Monday August 20, 2007
His investment approach is controversial; it has been praised as evolutionary and derided as science fiction. From either standpoint, a look at work offers a fascinating glimpse into the world of financial advisors, and its ability to allow individuals to develop and explore strategies far afield from the accepted mainstream on Wall Street.
Elliott Wave theory was first developed by Ralph Nelson Elliott, who wrote The Wave Theory in 1938. Bob began studying Elliott's work in the late 1960s while studying psychology at Yale.
Today, he is arguably the world's leading authority on the discipline. Bob began his financial industry career as a technical analyst for Merrill Lynch in New York in the mid-1970s, where he worked under the legendary Bob Farrell. In the late 1970s, he began publishing The Elliott Wave Theorist.
If any one individual in this industry represents the vagaries of "investment guru status", it is Bob Prechter. In the early 1980s, after a 17-year period of sideways market action, he was a relatively lone voice calling for the start of major bull market.
And he did not just call for a bullish phase; almost single-handedly, he championed the bullish mania that was soon to evolve. Subsequently, he won numerous awards for market timing, including being a two-time winner of Timer Digest's Timer of the Year, and the US Trading Championship (with a 4-month "real money" portfolio gain of 444%).
Those of us that remember the Financial News Network may recall that they dubbed him Guru of the Decade. In the early 1990s, however, he presented a dismal outlook for the economy and for the stock market.
At a time when investors and the media had fully embraced bullishness as the financial status quo, he once again found himself with the minority opinion. In fact, he forecast the eventual retracement of the entire bullish move made during the previous decade.
A Barron's feature in 1992 highlighted his “depression scenario”. As we will see, the ultimate success or failure of his forecast has yet to be seen. But first, let's take a look at the system behind his view. Ironically, most observers and commentators who voice opinions about Bob’s work often do so with limited knowledge of his methodology.
It is exceedingly complex and anyone interested in learning more about using this concept for charting or forecasting purposes will find many in-depth tutorials and books on the subject, including many offered on the Elliott Wave International website.
But for those interested in a general, conceptual understanding of his work, I offer this overview, with much help from Bob's writings over many years.
The mathematical basis of wave theory is the Fibonacci sequence. A mathematician from the Middle Ages, Leonardo Fibonacci introduced Europe to the decimal system. He also discovered a rather fascinating series of numbers that now bear his name.
The series begins with the number one, repeated twice – hence, 1, 1. To find the next number in the series, add the previous two. Thus, the third number in the series becomes 2. Continuing to add just the last two numbers to create the next in the series leads to what is known as the Fibonacci sequence: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and on infinitely.
The important part of this sequence is not the actual numbers, but rather, the ratio of the numbers to each other. If you take any number in the sequence, its ratio to the next number is 0.618 to 1, which is called phi.
Now, don’t confuse “Phi” with “Pi.” The latter is the well known irrational number that many may recall from high school geometry, used for such things as calculating the circumference of a circle. The former, Phi, is known as the Golden Ratio.
“Don't worry. If you've gotten this far, the rest is easy. Turn your hand palm up and take a look at your index finger. It is separated with three lines, one at the knuckle and one halfway again towards fingernail.
The ratio of the first section to the other two is 0.618. Look in a full-length mirror and hold your hands above your head; the ratio of your body above and below your belly button is 0.618. (This ratio was also the proportion used by Leonardo DaVinci.)
The golden ratio also determines the form of microtubules in the brain and the DNA molecule. It governs crystal arrangements, the reflection of light beams on glass, and musical arrangements. For determining scale, it has been used in architecture since the Pyramids and the Parthenon.
The golden spiral (specifically, where phi is the ratio of the length of the arc to its diameter) is seen in the curve in the tail of a comet to the shape of galaxies. The shape of pinecones, sea horses, and snail shells, and some sheeps' horns are governed by this ratio; there's even a spider that spins a golden spiral web.
The placement of leaves on a stem and petals on certain flowers, sand dunes and ocean waves are based on the golden spiral; bacterial growth can be plotted on a logarithmic golden spiral. Sir Isaac Newton had the golden spiral carved into headboard of his bed.
According to Bob, this ratio plays a critical role the stock market as well. The market, he believes, moves in waves, which — like the numbers in the Fibonacci sequence — relate to the previous and subsequent waves by the same golden ratio that is otherwise evident in nature.
What the Wave Principle says is that mankind's progress (which is to some extent reflected in the financial markets) does not occur in a straight line, does not occur randomly, and does not occur cyclically.
Rather, progress takes place in what he describes as a 'three steps forward, two steps back' - a form that nature prefers." In stock market terms, these trend movements must be punctuated by counter-trend setbacks, making the basic wave pattern for market analysis a 5-3 pattern.
Prechter notes, "Nature seeks the most efficient form, and this 5-3 pattern is the most efficient way to achieve punctuated progress." In his work, the basic pattern is three waves up and two waves down, which is as he explains, "the minimum requirement to achieve both fluctuation and progress in a linear movement."
These patterns also occur in degrees; each individual wave within a larger wave pattern can be broken down into similar patterns. This is known as a fractal system in which individual part mirrors the structure of the whole; in other words, the fluctuations in these patterns are the same on all scales.
In its broadest sense, the Wave Principle suggests the idea that "the same law that shapes living creatures and galaxies is inherent in the activities of people, en masse." And while "critics" point out that his bearish big picture forecast has not occurred (stocks have not given up the gains of the 1980s and 1990s), they ignore the credit due for his ongoing successes.
Based on wave theory, he was consistently bearish on gold throughout its bear market years in the 1980s and into 1990s, and correctly turned bullish on silver in 1993. In the mid-1990s he published a book – At the Crest of the Tidal Wave - that predicted deflation at a time when the majority was incorrectly focused on inflation.
As for stocks, his "generational" outlook may not yet have occurred, but he has been very successful at highlighting "cyclical" extremes over many market cycles. Those who try to apply his theories to very specific short-term decisions may find they are asking for the impossible.
He explains, "The stock market is knowable, but it is knowable only on the basis of probability or contingency. As with forces affecting weather, some aspects of the results are predictable, such as that summer will be on average warmer than winter, while others, are not, such as what precisely the peak temperature will be in Peoria on a given day in August."
Meanwhile, no one is more honest about the failure of his system to predict the continuation of the bull market through the 1990s than Bob himself.
Speaking with him some years back, he explained: " In the 1990s, I consistently missed the extent of the stock mania, which is what some people gripe about. It is a perfectly justifiable gripe. I'd like to be right all the time on markets, but I'm not. I hope this is not a revelation to anyone."
Meanwhile, he maintains the legitimacy of his long-term posiition. He says, "Suppose it is the early 1600s and someone observes that tulip bulbs, which have traded between 15 and 30 cents for two decades are about to undergo a mania that will take prices to $10 and then all the way back to 30 cents. People dismiss the outlook as delusional."
"But then, " he continues, "prices climb year after year, finally reaching $10. Then they go to $15. The forecaster who looked for a rise to $10 is judged wrong for having missed the latter part of the rise.
But what if prices peak at $30 and then collapse to 15 cents? What was more harmful, missing the final phase of advance or missing the message of the big picture?” Several years back he explained, "The 'guru' image is the same mass psychological phenomenon as the stock market.
The public gets an image in its mind, and then builds and inflates that image to impossible proportions. These impossible proportions meet reality, and reality wins. The result is that the image collapses."
I'd strongly argue that his image never has and never will collapse. Bob remains a highly successful advisor, and each and every issue of The Elliott Wave Theorist offers fascinating insights into investing that are unavailable through any other source.
In addition, he not only continues to research the impact of wave theory on financial markets, but has greatly expanded his reach, and in recent years, his work has been embraced by members of the scientific community in such areas as fractal geometry and chaos theory.
His multi-volume work -- Socionomics: The Science of History and Social Predication – is a pioneering effort to view sociology through wave-theory. It is a very challenging, but fascinating read.
Specifically as to finance, he notes, "The stock market reflects social mood. People communicate ebullience by buying stocks, wearing certain fashions, voting for certain candidates, and even buying certain types of music. People communicate depression by behaving in opposite ways. When there is a preponderance of activity at one end of the scale, it suggests a social mood extreme."
He is quick to point out that these popular trends are not a predictor of the stock market. Rather, they are coincident trends, which reinforce rather than predict a market outlook. Meanwhile, only time will tell how accurate his bearish secular outlook has been.
One thing is sure; decades from now, many of today's stock market seers will be long forgotten, but in financial graduate classes far into the future, Bob Prechter's pioneering work will still be the subject of debate.