Elliot Wave Theory Review

There are many critics of Elliot Wave Theory, and most cite the Efficient Market Hypothesis (EMH) as the reason why Wave Theory can't work. Indeed, even the weak form of the Efficient Market Hypothesis implies that any form of technical analysis can't work. I think that the EMH has merits, but also has its own flaws, which I discuss in the referenced article. However, the Elliot Wave Theory has problems that are specific to it.

The 1st major problem is that you cannot really recognize an Elliot Wave until it has already passed. So how can you make any forecasts or make trades based on it? After all, the Elliot Wave is simply a series of movements with the trend followed by retracements. The only thing that seems to be unique about it is that the retracement of Wave B is less than the 5th subwave. Otherwise, the Elliot Wave would just be a series of up and down movements, which is easily observable in stock charts or prices, but doesn't help in forecasting prices or directions.

Elliot was, however, more specific about his Waves, but whether the wave satisfies the necessary criteria to be an Elliot Wave can only be determined after the wave has already passed. For instance, Elliot said that impulse waves 1, 3, and 5 are impulse waves, and that Wave 5 retraces at least 70% of Wave 4. But then what if Wave 5 doesn't retrace at least 70% of Wave 4? And needless to say, you can't know this until Wave 5 has already passed.

R. N. Elliot's career as a publisher of stock market strategies began when he impressed Charles J. Collins, a publisher of one of the market letters that Elliot had subscribed to, with a telegram stating that the low of the Dow Jones Industrial Average on March 12, 1935, was a bottom, and that the DJIA would rise thereafter. The market did rise substantially, which impressed Collins. Subsequently, Collins collaborated with Elliot on the 1st book about the Wave Principle. Below is a graph of closing prices of the Dow Jones Industrial Average for 1935. Do you see any Elliot Waves here?
Graph of closing prices of the Dow Jones Industrial Average for 1935.

Source: Yahoo! Finance

This is a little off-topic, but an interesting coincidence. As I write this on March 30, 2009, we are in the midst of a bear market. Note the similarities between the above graph and the one for the current year up to March 27, 2009. The bottom was reached a little earlier in 2009 than in 1935, but the similarities are striking.
Graph of closing prices of the Dow Jones Industrial Average for January-April, 2009.

Source: Yahoo! Finance

The other problem is that the waves are not quantified precisely enough to use in trading decisions. Everyone knows that the stock market goes up and down at various times; however, this information isn't really useful without knowing when it is going to go up or down and by how much. Even to say that the waves have a specific form is not really useful without times and price targets. This is probably why Elliot started applying the Fibonacci ratios to his Waves in the 1940's. There have been studies[1] showing that Elliot Waves in the Dow Jones Industrial Index do not exhibit Fibonacci ratios most of the time, and, furthermore, there is no reason to believe that they would! Indeed, if Elliot Waves did have these ratios, why didn't Elliot discover these ratios before he learned about the Fibonacci numbers? After studying and looking at his Waves for at least several years, he probably would have noted that they have a specific proportion. It is clear that he learned about the Fibonacci sequence first, then applied them to his Waves—but if his Waves actually had those ratios, he would have discovered them even without knowing about Fibonacci numbers!

Although Elliot noted that some waves had sequences or ratios that roughly corresponded to the Fibonacci sequence, or the golden ratio, or some permutation of these numbers, these relationships were mostly the result of curve-fitting. However, the relationships are not specific enough nor do they occur in a predictable repetition that would enable an Elliottician to forecast the market.

R.N. Elliot was a very intelligent man. He learned railroading and accounting, including the latest developments, on his own, then got into publishing and consulting, and then, after a devastating illness destroyed his earlier career, he learned something entirely new and developed a new career. There is no question that Mr. Elliot's basic tenets underlying his Wave Theory are correct—the universe, including people, is governed by laws, and, hence, the future of the stock market is determined by these very laws, and that there is a crowd psychology that causes stock prices to gyrate in waves, emanating from emotional swings of the crowd that range from extreme pessimism to extreme optimism, then back to extreme pessimism. The problem is that it is impossible to quantify these interactions even today, so it has little value in actually trading the market except to determine the trend. But there are far easier methods to determining the trend.

Finally, after looking at various sources of Mr. Elliot's biography, the one thing that seems to be glaringly absent is his track record in actually trading the market. Like so many other technical analysts hawking books, seminars, and trading systems, Mr. Elliot seems to have made more money selling his books and newsletters and from public speaking than from actually using his own system to trade stocks.

Modern Elliot Wave Theory

Elliot Wave Theory has continued to garner much criticism—rightly so, in my opinion—but some of today's Elliotticians argue that the critics don't really understand Elliot Wave Theory. Fact is, Elliot Wave Theory is extremely complex. The problem with complex systems is that one could make almost any argument by selecting the facts that supports one's argument and ignore those that undermine it. Of course, selective reasoning isn't something that only applies to Elliot Wave Theory, so let's consider one example of a prediction by one of the foremost practitioners of Elliot Wave Theory: Robert R. Prechter Jr.

Prechter has written several books on Elliot Wave Theory and he is the president of Elliot Wave International. Prechter has also published the newsletter The Elliot Wave Theorist since 1979. Much of the investment advice given by Prechter is good, but predictions are hard to do by anyone.

Consider this Forbes article, Elliott Wave Wipeout - Forbes.com, published on 8/26/2002, which, during this time, the Dow Jones Industrial Average (DJIA) along with the other stock indexes had been declining from its peak in 2000. Prechter was quite bearish in this article, as many people were, since the market had been declining for over 2 years. Although I have not read his 10th book, Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression, the Forbes article states in its preface that Prechter was predicting in his book that a massive bear market was beginning, and the DJIA was going to decline to triple digits.

The market did decline some more, with the DJIA reaching a closing low of 7,591.93 on September 30, 2002, then climbed a little, then dropped again until March 2003. Afterwards, the markets climbed to record highs, with the DJIA reaching over 14,000 in October 2007.

Graph of the Dow Jones Industrial Average from 1999 to April 3, 2009.

Source: http://finance.yahoo.com/echarts?s=^DJI#chart2:symbol=^dji;range=19990103,20090330;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=off;source=undefined

Of course, the markets have crashed again since 2007, but the DJIA still isn't anywhere close to triple digits, nor is it likely to drop that low, since it is now climbing and will probably continue to climb for the next several years as it did in 2003, especially since the Federal Reserve is increasing the money supply by buying Treasuries and asset-backed securities. (A low in March is often seen in bear markets—the same pattern occurred in 1935 as well.)

Consider this quote by Prechter cited is this MarketWatch article, Elliott Waves market on, for now - MarketWatch, published on April 2, 2009: "This quarter is the 9-year anniversary of the peak of wave V in the Dow Jones Industrial Average. So, based on our projections, the bear market is more than halfway done in time. It is less than halfway done in price, however, as the steepest portions of the decline lie ahead." Furthermore, he is quoted as saying that crude oil will drop below $20 per barrel and the DJIA will drop to the 3000-4000 area.

Neither crude oil nor the DJIA is likely to drop to those levels. But if 2000 was the peak of wave V of the Supercycle, then how is it that the DJIA reached new highs in 2007? After all, every part of the corrective wave that comes after a motive wave that was uptrending should be below the wave V peak, but that hasn't happened. In fact, the DJIA surpassed the wave V peak by more than 12% in 2007. Of course, an Elliottician might argue that it was an expanded flat, where the peak of wave B does go higher than the start of wave A, but isn't that just a 7-wave motive wave instead of the usual 5?

Note: According to this tutorial at Elliot Wave International, the present Supercycle has been identified with the following time periods:

  1. 1932-1937 the first wave of Cycle degree
  2. 1937-1942 the second wave of Cycle degree
  3. 1942-1966 the third wave of Cycle degree
  4. 1966-1974 the fourth wave of Cycle degree
  5. 1974-19?? the fifth wave of Cycle degree

The MarketWatch article did mention that the Elliot Wave Financial Forecaster is up 22.8% according to Hulbert Financial Digest compared to -43.32% for the dividend-reinvested Dow Jones Wilshire 5000. However, this stellar result is probably because Prechter has been bearish and the ranking was determined at the bottom of a bear market. Let's see what the future holds.

[1] Magic Numbers in the Dow, Roy Batchelor and Richard Ramyar, September 2006 : (no longer available) http://www.cass.city.ac.uk/media/stories/resources/Magic_Numbers_in_the_Dow.pdf