Market forecaster Robert Prechter's father didn't trade stocks, but in the 1960s, he started subscribing to investment newsletters that touted gold plays, such as mining stocks -- then out of favor -- as an alternative to stocks. One newsletter also highlighted the work of Ralph Nelson Elliott, a stock market theorist who advanced the idea that the market moved in predictable cycles, or wave patterns. That interested the young Prechter.

Elliott wasn't a trained investment analyst but an accountant who came to develop "Wave theory" in a roundabout way. In the 1920s, the U.S. State Dept. sent Elliott to Nicaragua as the chief accountant for that country, which was then under control of the U.S. Marines. While in Central America, he contracted an illness that eventually led to a debilitating form of anemia. Bedridden throughout the 1930s, Elliott passed the hours drawing charts of the stock market in various time periods.

WAVES OF EMOTION.  By studying the charts, Elliott developed a theory that the market always seemed to move in a basic pattern, five steps in a back-and-forth wave that leads up, followed by three steps in a back-and-forth wave that leads down. The pattern goes one step up, the second step down, third step up, fourth down, fifth up, followed by step 6 down, 7 up, and 8 down (Elliott uses letters, not numbers, for the three downward steps).



Elliott theorized that human emotion explained the patterns because it tends to run from one extreme to the other, and after all, what's causing prices to rise and fall but the actions of thousands of investors and traders. He also found that the patterns were fractal. That is, they repeat themselves in ever smaller scales. A very long time period, such as a century, will see giant waves. A small time period, such as an hour, will see tiny waves. The same patterns should appear whether you look at the trading for one minute, one year, or one century.



Though his father was very interested in investments, Prechter first took a different path. He went off to Yale University, earning a degree in psychology. After graduation, he was a drummer in a rock band. But his father got him interested in the stock market again by urging him to buy two gold stocks in 1972. The shares quintupled in value in two years, and Prechter was taken with the stock market. He landed a job on Wall Street, working for Merrill Lynch's famous technical analyst, Bob Farrell.

"EYE-OPENING."  Farrell encouraged all of his analysts to seek out new ways to do their jobs. While others were studying options or interest rates, Prechter went back to the Wave principle and incorporated the methodology into internal reports. He tracked down Elliott's out-of-print books on microfilm at the New York Public Library and started to apply their lessons to the market.

"I kept an hourly chart on the Dow, and over and over again, Elliott's patterns recurred. It was an eye-opening experience," Prechter says. "I found I could predict turns pretty often."

As he dug further into Elliott's work, he also discovered other analysts who had taken up his mantle and advanced the theory in their own works. One was Canadian analyst A.J. Frost, who was planning a book on Elliott. Prechter and Frost met, hit it off, and together wrote a book, Elliott Wave Principle -- Key To Market Behavior, in 1978. By the next year, Prechter left Wall Street to start Elliott Wave International, which put out newsletters. He also relocated far away from the Wall Street crowd, in Gainesville, Ga., near where he had grown up.

A TRICKY ENDING.  Prechter's predictions made him a Wall Street star in the 1980s. His Wave analysis led him to foretell the 1980s bull market and the downturn in 1987. But he never expected the upward Wave -- what he calls a "Supercycle Wave" -- to last so long, all the way until 2000, as he now sees it. So during the 1990s he became bearish. And many of his followers lost out on the bull market.

Here's how Prechter reads the 20th century's Supercycle Wave:
Wave I (up) 1932-37
Wave II (down) 1937-42
Wave III (up) 1942-65/66
Wave IV (down) 1965/66-74
Wave V (up) 1974-2000

Prechter admits that he misread the length of that last big Wave. But he's not alone. Practitioners say they can never be sure how long a Wave will last. Some try to use Fibonacci numbers to gauge when the Wave will end.

A LONG DOWNTURN.  In Prechter's view, learning all the nuances of the Wave principle would take "about three lifetimes -- I'm still working on it." He complains that most people don't understand that Elliotticians -- what followers of the Wave principle call themselves -- disagree and get things wrong as often as anyone else. But that's not an indictment of the method.

"The Wave principle provides powerful information about markets, but it is not an equation or a formula," he says in an e-mail interview. Still, understanding Waves can give you an edge most of the time and, on rare occasions, tell you some aspect of the future in no uncertain terms. Says Prechter: "Those are the moments I live for." What the Waves are telling Prechter now is grim -- the downswing that started in 2000 will last a minimum of 7 to 10 years.

Cash is king. Prechter has been predicting harsh asset deflation for a few years now. While the sky hasn't fallen yet, he thinks it's sagging: "Many agricultural commodities have fallen hard in 2004, including cotton, soybeans, corn, and wheat, which are down 30% to 50%. I think these prices are leading the new downtrend." (Oil, of course, is a notable exception.) He points to the 35% decline in lumber prices as a sign of weakness in housing.

Prechter believes professional investors and the media have been "way too bullish, and for way too long." He reads the relentless optimism as a dangerous sign of trouble ahead. "Rarely, about once a century, there is sweeping deflation," during which no assets hold up, and the only place to have money is in cash, according to Prechter.

Furthermore, he recommends a "safe bank." He relies on ratings from Weiss Ratings and Martin Weiss's Ultimate Safe Money Guide.

A real trader is prepared to bet against the market. The best ones have to be able to make money whether the stock market is going up or down. In Prechter's view, people underestimate -- or block out -- the pain and loss during past bear markets. They may remember them as simply times when buy-and-hold investors didn't make money.

By sticking with their investments through a bear market, "people did far worse than not making money," adds Prechter. Understand the interplay of sentiment and the market is key, he says. "Realizing that when the majority is optimistic and bullish and prices are high -- sell. And when sentiment is down and prices are cheap -- buy."

Sell. Prechter believes that "Wave A," the first big step down in Elliott Wave theory, began in 2000 and lasted until 2003. Then the market veered upward until early this year -- and that was Wave B. Since then, the market has been trending downward and may remain on this course for as long as three years, Prechter says. According to the theory, of course, lots of mini wave cycles -- with up-and-down phases -- occur in between. Still, says Prechter, don't expect the market to go up significantly any time soon.

Name: Robert Prechter

Born: 1949, in Schenectady, N.Y.

Education: Yale, BA in Psychology, 1971

Family: Married, two children, Dana and Elliott

Career Highlights: Prechter was a technical analyst at Merrill Lynch in the mid-1970s, when he started studying and promoting the work of Ralph Nelson Elliott, who theorized that stock prices move in predictable waves. In 1978, Prechter co-authored a book, Elliott Wave Principle -- Key To Market Behavior, with A.J. Frost, a Canadian technical analyst. The next year, he struck out on his own by forming Elliott Wave International in Gainesville, Ga., and started publishing an Elliott Wave newsletter for traders.

What He Does Now: He offers market forecasts and analysis to 7,000 subscribers of Elliott Wave International, including many institutional clients. He has written 12 books, mainly on Wave theory. Prechter is also working on expanding the Wave theory to music, politics, war, and macroeconomics.

Current Prediction: Ruinous deflation will grip the economy and the markets. It's all laid out in a book he wrote last year, Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression.

Market theorist Ralph Nelson Elliott believed that the market behaves in predictable patterns, specifically in eight-step waves. The waves move in an up-down sequence -- sloping up, then sloping down -- movement that Elliott believed reflects the way human emotions swing from one extreme to another.



If you accept that theory, then you naturally want to know how to identify where the stock market is in this cycle and to predict how long the current wave will last. That's the tricky part. Elliotticians use a variety of very complicated and complex mathematical models to make these calculations, many of which are based on the Fibonacci numbers .

Even the most dedicated Elliottician, Robert Prechter, who runs Elliott Wave International, gets it wrong sometimes. In the bull-dominated 1990s, he was off by several years by predicting that Wave 5 would crest and the stock market go south.

Elliotticians study those mathematical formulas and calculations for years, but even a novice has a simple way to understand waves: Look for sentiment indicators in the outside world to confirm where the market is in the wave pattern. The wave itself isn't a sentiment indicator. Investors have a wide variety of choices to gauge sentiment. There are the Investor Intelligence Survey, the VIX and other volatility indexes, or the the put-call ratio, to name just a few. The idea is to look at the wave and see whether those external sentiment indicators match up to where you think we are on the chart.

WAVE 1 -- CAUTIOUS THOUGH RISING.  The public is skeptical that anything good is beginning. "You can see pessimism despite higher prices," says Prechter.

WAVE 2 -- SKEPTICAL PULLBACK.  People see this dip confirming their worries that the market is going nowhere.

WAVE 3 -- RECOGNITION OF UPWARD WAVE.  People are still worried, but by the time the wave has reached the top, they're convinced things are turning around.

WAVE 4 -- THE SURPRISING DISAPPOINTMNET.  Investors don't understand how there can be setbacks on the road up.

WAVE 5 -- CAUTION THROWN TO THE WIND.  Stocks are overvalued and people now concoct theories explaining why cycles no longer exist and things will never go down again.

WAVE A -- OVERCONFIDENT RETRACEMENT.  The public is now convinced every setback is temporary and buys on dips.

WAVE B -- SUCKER'S RALLY.  Despite misgivings that something is wrong with the market, investors buy in -- especially individuals.

WAVE C -- DEVASTATING DESTRUCTION.  Fear takes over. Cash is the only safe asset.