Robert Prechter Dispels 10 Popular Investment Myths, Part IX

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Robert Prechter Dispels 10 Popular Investment Myths, Part IX
The world's foremost Elliott wave practitioner tests economists' "Claim #8: 'Terrorist attacks would cause the stock market to drop'” -- and brings you another surprising conclusion

By Vadim Pokhlebkin
Thu, 30 Dec 2010 12:00:00 ET

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This is Part IX of the series "Robert Prechter Dispels 10 Popular Investment Myths," where EWI president explains why traditional financial models failed -- and why they are doomed to fail again (and again). (Excerpted from Prechter's February and March 2010 Elliott Wave Theorists.)

Here are Part I, Part II, Part III, Part IV, Part V, Part VI, Part VII and Part VIII; come back next week for Part X.

The Socionomic Theory of Finance

The Conventional Error of Exogenous Cause and Rational Reaction

By Robert Prechter

...Claim #8: “Terrorist attacks would cause the stock market to drop.”

I assume this is what economists mean when they say that something unexpected such as a terrorist attack would cause them to re-evaluate their stock market forecasts. At least, I doubt they mean that a terrorist attack would cause them to revise their estimates upward. It seems logical that a scary, destructive terrorist attack, particularly one that implies more attacks to come, would be bearish for stock prices.

Take a moment to study Figure 17. Surely all of these exceptionally dramatic swings in the DJIA must have been caused by equally dramatic news: bad news at each of the peaks and good news at each of the bottoms. At least that’s what the exogenous-cause model would have us believe.

As it happens, there was indeed a lot of dramatic news during this time. For one thing, there were surprise terrorist attacks on U.S. soil, first the “9/11” attack on the World Trade Center and the Pentagon and secondly the slew of mailings of deadly anthrax bacteria, which killed several people, prompted Congress to evacuate a session, and caused havoc lasting months. Where on the graph of stock prices would you guess all these events have happened? If you guessed “six trading days from a major bottom and all through a six-month rally,” you would be correct. But if you are an exogenous-cause advocate, you would not have made that guess. Figure 18 notes these occurrences.

The 9/11 attack occurred more than halfway through a dramatic price decline and only six trading days from its end. Afterward, despite deep concerns that more such attacks were in the works, the stock market rallied for six months. The first anthrax attack occurred on the very day of the low for the year, and the attacks, deaths and scares continued throughout the strongest rally on the entire graph. To put it more starkly, the market bottomed when they started and topped out as soon as people realized they were over. If one were to insist upon a causal relationship, one would be forced to conclude that anthrax attacks are bullish for the stock market.

This kind of perverse conclusion is what we invariably reach when examining an exogenous-cause case along with actual data pertaining to it. This is why economists after World War II (see Figure 12 in Part VII) decided that wars were good for the economy. Figure 18 has similar implications for public policy. Should we encourage crazed people to send deadly packages in order to get the stock market to go up? This idea is no dumber than advocating war to get the economy rolling. But the evidence for it is right there, just as it was for the supposed “oil shock” of 1973.

We have uncovered at least one irrefutable fact: Terrorist attacks do not make the stock market go down. The assumption behind economists’ repeated implications that terrorist attacks would constitute an “exogenous shock” that would serve to drive down stock prices is shown to be completely wrong.

Apparently political events and conditions, like economic events and conditions, have no consistent causal relationship to the rise and fall of stock prices. Happily, we are not entirely alone in making this observation. In the aforementioned 1989 paper, authors Cutler, Poterba and Summers concluded, “There is a surprisingly small effect [from] big news [of] political developments…and international events.”

That is indeed the case. But it is “surprising” only to devotees of the exogenous-cause paradigm, which means virtually everyone. Proponents of socionomic causality and the Elliott wave model of financial price change are not surprised in the least. ...

[Part X is now posted: Robert Prechter tests investment myth #9: "Inflation makes gold and silver go up."]

New from Prechter: The December Elliott Wave Theorist updates you on the stock market, gold, silver and shows several stunning charts, one with a reading so extreme it hasn't been seen in 45 years. Subscribe risk-free now for instant online access.

Tags: Bear market, bull market, Elliott Wave Principle, market forecasts, Robert Prechter, technical analysis, terrorist attacks

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