(This article originally appeared in SFO magazine's Nov. 2008 issue)
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Some of the best stories about global positioning systems (GPS's) are the weird detours they sometimes recommend to drivers. Just like some of the weird detours that financial markets can make you take when you think they would be better off going in a straight line either up or down, depending on how you've positioned your trades.
Not long ago, while taking a trip with my family through Great Smoky Mountains National Park on the way to Gatlinburg, Tenn., I decided to use my GPS to drive around the park's western boundary. We wanted to visit Fontana Dam and Cades Cove to see the wildlife. We’d do the go-carts, miniature golf and rides the following day. From Fontana Dam, my old-fashioned map made it look like it would take the better part of the day to drive around the park to Gatlinburg and then head into Cades Cove from the north. But my new GPS unit suggested that Cades Cove was less than 20 miles away. I could have kissed it -- my GPS was going to save me hours of travel time! Or so I thought. Little did I know until I got there that the road my GPS suggested for the final few miles was only the remnant of an old wagon trail -- and it was a one-way wagon trail, going the wrong way. I had to backtrack and take the much longer path my paper map suggested.
What’s the moral of the story? Sometimes the new-fangled gadget is not much of an improvement over what it’s designed to replace. Although my GPS unit is great when it comes to identifying the quickest and most efficient route from point A to point B, it sometimes fails to take into account some of those necessary nuances, such as whether a street is one way or whether it might be impassable at times. Every so often, the old-fashioned way of doing things is still the best way.
I believe that’s true when it comes to analyzing markets, too. The method I employ every day has been around since the 1930s, and it works as well as, if not better than, any newfangled technical analysis method for which you must buy some expensive computer software. My method is a form of technical analysis based on the Elliott Wave Principle, which Ralph N. Elliott worked out via hundreds of hand-drawn charts, well before the dawn of charting software. If you like those GPS units that talk you through every turn, you can almost imagine Ralph's voice explaining where to turn as you follow a market. Those directions -- the road map he drew for tradable markets -- have withstood the test of time.
As I found during my trip, detours are a fact of life. They are also a part of market trends. For instance, a bull market shows periods of “punctuated growth” -- that is, periods of alternating growth and non-growth, or even decline. The patterns then build on themselves to form similar designs at a larger size, and then again at an even larger size.
You’ve probably heard of this idea of repeating patterns on increasing and decreasing levels of scale. This emerging science, which is called “fractal geometry,” is a branch of chaos theory. And it is precisely the model identified by R. N. Elliott more than 70 years ago.
A Quick Road Map of Wave Analysis
For this overview of wave analysis, I have borrowed from the “Cliffs Notes” version that we provide for free [at EWI's Club EWI] to anyone interested in learning about wave analysis.
Elliott’s road map, or basic wave pattern, consists of “impulsive waves” and “corrective waves.” An impulsive wave is composed of five subwaves and moves in the same direction as the larger trend -- or the wave's next larger size. A corrective wave is divided into three subwaves, and it moves against the trend of the next larger degree. As you can see in Figure 1, there are plenty of right and left turns -- or up and down moves on a price chart.
Figure 1 reveals the general roadmap that markets follow during bull markets. Notice the building-block process. The completion of an initial impulsive wave (waves 1-5, up-down-up-down-up) sets the stage for a corrective phase (waves A-B-C, down-up-down). Combined, those waves represent the first two legs of a larger “degree” advance. In this illustration, waves 1, 2, 3, 4 and 5 together complete a larger impulsive wave, labeled as wave (1).
A five-wave rally from a significant low tells us that the movement at the next larger degree of trend is also upward. It also warns us to expect a three-wave correction -- in this case, a downtrend. That correction, wave (2), is followed by waves (3), (4) and (5) to complete an impulsive sequence of the next larger degree. At that point, again, a three-wave correction of the same degree occurs.
Note that, regardless of the size of the wave, each impulsive wave peak leads to the same result -- a correction.
If we isolate the corrective waves, the subwaves A and C move in the direction of the larger trend and usually unfold in an impulsive manner. Referring to Figure 1, the (A)-(B)-(C) decline that follows the (1)-to-(5) sequence illustrates this structure. Waves labeled with a B, however, are corrective waves; they move opposite to the trend of the next larger degree. In this case, they move upward against the downtrend. Notice that these corrective waves are themselves made up of three subwaves.
[Ed. -- Stay tuned for Part II, "Reading the Wave Analysis Map"]
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