Psychology and the stock market

I first started reading investment letters back in the late 1970s— the heyday of gurus, both on and off Wall Street. Most of these independent advisors and their audacious formulas for beating the market faded into obscurity as the explosion of the Reagan bull market made big fund organizations like Fidelity and Vanguard look about as good as, and certainly much safer than, these independent seers.

But one formula stood out in my mind for its ambitious attempt to describe market movements in psychological terms. That was the Elliott Wave Theory.

Ralph N. Elliott had started out in the first part of the 20th Century as an executive in restaurants (he wrote a book on the subject) and then railroads— two fields that will teach anyone plenty about the business cycle. Later, while incapacitated from some bug he caught while advising the Nicaraguan government, Elliott used his convalescence to study stock market charts. This research produced two books explaining the business cycle, as depicted in the movements of stock prices, plus a series of articles published in Financial World in 1939.

Recognizable patterns

Elliott's insight was that, regardless of the business cycle, human nature moves in repetitive progressions. Recognizable stages of investors' emotional swings from fear to optimism to greed and back again— well known to students of the markets and to psychologists— could be seen, concretely, in repeated patterns visible in stock prices.

In all stages, Elliott said, the emotional progression manifests in a wave pattern— an Elliott Wave— in which three legs run in the direction of the major price trend (downward in a bear market, say), interrupted by two intervening countertrend movements.

This pattern is driven by the gradual shifting of investors' psychological consensus from one extreme of overconfidence, to the other: abject fear. Elliott also argued that this impulse pattern can be seen in day trading, in intermediate periods, and especially in a full multi-year market cycle, such as the one on which we embarked in 2007.

His Achilles heel

Elliott practitioners on Wall Street numbered only the smallest handful 30 years ago. The Elliott Wave is much more widely referred to today, although it remains challenging to learn all its ins and outs. It also has an Achilles heel, in that the only way any method could cover such a broad range of time periods is to have a great degree of flexibility built into it. Thus at any given moment the most ardent Elliott disciples will sometimes reach differing, even contradictory, interpretations.

But..... But the wave patterns show up often enough to prove to my satisfaction that there's something to it.

That fact kept my eye on the Elliott Wave when I was an amateur investor, and it has compelled me to continue doing so for my last 20 years as a professional money manager. It seems to offer at least a useful insight into the workings of investor psychology, and perhaps something more profound. When Elliott works, it's well worth heeding for the uncanny clarity and precision it can offer to investment decisions. When it doesn't work, well— you find that out later. Or a true Elliott believer might blame your own blindness to an even-larger pattern evolving.

Avoid conventional wisdom

One of the good things Elliott does is to teach an analyst like me to be alert to top-heavy consensus— that is, to be willing to take the contrary view when a huge majority of investors or analysts all hold one specific conclusion. Since each market wave ends at some point, the wave patterns can help suggest when the consensus has become so popular that there are not enough potential incoming participants left to keep the trend moving in the same direction. The 2006-07 period, though it took a while for the market's topping-out to conclude, was full of such warnings.

All that territory is fascinating, but it gets beyond my scope here.
Let me simply point out that the wave theory appears to be saying something particular about the stock market's alleged current recovery right now.

A message about this market

Elliott theory can get very complicated, but one of its simplest rules is that Wave 4's ending point shouldn't bring prices back all the way to the ending point of wave 1. They cannot overlap. If you sketch out the textbook 5-wave pattern on paper, it makes a nice simple zigzagging shape— nothing complex. And that rule could be manifesting right now, as the market's large zigzag pattern in its drop since 2007 has reached a perfect spot for Wave 4 to end. Which may be why it's running into a wall of resistance at its current level.

The message, if this Elliott interpretation proves correct, is that the market's recent recovery is a false dawn created by prematurely bullish investors whose hopes have been raised by some tentatively improving data, and by rising stock prices themselves— a kind of self-hypnosis, in other words, rather than a harbinger of true economic recovery already getting underway.

Why stop with the stock markets?

How could the wave theory "know" that psychology is ahead of reality? I couldn't really tell you, though Ralph Elliott died convinced he could. His last book was immodestly titled, Nature's Law: The Secret of the Universe. And like Elliott himself, his leading current disciple, Robert Prechter Jr., has also been moving beyond the markets to apply Elliott Wave analysis to understanding society at large— a budding discipline he has named Socionomics, with its own book and newsletter.

I, for one, would argue that there is no scientific answer to understanding the market (much less understanding society), because it all depends on human emotion, which is infinitely variable. The virtue of the Elliott Wave is that it offers some tangible guidance to comprehend that ever-changing aspect— which, like mercury, will forever elude our grasp.