Elliott Wave Theory Predicts Quick Drop in Markets

Elliot Wave

Elliot Wave theory is predicting that the stock market may be in for a pretty big tumble soon. There are several prominent price influencers that also need to be accounted for.

Elliott Wave theory is a technique used to predict future prices of securities by applying correlations of up and down patterns to current conditions. We know that prices do move in waves, and you never see anything move in one or the other direction solely, so there is at least some potential in seeing what we can learn from the behavior of these waves.

The price of securities, stock prices for example, move in distinct patterns up and down, which followers of this technique call waves. We get a move up, that’s a wave, a correction of some sorts, another wave, then move back up resulting in a third wave, and so on.

Elliott Wave theory can be considered to actually be on the fringe of modern technical analysis, for the simple reason that it perhaps tries to do too much. The goal of technical analysis is primarily one of looking at what we could call waves of certain durations, and then looking to see how long we may be on the current wave.

When the current wave ends, we first confirm this, and then look to predict if the wave will continue long enough to stay in our positions, whether they just be for a few minutes or for a few years. This has us trading on the edge of charts, rather than looking to project them into the future and seek to predict such things further out, which is more difficult to do well.

This has is because it’s just easier to find correlations when we’re just analyzing a single wave instead of a number of them, as well as placing the decision-making process closer to the ground as well as more reactive.

Even so, Elliott Wave theory does have some merit, to the extent that it has looked to quantify typical market behaviors, such as if something moves like this then worry will set in and this may happen, then the price will drop to where more people feel bolder, and from looking at the way that this has transpired during the current set of waves up and down we can get a better idea than a pure guess what will happen.

Technical Analysis Just Needs to Beat Pure Guessing

The beauty of technical analysis is that you only have to be better than a random guess would be to have some sort of merit. Some means of analysis have more merit than others though, but they generally at least have something noteworthy to say.

There are some patterns here, and the fact that we are relying on the past more with Elliott Wave theory than we do from more impulse-driven analysis, shouldn’t scare us so much that we turn our heads away whenever they speak. It’s also not the only technique to rely a lot on past patterns, and books on technical analysis are full of such patterns.

Technical analysis actually started out this way, and what we could call pattern-based analysis still plays a prominent role, even though what we could call quantitative-based techniques have grown a lot in popularity.

The concern with the present market from an Elliott Wave perspective is actually the cleanness of the move of the current wave. A sort of mirror effect is assumed to some degree, and if something goes up quickly and cleanly, we may expect a pullback of a lesser degree that is also quick and clean.

If this is correct, then at some point soon, we should expect a sharp reversal, and that’s exactly what the Elliott Wave enthusiasts are prognosticating.

When the tide does turn on this rather short time scale, involving seeing the move since late December as a wave, it very well may be true that we could give whatever we do give back in the wave pretty quickly, and it’s true generally that the greater the slope upward, the greater it will be in the opposite direction.

A lot of traders in fact select their entries when they trade reversals based upon the slope and magnitude of the previous wave, with the ones with more of both producing the most profitable trades, as well as the ones easiest to trade. Clean and sharp is the ultimate, and cleaner and sharper deliver better results.

We then may worry a little more about this if we are considering exiting our positions right now, and also may want to be a little more prepared when the game is finally on and we start moving away from this current up wave and begin the next,

Many may think that what happens will depend on what is actually going on with the markets and not some theory of them that we came up with all the way back in 1939. These views do at least appear to be opposed, with the Elliott people being seen as ignoring the particular circumstances of the market, which surely do exert some influence.

Such events of course do shape stock prices, and they also influence the behavior of these waves. If a sharp wave down is in our near future, we might want to say that the things that we observe influencing stock markets, and quite clearly influencing them at that, might have something to do with this, allowing these circumstances to both shape and limit market behavior.

Deciding Between These Viewpoints

We can find correlations with patterns on our charts, and these patterns may have some real statistical validity, so we can’t just write off this side of the fence. Whatever the reason that people behave in similar ways during certain times are, they just do, and there are people out there that make very good livings applying principles such as this to price charts, as well as some who manage huge amounts of money in their hedge funds.

Hedge funds generally don’t go with just one view or another, and will consider all of the evidence we have, the fundamental drivers as well as whatever we can learn from studying charts. The answer to this dilemma lies, as it so often does, in between.

Price behavior does influence price, for instance it’s easier to jump on a stock moving up than down, or to sell when the price is plummeting. While we can predict trends quite well if we are good at it, and produce results that have enough of a statistical advantage to be profitable, this does not mean that we should only look to these predictions when seeking insight.

What is also important to realize when we see things like Elliott Wave theorists predicting that stocks are going to take a fall is that while Elliott Wave theory has been shown to have enough of an advantage to be profitable when used properly, we’re not really talking about that big of an advantage. Being right 6 times out of 10 can make a trader rich, but is only a bit over random.

We would have to therefore frame such claims as “it appears to be a little more likely than not that we will see stock prices tumble,” quite different than “stocks will tumble.”

One of the things a technical analyst will tell you is that this is what is more likely to happen, but there are lots of times when it does not, and the best we can do is to be right more than wrong.

What influences whether the chart prediction ends up being right or wrong can involve quite a few factors, but all of these are outside the sphere of the analysis, and therefore need to be accounted for.

This includes things like news-driven events and fundamental influences. We still need to look at such things, and their telling a different story than Elliott Wave is does not mean that these factors are not to be considered.

It’s best to take anything useful into account, whether that be trend analysis, macroeconomic analysis, or the trade war. The next wave may be a sharp one, or it may not. Knowing that it may be more likely to be sharp is still useful information though.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

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