all waves are components of larger ones.
referred to the Wave Principle as the purest form of technical
a hundred years, investors have noticed that events external to the
market often seem to have no effect on the markets 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
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 dont 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.
the basic path?
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.
five-wave form does occur on the downside.
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.
go on Elliotts description alone. Does that mean you must act
without knowing whats causing the pattern?
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. Elliotts
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.
Elliotts a mechanical system?
really. What were dealing with here is the behavior of people. If
the tools you work with measure something other than the behavior of
people, youll be removed from the reality of whats 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.
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.
infinite variation imply that anything goes?
at all. Trees vary infinitely, but they all look like trees, dont
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
knowing Elliott guarantee profits?
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
mans 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.
to Part II