Elliott Wave: Challenges Faced By An Expert
  1. Elliott Wave: Introduction
  2. Elliott Wave: Challenges Faced By An Expert
  3. Elliott Wave: The Best Of The Theory
  4. Elliott Wave: Shifting Into Trading Gear
  5. Elliott Wave: Solving The Probability Problem
  6. Elliott Wave: Conclusion

Elliott Wave: Challenges Faced By An Expert

By Matt Blackman with Mike Green
Contact Matt

In late September and early October 1987, Robert Prechter saw three conditions that had not occurred since the top of 1976. To begin with, the price pattern of the wave structure in the U.S. stock market rally between September 20 and October 2 of 1987 took the shape of a rebound in a larger decline, rather than the start of a new wave. It was typical of a bear market rally.

Secondly, he observed a distinct reduction in upside momentum, and the trading index quickly became extremely overbought, which indicated that the rally was in trouble. Advance/decline ratios were the worst of the year, suggesting that market internals were in failure mode.

Finally, Prechter noticed that investor psychology was shifting strongly and that premiums on stock index futures had soared to their highest levels in 18 months. In other words, traders and investors were more bullish than they had been in the previous year and a half. With most of the market players in long positions, who was left to buy?

Figure 1 – Daily Dow Jones Industrial Average 1987 showing date (Oct. 2, 1987) when Prechter advised clients to exit the market.

It was enough to cause Prechter to advise his subscribers to get out on Friday, October 2, 1987 (according to the article "Black Monday Postscript," published in S&C Volume 5 Issue 11) (see Figure 1). The Dow Jones Industrial Average closed at 2640.99. The following Monday - and the ensuing two and a half weeks - saw the mighty index drop to 1738.74 in an astounding decline of more than 34%. October 19 became known as Black Monday and set the record for the largest one-day percentage drop - a startling 23%. Clients who took Prechter's advice to get out missed the sickening ride down and no doubt felt deeply indebted to him.

Robert Prechter has been studying Elliott Wave theory since the 1970s. He used it while working as a technical market specialist at Merrill Lynch. In 1978 he co-authored "Elliott Wave Principle" with A.J. Frost. He also launched The Elliott Wave Theorist, a newsletter devoted to the analysis of U.S. markets. In the 1980s, Prechter became a household name in the financial community, and he won numerous awards for market timing, as well as the U.S. Trading Championship. The Financial News Network (now CNBC) dubbed him the "guru of the decade" in the 1980s. He is the CEO and founder of Elliott Wave International and has authored numerous books about Elliott Wave, including "At The Crest Of The Tidal Wave" (1995), "View From The Top Of The Grand Supercycle" (2003), "Conquer The Crash: You Can Survive And Prosper In A Deflationary Depression" (2002), "Socionomics: The Science Of History And Social Prediction" (2003), "Market Analysis For The New Millennium" (2002) and "Beautiful Pictures From The Gallery Of Phinance" (2003).

Discerning Patterns
Trader Garrett Jones, a 30-plus-year veteran in the money management industry, initially met Prechter in the early 1980s when both were occasional speakers on the same financial speaking circuit. Jones had been aware of market waves for years and had read the work of numerous technical analysts discussing price patterns. Jones noticed that things seem to happen in threes. The market would frequently make three advances and then have a correction. He also noticed that three advances would generally have a definable pattern.

The first pattern Jones observed was a series of three waves (each of which was interrupted by a retracement or corrective wave) in which the first wave was longest. In the second pattern, wave 2 was longest, and in the third, the last wave was longest. It is important to note that the middle wave is never the shortest wave in any viable pattern. What Jones realized in listening to Prechter was that the price patterns he had observed on occasion were actually the basic impulse waves discussed in Elliott Wave theory.

Jones credits Prechter with helping him better understand the intricate details of Elliott Wave theory and thus become a better trader. However, Jones still thinks the theory is most valuable for looking at the macroeconomic picture.

The Elliott Challenge
Prechter has had other notable successes in forecasting Dow Industrial moves well before they occurred. In the September 1982 issue of The Elliott Wave Theorist, published one month after the end of a 16-year sideways trend, he correctly forecasted the great "lift-off" that year. It was the start of what many have called the big bull market, although Prechter believes this bull market really began at the Dow multi-year low in December 1974.

But in his earlier book, "Elliott Wave Principle", co-authored with A.J. Frost in 1978, the two underestimated the top of the next wave five 'supercycle,' projecting a final target top at 2860. Those reading Prechter's Elliott Wave Theorist newsletter in 1982 were advised that the target had been revised to 3873-3885 and would be reached by 1987 or 1990. While in retrospect these forecasts fell far short of the ultimate gain, they were the highest published predictions of their day during a time when most people doubted the market's prospects.

When the '90s rolled around, Prechter was just as radical in the other direction, once again opposing the general consensus. But as we mentioned earlier, his book "At The Crest Of The Tidal Wave", which publicly called for the end of the great bull market in 1995, was nearly five years and many Dow points premature. Prechter subsequently wrote a chapter detailing why he missed a big portion of the bull market.

Garrett Jones is quick to come to Prechter's defense:

"It doesn't matter if you use EWT or other methods of technical analysis, it is important to be disciplined and admit when you are wrong. No one is right 100% of the time and Prechter has been quick to adjust his forecasts as new information comes in. He is a brilliant analyst, and he remains bearish to this day for reasons to do with his understanding of Elliott Wave and overriding market and economic fundamentals. He may not be sure exactly when the market will crash, but he knows it's coming."

As Prechter points out, the Dow nearly quintupled from 1974 to 1987. Who would have believed it would more than quintuple again by 2000? Such a move was unprecedented.

Plug and Play Elliott Wave Theory - Can it be Done?

Ralph Nelson Elliott's original work, "The Wave Principle", was published in 1938 long before the days of the computer. The fact that he progressed as far as he did with his observations and calculations without the use of a computer is an amazing feat in itself. Given the highly technical and analytical nature of developing Elliott Wave-based forecasts, would it not make sense to have computers do the difficult and tedious background work, thus freeing the trader to take the results and use them with far greater ease? Many traders think so, and while Prechter maintains the conviction that it will always take a certain amount of human intervention to finalize an Elliott Wave forecast, his company is currently working on a computer application that will greatly streamline the process for clients. They are not alone.

In our next installment of this series, we'll examine an approach that takes specific parts of Elliott's principle and uses it for short-term intraday trading and longer-term end-of-day trades to greatly simplify trading decisions. It is a great way to discuss Elliott Wave theory and how it works in real-time trades.
Elliott Wave: The Best Of The Theory

  1. Elliott Wave: Introduction
  2. Elliott Wave: Challenges Faced By An Expert
  3. Elliott Wave: The Best Of The Theory
  4. Elliott Wave: Shifting Into Trading Gear
  5. Elliott Wave: Solving The Probability Problem
  6. Elliott Wave: Conclusion
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