Markets' Wave of Fear

Robert Prechter is predicting a cataclysmic fall on Wall Street. "The American stockmarket rally peaked on March 4, 2005, at 10,941 points on the Dow Jones Industrial Average Index," he says. "The exhilarating 50% bounce since the October 2002 low fell more than 7% short of the previous all-time high, reached in early 2000. This week the Dow is at 10,877; by the end of March 2007 it will have crashed by over three-quarters, to 2550. Never (in 300 years of market data) has a recorded stockmarket had so far down to fall.”

Prechter is the most celebrated current exponent of the avidly watched Elliott Wave Theory of price behaviour.

The theory was developed by Ralph Nelson Elliott in the 1930s. It is described on www.elliottwave.com as "a detailed description of how groups of people behave. It reveals that mass psychology swings from pessimism to optimism and back in a natural sequence, creating specific and measurable patterns. One of the easiest places to see this phenomenon at work is in the financial markets, where changing investor psychology is recorded in the form of price movements. If you can identify repeating patterns in prices, and figure out where in those repeating patterns we are today, then you can predict where we are going in the future."

Pretcher's forecast fall would slice the Australian All Ordinaries benchmark index to about 1075, from its present near-peak of 4600, if our market performed in lock-step as it has tended to do during major crises. And if the American market continues to be the bellwether for international equities, we’re certainly talking about the grandfather of all world crises just around the corner if this predictive theory turns out to be reliable.

Should we lose any sleep over such prophecies? Are there any valid reasons at all for believing them? However implausible they might now seem to us, should we take any concrete action in case they happen to be right?

These are all sensible questions with no easy answers. Prophets have always been held in simultaneous disbelief and awe by ordinary people simply because the ability to foretell the future confers gives great power on the very few who seem able to do it. Priests, oracles and scientists have all been feared and respected for that in their time. Should investment analysts be any different?

This suggested similarity between the expert exponents of different systems of faith is worth thinking about as we grope for answers. Without going into the mathematical complexities of the Elliott Wave Theory, what do “technical analysts” such as Prechter actually claim as the intellectual basis of their forecasting?

Well, as in most predictive systems that don’t rely solely on divine revelation, their supporters '” including many stockmarket traders and chartists '” declare that the present rhymes with the past (though it may not perhaps repeat it exactly) and that a rigorous dissection of the past therefore provides us with the best available guide to the future. But that same belief underlies all human logic; otherwise how else could one assume, for example, that the sun will rise tomorrow?

They go on to assert that our comprehensive data of past stock and other commodity prices reveals very distinct recurring patterns, which can be analysed mathematically. The analysis reveals the existence of "wave patterns" of price advances and declines that occur, with remarkably similar profiles, at many different time scales. In fact it shows that there are waves within waves, all operating in the same way; and that their relationships to each other can be found and used to predict their future behaviour, in much the same way that the Newtonian "laws" of motion can be used to predict the movements of celestial bodies.

Elliott Wave theorists believe these cyclical patterns are caused by regular fluctuations in the underlying forces of market supply and demand, which reflect in turn the acquisition, distribution and liquidation of financial assets by innumerable players. Those forces don’t operate randomly, any more than do the forces of nature recognised by scientists; if they did, no patterns would be apparent.

Moreover, these patterns are no more imaginary than those detected by the analysis of any data in the natural sciences. They are just as real, and their relationships reflect some underlying order. Markets are not chaotic in their behaviour any more than is the universe. But this isn’t due to any kind of supernatural predestination, as magicians, numerologists and necromancers would have us believe; it’s due to the complex working-out of forces acting on each other over time. All we need to know to predict their future behaviour already lies in the historical data and in the continued operation of those unvarying cycles, which can be systematically deciphered.

None of these basic claims seems outrageous. All the other systems of prediction that don’t just appeal to Scripture make them. Galileo was excommunicated by the Church for making similarly based claims that conflicted with the doctrines of his time. As a matter of record, it took the Vatican until 1993 '” more than 350 years after his death '” to formally recognise Galileo’s heretical scientific work; and there are still those who deny Darwin’s conclusions about the evolution of life, as well as the cosmologists’ deductions about the age of the universe. Uncomfortable ideas are always resisted.

By contrast, those critics who don’t believe in the idea that the future can be foreseen must necessarily believe some rather peculiar things. They have to think that the past has no logical extension beyond itself; that all events follow a random walk of chaotic steps; and that trends cannot therefore exist. In investment terms, it follows that they must also believe that any departure from the stable arithmetic average of past prices must be a momentary aberration that will soon be corrected through "mean-reversion", because market prices have an exactly equal chance of rising tomorrow as they do of falling, and by the very same amount.

This strange way of looking at the world does actually underlie the rival and still-dominant Efficient Markets Theory, whose many business-school adherents are the greatest sceptics of any technical analysis, of the Elliott Wave approach, and of all market-timing investment strategies. They hold that history in general, and market history in particular, are useless distractions. Should investors really prefer such alternative beliefs, and why?

It’s interesting that the great majority of investors who pin their faith in "fundamental analysis", in preference to the competing "technical" systems, are also forced to reason by an extension from the past into the future; and yet they consider their own logic to be quite superior. This "funnymental" approach will assert that because such-and-such a combination of "relevant" factors was present in the past, and share prices went up, it’s likely that the recurrence of those factors will cause prices to rise in future. For example, they might observe that a fall in general interest rates has previously tended to lift share prices because bond prices rise as that happens, and shares compete with bonds as assets in many portfolios. Such correlations between different sets of data can now be conveniently modelled with computer technology, and the models can be tortured into providing the analyst with numerical future price targets on which he can act '” a 45% probability, say, of a 17% share-price rise within three months if 10-year bond yields fall by 1%.

The difference in methodology is merely one of complexity, not one of logic. The Funnymentalists are driven to trawl for all sorts of non-price factors to incorporate in their predictive models (we’ve even seen them include planetary alignments, phases of the moon and other "seasonal influences" to account for the observed price cycles that they profess not to believe in). Then they have to define which of those factors are relevant by statistical back-testing, and finally must assume that their influence on future prices will continue unabated into the future, before they can decide what to do.

Returning, therefore, to our earlier questions: What can a rational investor believe, when one respected analytical approach predicts a surge of more than 225% in the DJIA to 36,000, as some Funnymentalist brokers continue to proclaim (the notional target of 36,000 comes from the title Dow 36,000, a best-selling book released in 2000 by well-known US-based economists James Glassman and Kevin Hassett) while the generally misunderstood and derided, though rigorously disciplined, Elliott Wave Theorists like Prechter are now forecasting a 77% drop to 2550?

The answer, of course, is that he can believe whatever he likes, because belief in the future is in the end a matter of faith, and the market will go wherever it’s pushed by the beliefs of the majority. But the wise rational investor will also recognise and never forget that those beliefs can change in a flash, and for reasons that are seldom obvious to the fundamentalist analysts and their computer models at the time. As the hoary old saying goes: Markets go up by the stairs and down by the lift. And as those of us who are old enough to be respectful of history know, it’s never wise to deny the possibility of an improbable crash.

What to do, then?

First, pray that Prechter’s system is wrong this time, even though he did successfully predict the intensity and duration of the 1987 crash and of the huge post-2000 market slump, as well as the scale and timing of the intervening massive bull market. Very few prophets can make the same claim; but he, too, is fallible.

Second, hedge your bets. Capital preservation is far more important to most people. They like to make a killing, but they prefer not to get killed in the attempt. Even if the doomsters are wrong this time, there are plenty of rational people out there who have big portfolio profits and are beginning to fear self-fulfilling prophecies.

Third, study the contesting schools of investment thinking and then use your abilities and common sense to make up your own mind. Following any herd is seldom a clever strategy if you don’t want to become mincemeat. You need to be able to praise and blame yourself, and nobody else, for your successes and failures as an investor.