Catching the right Elliott waves

By Jason Chow
Globe Investor Magazine Online, April 29, 2008

We all know the market moves in waves - the rising waters lift our portfolios while the undertow drags it down. But some insist that these waves - markets look like a series of waves when they're depicted on a chart - can be studied similar to how oceanographers track the movements of the sea.

Enter the Elliott Wave Theory. Some swear that it's the bedrock of reading stock charts; others write it off as the stock equivalent of pre-Copernican astronomy. Still, it's concepts are widely cited and so here, we give a quick and elementary primer on what it's all about.

The waves explained.

The theory is named after Ralph Nelson Elliott, an accountant who developed his ideas in The Wave Principle," a book published in 1938. The foundation of his thesis: Humans behave in a rhythmical pattern and markets are no different. Stocks move in repetitive cycles and these cycles can be broken down into a number of phases or "waves."

Mr. Elliott believed that markets moved in a sea-saw action that comprised eight waves. The first five are labelled 1 through 5; the last three are A, B and C. During a bullish move, stocks will rise on wave 1, pullback slightly on wave 2, rise on wave 3, pullback again on wave 4, then rise to its top at wave 5. The rules of determining the waves are this: The crest of wave 3 is higher than the top of wave 1 and the top of wave 5 surpasses the high of wave 3. Also, wave 4 doesn't decline further than the bottom of wave 2.

Once stocks have reached their height at wave 5, Mr. Elliott said that stocks would then pull back and descend in a three-wave pattern. In wave A, stocks will decline. Then they'd rally a bit in wave B only to give way to another downward move called wave C. Once this three-wave decline was over, another five-wave incline would start, which is why many call this pattern "five-up/three-down." Identifying these patterns is what Elliott Wave practitioners calls "wave counting."

The theory has become popular thanks to the proselytizing of Robert Prechter, a market technician who has been flogging Mr. Elliott's teachings since the 1970s. Using the theory, he successfully predicted a "super bull market" and a significant reversal in gold markets in 1982 and he called the market crash in 1987. On the flipside, he also thought that gold and oil peaked two years ago.

What are the wavers now saying?

Mr. Prechter is still the biggest proponent of Mr. Elliott's teachings at his research firm Elliott Wave International and he's been trumping a bearish theory for years now, arguing that we are in a major downward cycle similar to the 1939 Depression. He combines his own wave counts along with economic research and has been predicting that the heavy debt load in America will sink stocks into a very long-term downslide. While he saw the problem of rising debt, the timing of his market call is still questionable: Mr. Prechter has been flogging his bearish forecast since he published his book Conquer the Crash in 2002 and kept on the same message throughout the last bull market from 2003 to 2007.

Still, the Elliott theory can be applied to other markets as well, like gold, commodities and currencies. And according to Robert Kelley, a research analyst at Elliott Wave International who follows the Canadian dollar, the loonie could be heading for another major spike upward. He says the dollar is in a wave 4 right now. And when wave five comes upon us, he sees that the U.S. greenback could sink to 90 cents in Canadian currency, which would mean the loonie could soar to $1.11 (U.S.) and past its previous highs. "That would serve as an important bottom [for the U.S. dollar]."

Mr. Kelley, however, admits he's not totally confident in his forecast. "The hard part is getting the wave count right and often, the market is open to several interpretation." He says that the if the U.S. dollar goes up to $1.0867 (Canadian) - or one loonie equals 92 cents (U.S.)- it would ruin his "preferred wave count" and that would mean the current wave 4 phase would be longer than he first expected. An extended wave 4 would mean the loonie's value would sink deeper from its highs of last fall.

Market quackery or accurate forecasting?

Mention the phrase "wave count" to even the most ardent chart-watchers and many will roll their eyes. Mathematician Benoît Mandelbrot called Elliott theory a "subjective art" and questioned its validity while technical analyst David Aronson said in his book Evidence-Based Technical Analysis that the theory was fundamentally flawed. And while Elliott Theory is part of the curriculum to become a certified market technician, many chartists think it's more voodoo than science. "I do believe in the concept of waves but the Elliott theory doesn't apply to us here in Canada," said Jeff Parent, a portfolio manager with Quadrexx Management and a market technician. "I've never seen it used effectively. The main risk is the wave counting. How you determine the waves is very subjective."

Even Mr. Kelley admits the criticisms are natural and he's heard them all. But he says the critics don't get the Elliott theory because it's such a subtle craft. "That response is typical and understandable," he said. "Thing is, to get Elliott Wave right, you really have to learn it. I've been doing this for 20 years. If you're not applying the rules correctly, you're not going to get a good outcome."

Special to The Globe and Mail