Ralph Elliott was an American accountant who, during an illness in the late 1920s, set to work to examine many decades worth of stock price charts. He did so in exacting detail: down to half-hour price movements.
Elliott decided he had spotted several regular patterns from his work, and that these patterns were knitted together by Fibonacci Numbers. This
H C’s 1st offspring G
B’s 2nd offspring F
B’s 1st offspring E
A’s 4th offspring D
A’s 3rd offspring C
A’s 2nd offspring B
A’s 1st offspring A
original pair
12 11 10 9 8 7 6 5 4 3 2 1
144 89 55 34 21 13 8 5 3 2 1 1
*
immature rabbit rabbit starting to breed rabbit continuing to breed
A’s 5th offspring B’s 3rd offspring C’s 2nd offspring D’s 1st offspring F’s 1st offspring
* not shown for month 7
month count (pairs)
Figure 7.1 Fibonacci’s rabbits
potent concoction, which he termed Nature’s Math, surfaced in 1934. At the time Wall Street, which had in 1933 shown the first serious recovery from the Crash, was experiencing a downturn, feared by some to herald a return to misery. Elliott informed investors that the downturn was a mild bull market corrective wave, due to turn round at any time and make way for the next cardinal wave. Cardinal waves head in the direction of the trend, and the trend was up. As to where the market was going in 1934, he was right. It recovered a 20 per cent downturn by the year end and went on to double within 30 months.
Mystified but impressed stockbrokers learned that these two waves belonged to a pattern of eight, and the eight were a cycle which had been driving the stock market for a century or more. The basic idea of Elliott Wave Theory is shown in Figure 7.2.
Where did Fibonacci come into it? In three ways. First, the basic pattern of 5 + 3 = 8 uses Fibonacci Numbers. As does the 21 up, 13 down – and a total of 34 – make-up of the next degree. Next, the vertical extent of waves related to Fibonacci’s Numbers, with the ratios 1.618 and 0.618 and others explaining how far each advance or retracement extends. Finally, time spans between turning points were often Fibonacci Numbers. In Elliott’s book, Nature’s Law: The Secret of the Universe, published in 1945, he cited the list of significant highs and lows in the Dow Indexes shown in Figure 7.3.
Elliott pointed out that all the time spans (which he had somewhat selectively chosen) were constituents of Fibonacci’s series, some twice over! He was not troubled by the fact that Nature’s Law counted in both months and years, whichever suited. Rather, he suggested, the law worked through crowd psychology and the crowd did count in both. In an upwave, he argued, bulls progressively get the upper hand, eventually taking an asset price to an unsustainable peak. The inevitable fall in prices forces out optimists and puts the bears in charge.
Despite this encouragement from then current events, Elliott did not suggest that his analysis enabled precise forecasting. Sometimes the pattern missed a sequence or extended one. In fact, he formulated a Rule of Alternation: if the market failed to match the wave sequence once, it would shortly do so again. However, he was pretty sure that the third wave (running between Points 2 and 3 in Figure 7.2), if you could spot it, was almost always the best. It lasted the longest and moved the furthest.
If you could spot it. The problem, he acknowledged, was that since smaller waves exist within larger ones, 11 times over, wave identification was an art, not a science.
Two sets of 5+3 and one set of 5
Two 5 downs separated by one 3 up comprise one set
of five in larger cycle
comprise correction leg of larger cycle
1 BASIC WAVE PATTERN
5-wave sequence in trend direction
3-wave corrective sequence
1
2
*There are 12 degrees in all . . . Lowest : Subminuette, lasts under one day Highest : Grand supercycle, lasts 150–200 years 1
2 3
4 5
a
b
c 1
2 3
4 5
a b
c
2 Each wave subdivides into junior waves of identical pattern
3 Each set of 8 comprises two waves in a cycle of the next degree*
Figure 7.2 Elliott Waves
After Elliott’s death in 1948, his works fell into relative obscurity, a passage assisted by a long-lasting bull market on Wall Street. There was barely a need to call the turning points. But in the 1960s cognoscenti revived interest in Elliott Wave Theory by picking out more Fibonacci Numbers. A low in 1970 was correctly forecast on the basis that preceding lows had occurred 21, 13, 8 and 5 years previously. And had there not been a low 55 years before that of 1962? There had.
Enter Robert Prechter, Yale graduate, ex-rock drummer and technical analyst at Merrill Lynch. Prechter relaunched Elliott by co-writing an interpretation of Nature’s Law, in 1978. All the Dow’s trends to date, it turned out, could be accurately assigned to Wave Theory, with a corrective fourth wave which had started in 1965 about to complete and an upwards heading impulse wave (the re-christened cardinal) due to follow. This would end, he forecast, in the late 1980s, to complete the upwards phase Figure 7.3 Elliott Waves on Wall Street
Jul-21
▼ 89
Nov-28 months 8
years Sep-29
▼ 34
Jul-32 months
▼ 13
Jul-33 months 5
▼ 13 years 13
Jul-34 months (55 years
▼ 34 months)
Mar-37 months
▼ 13
Mar-38 months
▼ 55
Apr-42 months
of one of Elliott’s supercycles(one degree beneath the grand supercycle), which had kicked off in 1932.
Prechter left Merrill Lynch to launch an investment newsletter and manage money on his own account and throughout the early 1980s called the market with great accuracy. In 1984, he beat all records by scoring a four-month gain of 440 per cent in his managed fund. Prechter appeared to have turned Elliott’s art into his own science, until 1987. Prechter foresaw a correction in the October, but expected it to be modest. He had targeted his impulse wave to terminate at 3,686 in 1988. When October 1987 turned out to be a less than modest reversal, he assigned it ‘end of Wave 5’ status. Long-term investors, who had been advised – when the Dow stood at 2,600 – to hang on through the October correction, were now advised to get out at 2,000 and to be ready to get back in again in the early 1990s at around 400 (which would neatly have returned the Dow to its 1929 peak).
Such is life. The Dow sped back to its 1987 peak and, with one pause for breath, carried on upwards. Around the time Prechter suggested it should be 400, it was heading to 4,000. Prechter still pumps out a newsletter, but it no longer attracts the coverage he received in the 1980s.
In the futures and options markets, ‘Elliotticians’ spot his waves on time spans measured in all units of time from minutes upwards, and in instruments from orange juice futures to interest rates. He would surely have been surprised, as he insisted his waves only occurred in generalised fields such as stock market indices.
The stock market too continues to attract Elliott-inspired analysis, also applied to individual stocks as well as the indices. Elliott has probably achieved a modest immortality. His five-up, three-down patterns crop up remorselessly, though rarely predictably (as he warned) and the issue of whether this is a great third wave, and from where a 62 or 38 per cent correction should be measured, are such entertaining topics that they may well last market commentators for all time.