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This
is part 2 of a three-part explanation of the Wave Principle by Robert
Prechter. Part 1 Part
3
Most
people are more interested in how the Wave Principle works than why it
works. Is there any one thing people need to remember to make it work
for them?
The key to
Elliott Wave patterns is that the market goes three steps forward for
every two steps back. If you do not get scared by the two steps back,
and if you are not euphorically confident after the third step
forward, you’re light-years ahead of the pack. Even then, I would
add that it is one easy thing to recognize that the Wave Principle
governs stock prices, while it is quite another to predict the next
wave, and still another to profit from the exercise. There is no
substitute for experience, so that you can learn what you feel and
when you feel it, with respect to market behavior.
Jack
Frost has described the Wave Principle as something that has to be seen
to be believed. What does he mean by that?
The principle is
complicated to express in words. With the Wave Principle, you are
dealing with a phenomenon that reveals itself visually. Try describing
the concept and variations of “tree” in detail to someone who’s
never seen one and you’ll see that it can be a complex task. Saying,
“Look! There’s one,” is a lot easier. The human brain is very
good at recognizing a pattern visually. If a computer must be
programmed to recognize shapes in the sky, it would be difficult to
teach it the difference between a cloud and bird and an airplane. Once
you have that programmed, of course, a blimp floats by and the
computer is in trouble. The human brain works differently, however,
and is extremely efficient at pattern recognition. If you draw out the
Principle, it is much more quickly grasped. Then when you compare
actual market pictures with the model, you can accept the truth more
readily. It is at the
perceptual level that it is best presented, then, not the conceptual.
Can
you really
teach it?
Sure. Video is an
excellent approach, for instance. A lot of people have learned how to
apply it that way. Some have trouble at first, but then say “Once I
saw your video tape, I understood it all.”
What
are the Wave Principle’s key strengths?
Frost liked to
say, “Its most striking characteristics are its generality and its
accuracy.” Its generality gives market perspective most of the time,
and its accuracy in pointing out changes in direction is almost
unbelievable at times.
Why
does the Wave Principle work so well?
Because it is
100% technical. No armchair theorizing from economics and politics is
required.
What
are its biggest shortcomings?
There is one main
weakness, and this accounts for just about all the problems. There are
eleven different patterns for corrections. When a correction starts,
it is impossible to tell in advance which pattern has begun, so you do
not know how it is going to unfold. Therefore, the best that you can
do is apply some of Elliott’s observations as guidelines in making
an intelligent guess as to what it is.
Another problem
is that corrections can do what Elliott called “double” or
“triple” — that is, repeat several times. Triple corrections are
the largest formations possible, so at least there is a limit. These
repetitions can be frustrating because they can last decades. For
example, we had a 16-year sideways correction in the Dow Jones
Industrial Average from 1966 to 1982. A.J. Frost and I thought it was
over in 1974, and the market was ready for another bull wave. To be
sure, most stocks rose from that point forward, but the Dow went
sideways for another eight years in a doubling of the time element,
which caused some frustrations before the next bull wave finally began
on August 12, 1982.
It
sounds like a chess game. The number of possibilities, and therefore the
probabilities of success, vary at certain junctures.
Chess provides an
excellent analogy. The market can do whatever it wants, except that it
will always do it in an Elliott Wave structure. Similarly, your
opponent can move chess pieces wherever he wants, except that he must
follow basic rules. On the other side of the board, you still have a
lot of hard thinking to do despite your absolute knowledge that pieces
must move according to those rules.
Are
there situations where the Wave Principle does not hold true?
No, it always
holds true. But of course, it is one thing to say the markets will
follow the Wave Principle and another thing entirely to forecast the
future based on that knowledge. It is always a question of
probabilities. Once you have hands-on experience with it, once you
understand all the rules and guidelines, it is a lot like becoming
Sherlock Holmes. There are many possible outcomes, but guidelines
force you along certain paths of thinking. You finally reach a point
where the evidence becomes overwhelming for a certain conclusion.
Have
you ever had a case where you thought the probability of a certain
outcome was high, say 90%, but the market went otherwise from your
expectation? What did you do then?
Of course it
happens. But you should never be wrong for long relative to the degree
that you are trying to assess. One of the terrific things about the
approach is that it’s price that tips you off. With other
approaches, price can go a long way before the reason behind your
opinion changes, if it ever does. No matter how difficult the pattern
is to read sometimes, it always resolves satisfactorily into a classic
pattern.
Can
you illustrate how knowledge of “wave structure” comes into play
when trading?
For instance, the
bottom of the fourth wave, which is a pullback, cannot overlap the
peak of the first rally. If it does, then it’s not a fourth wave.
The fourth wave is still ahead of you, and the third wave is
subdividing. Knowing this tenet can keep you out of a lot of trouble
that an armchair wave counter would encounter. Another very basic
tenet is that wave three is never the shortest. It is usually the
longest. Wave three is the recognition stage when most people get
aboard.
But
if there is always a correct pattern, and it is only a matter of seeing
it, why aren’t accuracy levels higher than the 40%, 50%, 60% or even
the 80% ratios of hits to misses?
First, just
because R.N. Elliott discerned that the market follows rules as in a
chess game doesn’t mean you can predict the market’s next move.
All you can give are probabilities. But the psychological difficulties
are at least an equal impediment. Hamilton Bolton once said that the
hardest thing he had to learn when using Elliott was to believe what
he saw. Despite all I know, I have fallen prey to that problem more
than once. The fact that even perfect analysis only results in the
best probability provides the uncertainty that feeds the psychological
unease. As Frost is fond of saying, “The market always leaves its
options open.” So when you combine human weakness with a game of
probability, the result is many errors in judgment. Nevertheless, I
must stress that the ratio of success with Elliott is better than that
with other approaches, and that is the only rational basis for judging
its value. Besides, the inestimable value of the Wave Principle is not
so much that it provides a high percentage of correct “calls” on
the market, but that it always gives the investor a sense of
perspective.
Is
it possible that the system merely takes into account every possible
pattern and thus allows the practitioner to force things into a
satisfactory wave count retrospectively — but not prospectively?
No, for two
reasons. First, if that were true, then there would be no record of
success such as the Wave Principle has over the decades. There are
numerological approaches to the market, ones based on fantasy that may
as well be dealing with a random walk, and they produce worthless
results, as they should. As Paul Montgomery likes to say, a good test
of a theory is whether it can predict. Second, there are many
non-Elliott patterns that the market could trace out if it were a
random walk; but it has never done it. I have never seen a market
unfold in other than an Elliott Wave pattern.
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