reme readings. At those times, I think it’s fair to stretch the pointsomewhat and presuppose that sentiment can be used to signal a majorbull or bear market. This is especially true if the extremes in sentimentare also occurring during a period of extreme public interest and speculation in the stock market.
THE THEORY IN PRACTICESomething as powerful as contrary opinion has many applications, andusing contrary opinion to help determine market trends is also a fine art.The following sections explain what I’ve learned about it over the years,especially its capability for determining where you are in the Elliott wavecycle.
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Keep in mind that the theory of contrary opinion holds only whenthere are extremes in sentiment. In practice, many market techniciansmake the mistake of attempting to apply the theory before sentiment(whether bearish or bullish) has reached an extreme. I know because I’vemade that mistake enough to know that it can be a major weakness. Ingeneral, I found myself doing this when the market was in a highly unpredictable state and I was pressing to know what it was saying.For example, suppose the market enters a sideways trading rangeand it is not yet clear exactly which way the market will go. The tradingrange lasts for a long time and you get impatient. You look at the sentiment readings and find that 55% are bullish and 45% are bearish, atwhich point you might conclude, since more people are bullish thanbearish, that prices are ready to break out of their trading range and decline. This would be a mistake. You should hold your ground and just accept the fact that investor sentiment, at that moment, does not indicateanything. Wait until the picture becomes clearer; it almost always will.Using the TheoryWhen I first began studying the market I thought that contrary opinionwas useful only for finding major market tops and bottoms in movementsthat last from six months to a year. I thought the best approach was towait for an extreme reading to signal the start of a movement (whetherup or down) and then wait for an opposite extreme reading to signal theend of the movement. I assumed that a major market movement wouldn’t begin or end until an extreme reading had occurred. Although I stillgenerally believe this, I’ve found some other ways of using contrary opinion that are just as helpful. It would be hard to test these methods (as Idid the Investor’s Intelligence data), but personal experience has provedthem useful.For example, I have found that contrary opinion is very useful at determining whether, after a really good advance, the market will go stillhigher. For instance, suppose the market has had a good upward run fortwo or three months and then goes into a sudden three-day sell-off. Now,for any advance that has sustaining power, there will always be a wall ofdoubt and worry, except near the very end. So in this situation, you needto watch the put/call ratio and at the same time, keep track of what themarket commentators on television and radio are saying. If the marketis to push forward, you will hear a chorus of analysts claiming that the
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market is now finally ready for its correction. Such a sudden increase incaution is good. From my experience with contrary opinion, it is clearthat the market will probably continue higher.Let us look at this in a little more detail. Quite often, after a long runup, there is a sudden sharp sell-off that quickly stops and then begins aslow recovery to its previous highs, at which point it stalls and begins asecond sell-off. This second sell-off (the final C leg of an ABC correction,as you will learn in Chapter 6) usually generates much more skepticismbecause more people think that the last rally was the rally that failed andthe run-up is over. The market acts like prices are rounding over, andbeginning a larger decline. At such a time, be sure to watch the put/callratio very closely. If the ratio suddenly increases with more put buying,the movement is probably a sideways correction before another lengthythrust (Figure 5.7). However, if put buying doesn’t increase and therecontinues to be high call buying, be very careful, because there is probably more movement behind the correction. Always pay close attention
FIGURE 5.7 Watch for a rapid rise in bearish sentiment during a sidewayscorrection after an extended advance. It is a good signal that the rally willcontinue.
BearishSentimentBullishSentiment
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anytime you observe a widely held belief that a market correction hasbegun and yet prices are only a few days away from possibly breaking tonew highs—that is a strong market.How the Theory Helped in Navigatingthe 1994 to 1999 MarketLet’s look at one use of contrary opinion that helped my clients stay almost fully invested through the great bull market of 1994 to 1999. Thestory starts in December of 1994, when at my year-end client seminars,I pulled out the Investor’s Intelligence readings for the first time. I didthis because the Investor’s Intelligence reading was showing the highestbearish sentiment since the bottom in 1987—equal in bearish sentimentto major bear market bottoms. I told my clients this probably meant amajor advance was imminent, so they should stay put with their stock investments. I explained contrary opinion to them, much as I havethroughout this chapter. After the move started, we religiously providedupdates of the Investor’s Intelligence readings at our client seminarsevery six months.One fact kept hitting us in the face: As the advance continued, wenoted no swing toward the type of extreme bullish sentiment readingsthat would indicate a market top. In fact, the bullish readings stayed verymuted, and they were accompanied by magazine articles illustrated withpictures of bears, in which many analysts argued that the market wasovervalued. These naysayers represented the well-known wall of worry(Figure 5.8). True to what I said in the beginning of this chapter, we keptthe theory of contrary opinion senior to any data about the economy. Itwas highly unusual, and to us much more important, to have such a visible wall of worry than to worry about the market being overvalued. So,we just stayed with this bullish idea, and in this case, it worked very well.Understanding the Consensus Opinion and How It ChangesIt is important to watch how quickly investors change their opinionsabout market direction. As a general rule, a rapid and sudden change ininvestor sentiment when the market starts into a correction or rallymeans that the prior trend will soon continue. This is particularly true inbear market rallies.For instance, suppose the market has had a severe three-month decline. High bearish sentiment registers at the bottom. The market hits a
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FIGURE 5.8 The wall of worry. It is an old cliché that markets continue to riseagainst a wall of worry and doubt. You could actually see this cliché in actionfrom 1994 to 1999 by watching the guru index, Investor’s Intelligence. Bullishsentiment refused to rise above 50% until the beginning of 1999, when the wallfinally broke.65%
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level, stays there for a few weeks, and then starts a sudden rally. If during this rally sentiment goes rapidly to the bullish side and stays there,you can assume that it is only a bear market rally (rather than a sustainedupward move) and that another leg down is imminent. As a rule, sustainable rallies off market bottoms hold the bearish sentiment even asthe market rallies. There should always be a wall of worry and disbeliefas the market works higher.It is important to pay attention to analysts’ opinions in the press.Market analysts on television or radio are talking to a mass audience andso will generally make only statements with which their audience willagree. Both their caution and their enthusiasm generally reflect the overall feelings of the investing public. Therefore, don’t pay any attention tothe reasons these commentators present! Tabulate only the overall conclusions (bullish or bearish) of the viewpoints being broadcast. Althoughthese conclusions can be difficult to quantify, they are sometimes extremely useful as a confirming indication of a statistical measure.
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Finding Correlations between GroupEmotions and Market VolumeIt is important to understand emotions because they govern and regulatealmost all human activity, which includes the human activity of investing.They are also thought to be one of the causes behind the instabilitiesof feedback loops. People like to say that two emotions drive the market: fear and greed. However, this simplistic picture is incomplete anddoesn’t explain what is actually observed. For one thing, greed isn’t anemotion, it’s a vice. Furthermore, a great many other emotions are manifested in the stock market besides fear.For example, investors can become emotionally apathetic about investing, especially after a major bear market. What kind of volume wouldyou expect if most investors were in the state of apathy? Very low volume. I’ve seen angry markets, a phenomenon that usually occurs wheninvestors become frustrated after missing a large price movement andhave been waiting for a correction that hasn’t come. They get angry andcharge the market, buying in a huge surge of volume and paying anyprice.Because of the strong correlation between an emotion and the character of the activity associated with it, you can often measure the groupemotions of investors by closely following volume. Table 5.1 summarizesa few emotions and the volume characteristics expected from groups ineach emotional state. Such factors are important because major tops andbottoms of the market are usually associated with investors manifestingcertain group emotions. Certain volume patterns evolve that can be explained by the action of group emotions.Bear markets, for example, often end in selling climaxes. Volumebuilds when fear and panic set in as prices plunge but this emotion issoon followed by the emotion of apathy (complete demoralization),TABLE 5.1
Group emotion and market volume
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Excitement, enthusiasmFearBoredom*Anger, frustrationApathy, low interest
Constant high volumeHigh, rising volumeRelatively low, flat volumeSuddenly rising volumeVery low, flat volume
*Normally found during long, fourth wave corrections (see Chapter 7)
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which produces very low volume. It is best to buy into this low volume.It’s also common for investors to lapse into a state of boredom as themarket moves into a long consolidation after a lengthy advance. In sucha situation, volume will dwindle during the boredom phase. The marketcan stay in this state for some time.Of particular interest is the emotion of enthusiasm or exhilaration,which shows up during the final stages of a protracted bull market andaccompanies high levels of speculation. The effects of enthusiasm usuallyplay out something like this: After a long period of advancing stockprices, investors get the feeling that making money is easy, and so theystart to feel cocky. After seeing many examples of small stocks or highlyspeculative investments rising dramatically in value, investors lose theirnormal caution and become willing to gamble on these seemingly surethings. As a result, the volume activity in these investments rises dramatically compared to more stable, investment-quality issues.Market students and analysts still have much more to learn about thecomplicated relationships between group emotions and stock investing.
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I’ve made a clear case for the value of the theory of contrary opinion inpredicting intermediate-term movements of the stock market. If thestock market is predictable, as my model holds, the ability to predict itlies in understanding and applying contrary opinion. Of all technical indicators, sentiment is by far the most valuable tool. Nevertheless, as wehave seen, it presents problems.Through my seminars, I have found that the general public sees thelogic of the theory of contrary opinion but nonetheless, refuses to take itseriously; therefore, investors have trouble applying it. Why? Because toapply the theory, you have to ignore the pressing economic circumstancesthat are making the vast majority of investors either bullish or bearish.You have to be willing to say, “The economic scenario that everyone istalking about must be wrong, even though it seems so obviously right.”Since most people consider economic data more important than the factthat there is an extreme reading in sentiment, investors find it hard to ignore the obvious economic picture and go with contrary opinion.I often hear clients say, “Yes, we know everyone is currently bullish,but this time there’s a good reason to feel that way.” That is always theproblem! As I said in the beginning of this chapter, you will successfully
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apply the theory of contrary opinion only if you elevate it to a senior position above any economic data.How can BABES and O’BUCS really be the way things are? I don’tfully understand it myself, but I can describe it and tell you that historyshows that it is this way, but I can’t tell you exactly why. What I havelearned, however, is that the stock market tells a story by its price action.The long-term price pattern has an economic reason behind it, a financial story that evolves over time and makes sense in terms of stock prices.The situation resembles a novel in which the author has hidden cluesto the ending extremely well. Only near the end of the book does thewhole story suddenly become clear. The stock market story is written ina special book, however, in that when everyone sees the story, it ceasesto exist as the story; the final pages just disappear. At that moment ofrecognition, few notice that a new book has been pulled out and a newstory has begun. Investment success goes to individuals who can see thecorrect story before the next person.The only explanation I have is this. At any point, there are two forcesat work in the market: One builds the economy up; the other tears itdown. These two forces coexist and the price of stocks always reflects theconsensus viewpoint on which of the two is dominant. In truth, however,people have a tendency toward sloppy thinking. At critical market junctures, if you key off investor sentiment and study the situation deeplyenough, usually you can find holes in the consensus thinking. Some greattraders, the geniuses, spot these holes naturally and quickly. GeorgeSoros and Warren Buffet come to mind. They seem to see the correctbut opposing view, the O’BUCS idea, almost instinctively.In applying contrary opinion, when you observe extreme sentiment,you must reject the consensus story and search for the new, correct,emerging story—and have confidence that it will be there. This is the key.
6Price Patterns,Fractals, and Mr. Elliott
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he first five chapters explained the model I use to understandstock market movements and integrated technical and fundamental analysis into the framework of that model. According tothat model, stock prices equal a fair value that is modified and stretchedby that action of three feedback loops in three different time domains.Each time domain can become unstable by itself, which can trigger afeedback-loop price movement in that domain. Sometimes these movements can affect each other since there is a degree of interdependency.It is my belief that this model opens the door to a predictable stockmarket. Chapter 5 explained that these predictable moments for thestock market are best located using the theory of contrary opinion.Theoretically, the interplay of the four elements of the model—afair value term evolving over time as the economy changes and the threefeedback loops—are the forces that produce the minute-to-minute, dayto-day, week-to-week, and year-to-year price movements. The zigzagprice movement from minutes to years is simply the result of the interplay of these four components. In this chapter, you will learn about several additional ideas that open up a greater understanding of thesepatterns.The last 20 years ushered in a new era of discovery in mathematics,physics, and finance. One of these discoveries has application to understanding stock price patterns: the concept of fractals. The link between122
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the theory of fractals and stock prices is forged from two fascinatingfacts.After the discovery of fractals in the 1970s, people started noticingthat stock prices produced charts with patterns that fit the definition ofa fractal. Mathematicians had discovered that fractal patterns occur insystems that are composed of feedback loops. People knew that the stockmarket behaved at times like a feedback loop, so its fractal nature wasn’ta surprise.More startling is that fact that a fractal theory for stock prices (theElliott wave theory) was actually developed in the 1930s—40 years before the theory of fractals was formulated by Benoit Mandelbrot! Thischapter explains what fractals are as well as the Elliott wave theory—thefirst fractal theory for stocks—finally establishing a theoretical foundation for this controversial theory.
ORIGINAL PRICE PATTERN OBSERVATIONSThe accepted models of the stock market, such as the efficient marketmodel, give no good explanation for the patterns we see in stock charts.The usual interpretation is that these jerks and starts are the sudden adjustments to fair value as news about companies continuously streams in.The new model presented earlier in this book gives a different interpretation. It says that economic news does cause price adjustments, but italso triggers instabilities, setting into motion the interplay of the threefeedback loops. The vibratory price pattern we see is the concurrent sumof all these effects.People have learned that they should always pay close attention toanything that is observed over many generations. Buried in those observations is usually something very important, and when that truth finallysurfaces, it can be quite illuminating. The Elliott wave idea appears tohave come into being in just this way; it seems to be the culmination ofobservations made by many people over many years. The seminal observations of Charles Dow and W.D. Gann underlie what eventually became the Elliott wave theory.Reviewing the Dow Theory of Price MovementThe story begins with Charles Dow, whose observations and thoughts atthe turn of the century later became known as the Dow theory of price
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movement. Although the theory is generally considered old-fashionednow, careful study shows that it is surprisingly modern and contains mostof the basics of today’s technical analysis. Discussing the entire Dow theory is beyond the scope of this book, but I do cover the part concerningprice patterns. The following paragraph is from Robert Rhea’s book TheDow Theory, written in 1932.The Primary Bull Market: A primary bull market is a broad upwardmovement, interrupted by secondary reactions, and averaging longerthan two years. During this time, stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity. Thereare three phases of a bull period: the first is represented by revivingconfidence in the future of business, the second is the response of stockprices to the known improvement in corporation earnings, and thethird is the period when speculation is rampant and inflation apparent—a period when stocks are advanced on hopes and expectations.[Italics added.]
Reviewing W.D. Gann’s ObservationsAnother well-known advisor and market technician, W.D. Gann, had atrading career that began near the turn of the century and lasted morethan 45 years. His observations about stock market price patterns werevery similar to those of Charles Dow.Stock market campaigns move in three to four sections or waves. Neverconsider that the market has reached final top when it makes the firstsection in a move up, because if it is a real Bull Market it will run atleast three sections and possibly four before a final high is reached.
We explore Gann’s comment about the possible fourth wave later inthis chapter.Combining the Dow and Gann PatternsNow that we have that simple background, let’s draw Charles Dow’s andW.D. Gann’s observations. In Figure 6.1, you can see the bull marketstructure that both Dow and Gann describe: a pattern composed of threesections interrupted by two secondary corrections. Neither Dow norGann saw any repeating pattern or definable structure other than these
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FIGURE 6.1 The three movements of a bull market, as described by CharlesDow and W.D. Gann.
three simple movements; they considered short-term movements random and unimportant.The major drawback to Dow’s and Gann’s observations is that thereis no financial theory to explain them. They are simply empirical observations, without any supporting structure, begging for an explanation.That’s not to say the observations are not useful; it means only that wedon’t know why this pattern occurs. However, even without a theoreticalfoundation, any real effort to predict the stock market must somehow address this long-observed phenomenon.It would seem that any observation made repeatedly over such along period has to contain some fundamental truth since it is constantagainst the ever-changing economic picture. As a physicist would say, “Itis an observation that seems to measure something that is time invariant”and physicists always look for things that stay the same when everythingelse changes. When they find something that stays constant when everything else changes, it is always an important discovery.However, without a supporting theory that would explain why a bullmarket contains three sections, why limit the existence of price patternsto the bull-market level? If we look a little harder, we might discoverother repeating price patterns over other time frames and, from thishigher level of observation, develop an explanation or theory for the patterns. Enter a man named R.N. Elliott (Figure 6.2).
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FIGURE 6.2 R.N. Elliott developed the first fractal theory of stock prices in1937, 40 years before the discovery of fractals. (Source: Reproduced bypermission from R.N. Elliott’s Masterworks, edited by Robert R. Prechter, Jr. ©1994, Robert R. Prechter, Jr.)
R.N. ELLIOTTR.N. Elliott, an accountant, formulated his observations of the waveprinciple during a long period of convalescence during the 1930s. Hestarted with the basic ideas of Gann and Dow, but he went much further.Mathematicians today would recognize the theory that he formulated inthe 1930s as a fractal theory.I first learned about the Elliott wave theory in 1979, from RobertPrechter’s book Elliott Wave Principle—Key to Market Behavior. Now,after applying the Elliott wave theory for more than 20 years, I believeI’m in a position to explain the power and the limitations of this interesting theory. It has received some negative press from market analysts whotried to make it into more than it really is and who pushed the theory beyond what it is capable of doing. This caused numerous forecasting failures, which tended to invalidate the theory in the eyes of many people.
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Expanding on the Dow-Gann Bull-Market PatternTo describe Elliott’s deeper observations, let’s start with the basic threesection Dow-Gann pattern for a bull market diagrammed in Figure 6.1.As you look at the pattern, consider the first of the three sections. NeitherDow nor Gann saw any deeper underlying pattern in this simple upwardmovement; it was simply the first extended, advancing period of the bullmarket. In contrast, Elliott said that if you looked a little closer, you wouldsee a similar pattern there, too. The first movement of the bull market isactually composed of three smaller movements of its own. In the secondsection of the bull market are three additional smaller movements. Thesame is also true of the third section. Figure 6.3 illustrates the finer detailthat Elliott observed in the three advancing waves of a bull market.Elliott expanded his observations. Where Dow and Gann saw no pattern to the two corrections separating the three waves, Elliott did. According to him, these corrections didn’t just go down, they werecomposed of two declining waves separated by a little rally. In otherwords, a correction is seldom one sell-off but two. Figure 6.3 diagramsboth these observations in the complete Elliott wave pattern for a bullmarket, showing the down-up-down pattern of the two corrections thatseparate the three advancing waves.
FIGURE 6.3 The expanded pattern for a bull market, as seen by R.N. Elliott,including the pattern for the corrections that separate the primary waves. Alsoshown is the wave structure of the bear market that follows the three advancingwaves of the bull market.
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Elliott even found a price pattern for bear markets—something noone else had ever done. He considered a bear market a correction of thebull market and, like all corrections, it should have two down waves, separated by a rally (the bear market rally). Furthermore, these two downwaves break up, like all other price movements, into smaller movements,as Figure 6.3 shows.At this point Elliott (although he didn’t know it) made the leap intofractals. He said that the three waves that make up each of the three sections of the primary bull market also have a structure. You guessed it—each of the three waves is composed of three smaller movements. Thecorrective movements that separate these three also have the same pattern as the earlier correction: two down waves separated by a small rally.Figure 6.4 shows the breakdown of these patterns into their nextlevel of smaller movements. In this figure, you can see the basic Elliottwave pattern, showing three levels of the basic pattern; this is the veryessence of the Elliott wave principle. When can a movement not be broken down into three smaller movements? According to Elliott, never.Any stock price movement can be broken into three sections of smallerprice changes and time lengths. This is true of movements over days,hours, or even minutes.
FIGURE 6.4 On closer examination, it becomes apparent that each section, orwave, in the price pattern also consists of three smaller waves. Similarly, themovements of each correction can be subdivided into finer movements.
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Patterns Bigger than Bull MarketsElliott expanded on this idea of continuously repeating patterns, but thistime he went in the other direction. He said that the three-wave repeating doesn’t stop at a bull market. According to his theory, what we usually call a bull market is just one section of a larger three-sectionmovement. Similarly, three of these much larger movements come together to form an even larger three-wave movement. He called theselarger-than-a-bull-market movements cycles, super cycles, and grandsuper cycles.The accepted belief among Elliott wave practitioners is that thelongest known cycle, called the grand super cycle, started in 1790, whenthe New York Stock Exchange was formed. Each advancing wave in thisgrand super cycle is about 50 years or longer and is composed of manybull markets (Figure 6.5).
FIGURE 6.5 The longest known cycle—Elliott’s the grand super cycle—startedin 1790. Many Elliott wave practitioners believe that the grand super cycle isnearing an end. (Source: Reproduced by permission from Elliott Wave Principle—Key to Market Behavior, by Robert R. Prechter Jr. and Alfred John Frost. ©1978–2000 Robert R. Prechter Jr.)Reproduced by permission from Elliot Wave Principle—Key to Market Behavior,by Robert R. Prechter, Jr. and Alfred John Frost. Copyright 1978–2000 Robert R. Prechter, Jr.
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THE ELLIOTT WAVE THEORY VERSUS THE REAL MARKET
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Let’s see how Elliott applied the theory to the real stock market. We’lluse an example from Elliott’s original works (Figure 6.6). The great stockmarket crash of 1929 hit bottom in the summer of 1932, at which pointthe market began a 5-year bull market. Notice how Elliott labeled thewaves. You can see that the waves are nowhere near the same size interms of price or time duration as those in the idealized wave pattern.For example, the first advance lasted 3 months, the second advancelasted 5 months, and the third lasted 31 months. Therefore, we can understand that the simple patterns building up into larger patterns mightbe much more difficult to determine in practice. Unfortunately, this istrue. Interpreting the waves in the real world is always very difficult andrequires adding a few ideas that help bridge the gap from the ideal pattern to the real pattern that stock prices make. These nuances includethings called extensions, irregular corrections, horizontal corrections,and fifth-wave diagonal triangles.
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FIGURE 6.6 The 1932 to 1938 stock market, as labeled by R.N. Elliott. Thechart plots the monthly range of the Dow Jones industrials. His labeling of thelong extension wave from 1934 to 1937 as ABCDE does not follow the currentprotocol of using numbers for the advancing waves.
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Labeling Elliott’s WavesNotice that describing Elliott’s concept of sections within sections withinsections can become a little confusing—it’s easy to get lost in the variouswaves. Up to this point, I’ve intentionally avoided the normal Elliottwave labeling to accentuate the similarities between his observations andthose of Dow and Gann. The basic advancing movement in the Elliottpattern consists of three advancing sections separated by two corrections. The waves are labeled 1, 2, 3, 4, and 5. Waves 1, 3, and 5 are advancing, and waves 2 and 4 are corrective.A correction follows at the end of wave 5. The correction has threewaves or sections labeled A, B, and C. A and C are the downward moves,and B is the separating rally. Movements of different degrees are distinguished by numbers, numbers within circles, numbers within brackets,and so on. In the ABC parts of the correction, capital letters, small letters,letters within circles, letters within brackets, and so on are used, althoughthere is no established procedure for the labeling. In Figure 6.7, I have labeled the three degrees seen in the basic Elliott wave pattern.
FIGURE 6.7 The varying levels of the Elliott wave pattern are differentiatedusing variations on the basic 12345ABC labels. Shown are three levels of thebasic pattern, with corresponding numbers and letters.
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NOTEThe waves, or cycles, of the Elliott wave pattern are not time cycles,like sound or sine waves; they are action cycles. Eight events mustoccur before a cycle is complete. These eight events—12345ABC—do not have to be of the same size or duration.
The Elliott Wave VariationsBefore we can apply the Elliott wave theory to the real stock market, weneed to know more about the variations of the ideal pattern. These allowus to fit the theoretical pattern closer to the real patterns the market makes.ExtensionsWe know that if the market does follow the Elliott wave pattern, it wouldhave to be a stretched and compressed version of the idealized pattern.One way the Elliott wave can be stretched is for one of the three forwardwaves (waves 1, 3, or 5) to become much larger than the other two. Yousaw an extension in Figure 6.6, where wave 5 was the extended wave. Because an extension wave is larger and longer than the other two, the fivewaves that form the extension are