From March 2009, when the Dow Jones Industrial Average index bottomed below 6,500, it has been moving mostly up -- until January 19, 2010, when it peaked and has been trending down ever since. Does it look like a top, act like a top, feel like a top? Unfortunately, it's not quite as easy to answer that question as it is to answer the famous "looks like a duck" questions. That's where wave analysis can help. Here's an excerpt from Prechter's Perspective in which Bob Prechter answers a reporter's question: What does it feel like when a bull market in stocks tops? Of course, we have been calling this price action a bear-market rally rather than a bull market, but his answer applies just the same.
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Question: Would you describe what it feels like when a bull market in stocks tops?
Bob Prechter: Unlike commodities, stocks don't just blow off. If you throw a ball into the air, it has to slow down before it comes down. The market doesn't exactly follow the laws of physics, but its action does seem to reflect this one. Even the 1929 high was accompanied by "top building," that is, a glaring divergence in the six-month percentage rate of change. In the stock market, the idea is a psychological feeling more than a true description of a stock market chart formation. The market slowed into the 2000 top, too. The advance/decline line topped in April 1998, and the corrections of 1997 and 1998 set up momentum divergences in the first quarter of 2000.
Q: Does this slow topping process serve any function?
Bob Prechter: Many manias in history have outlasted the Cassandras and, in the process, have devastated the finances of the largest possible number of people. The crowd is buying fantasies. When fantasies get far out of line with reality, you've been presented with the opportunity to make money, whether it's on the downside or the upside.
Q: But a contrary stance can't be rewarding unless one is following the Wave Principle?
Bob Prechter: Precisely. The problem is that contrarianism is only a one-way comment. The observation made by contrarians is that at the top of a market, there will be a substantially greater number of bulls than bears. This is a fact, but it doesn't tell you how far the pendulum can swing in one or the other direction. That is why the Wave Principle is necessary. It provides a background for knowing when to go with a trend and when to go against it.
Q: In real time, the Wave Principle can be complicated and dealing with corrections is particularly difficult. Why?
Bob Prechter: Five-stage movements (the prevailing trend as opposed to a correction) are generally uniform, with very few exceptions to the rule. When prices are moving with the trend, they are moving very freely, and you get the full five-wave structure. In that case, analysis is not that much harder than it sounds on paper. But when the short-term trend is fighting the intermediate-term trend, it is going against the tide. Corrective processes by their very nature are fighting the larger flow of price movement. When the market is fighting the flow, it can only go so far. It never develops the five waves. In more than 30 years of studying the market, I've never seen an exception.
Q: Is this also why there are several different ways that corrections can unfold?
Bob Prechter: Corrections are the point at which the outflowing river meets the incoming tide. The jumble that results is far less uniform than the river's flow or the tidal force. The analyst knows that moves against the larger trend never develop into a full five waves, but he or she does not know precisely which non-five-wave structure will develop out of this turmoil.
Q: Is there a simple guideline that a novice can follow to help weather corrective Elliott wave patterns?
Bob Prechter: Sure. During these periods, in which Elliott wave analysis is the most difficult, do nothing. It is not necessary to forecast all the time unless you are in the business, like I am. So just wait for the pattern to clear and then take action.
Q: Some analysts get annoyed at this. They say, "That's the problem with the Wave Principle. It doesn't work in bear markets."
Bob Prechter: Well, tough break! Bear markets are what they are. If someone objects to what the market is, then he is arguing with nature and the reality of markets. "Less predictable" does not mean impossible, indecipherable, disorderly or random, either. You can form some useful opinions about corrections. The ultimate price goal of a fourth-wave correction, for instance, can be forecast with more accuracy than most impulses. What's more, it is the Wave Principle that tells the analyst when to expect less predictability. One of the greatest services a method can provide is to tell you when to stand aside. So your overheard "objection" is not a problem with the Wave Principle or a revelation of where the Wave Principle cannot be applied. That the Wave Principle recognizes and identifies the differences in market behavior is one of its greatest strengths.
Q: What about those who say investing with impulse waves – or in the direction of the trend – isn't that hard anyway?
Bob Prechter: Tell that to 83% of the professional money managers who underperformed the Standard & Poor's or the Dow Jones Industrial Average for three years in the heart of the bull market of the 1980s. Tell it to the 98% of money managers who couldn't identify the end of an impulse in 1966 and got killed in the bear market. Tell that to the 99% of public investors, who lose money in their investments over the long run. I, for one, recognize the fact that successful investing is extremely difficult. Anyone who tells you it is not is headed for a fall.
Q: Can Elliott save you from a fall?
Bob Prechter: It can save you from a catastrophic loss. It is one of the few approaches that allows the investor to get out of a losing position with a small loss for an objective reason. The alternatives are to ride it out or simply get out because an arbitrary "stop" level has been reached, which usually has the nasty result of getting you out just before the big gains are due.