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The
Elliot Wave Theory
Fascination with the ocean has attracted people to
the beaches for thousands of years. Even today, one of the best ways to
relax and focus on one’s next strategic move is to walk along the seashore
listening to the waves crash. Three hundred and thirty nine years before
Elliott wrote The Wave Principle, William Shakespeare, in his play Julius
Caesar, wrote about the importance of identifying trends in one’s life.
Shakespeare’s now famous verse “there is a tide in the affairs of men,
which, taken at the flood, leads on to fortune…” survived the test of
time because it applies to many aspects of life, including the stock market.
Recognizing and seizing opportunities when they present themselves, is a
recipe for success in all areas of one’s life. Elliott, like Charles Dow
before him, realized that the stock market, as well as life, moves in waves,
and catching the right tide can lead to fortune.
It’s important to know a little about the man who
wrote the theory. Ralph Elliott lived from 1871 to 1948. He was an
accountant, who loved the ocean. Elliott, among other things, noticed the
relationship between ocean waves and the stock market. He concluded that the
ocean tides going “in and out” bore remarkable similarities to the stock market going “up
and down”.
He called the primary waves that made up the tides
“impulse waves”, with the smaller waves, the undertow, being
“corrective waves’. He then quantified the waves into a 5-3 movement.
The first five waves he identified as impulse waves, followed by 3
corrective waves. The eight wave cycle functioned consistently with the
Fibonacci numbering sequence. Additionally, the 5-3 wave sequence could be
broken down into sub-waves, all following the 5-3 movements. The sub-waves
can be hard to identify and are infinite in number. Sub-waves can also
extend the length of the impulse waves, further complicating one’s
interpretation of a trend.
Elliott believed that human behavior, as well as the
stock market, could mathematically predict the retracement percentages and
multiples based on the Fibonacci ratio principles. The most important
Fibonacci retracements are 38%, 50% and 62%, with inverse multiples of 2.6,
2, and 1.6 times. Elliot’s thinking was that all human activity was
connected by repeating patterns, ratios and time. Overall, the wave theory
encompasses the belief that the stock market acts in accordance with the
upward and positive movement in life, progressing in the manner of “three
steps forward and two back.”
The Fibonacci numbering sequence is interesting
because the ratios derived from it are found repeatedly throughout nature.
Fibonacci first discovered the sequence when he was solving a problem as to
how fast rabbits could breed. The same ratio repeats in geometry, the solar
system and even body proportions. The sequence starts with 1 and adds the
number preceding 1 to calculate the number following 1. For example:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233,
377, 610, 987, 1597 …
The retracement and multiple ratios are calculated as
follows:
Retracement: 1597 / 987 = 62%
Multiple: 1597 / 987 = 1.6x
Retracement: 1597 / 610 = 38%
Multiple: 1597 / 610 = 2.6x
The values of 1 are also important retracement and
multiple ratios:
Retracement: 1 / 2 = 50%
Multiple: 2 / 1= 2x
Elliot’s wave theory, combined with Fibonacci’s
numbering sequence, took a lot of creativity; a good percentage of the time
it works.
The wave theory is better utilized to identify
trends, rather then to predict future movements. That said, I believe Elliot
was trying to make money in the market and, as such, was using the wave
theory as a forward or projective tool. The wave theory is popular today
because it helps predict the direction of the market. Where the market is or
has been is secondary to where the market is going.
Below is the classic diagram of the Elliott Wave
Theory:
From the above example 1, 3 & 5 are the impulse
waves. While 2 & 4 are retracement waves, they are considered part of
the overall action orientated impulse waves. There are also three corrective
waves at the end of the main trend, represented in the above example as A,
B, & C.
The waves are formed based on the emotional reaction
to events. Described below are the rationale behind the waves in a bullish
trend (the opposite reasoning would hold true in a bear market):
Wave 1 – This is the first impulse wave, where
“scavenger’ investors see value and opportunity, and start to bid up the
value of the stock. This is the beginning of new money entering the stock.
Wave 2 – This is a retracement wave, where profit
taking occurs. Many of the “tired of waiting” investors, as well as
those with losses, will exit the security. The wave 2 pullback should not
decline below the starting price of wave 1.
Wave 3 – This is the longest of the impulse waves
and where good news and positive earning are taking place. The company has
fundamentally improved and investors realize it, and want to participate in
the company’s success.
Wave 4 – This is another profit taking retracement.
The rule is that the price decline in wave 4 should never go below the peak
of wave 1. The disciplined fundamental investors will take profits in this
phase.
Wave 5 – This is where emotions are driving the
market, inflating prices well beyond the normal pricing benchmarks of a
security. It was in this wave that many of the technology investors in 2000
wished they would have sold. What were people thinking when they priced AOL
higher then Time Warner? However, Wave 5 is considered to be part of the
natural rules of the universe. Humans have a habit of taking things to
excess. Wanting to succeed and being a little greedy or piggish is all part
of life. Wave 5 represents the extreme end of the market, where expectations
exceed reality.
Wave A – This is the beginning of the corrective
waves. Most investors initially view the pullback as normal profit taking,
not realizing they are now in the beginning of the corrective stage of the
market.
Wave B – This is where the foolhardy or overly
optimistic investors enter the market. They push prices higher, hoping and
wishing to see prices return to their previous heyday, only to be
disappointed by the continuing slide in wave C.
Wave C- This is the realization wave, where investors
know the past trend is over and the excessive run-up in stock prices needs
to be brought in line with historical benchmark valuations. Some investors
sell, causing prices to fall further, while others hold on, in anticipation
of a new upward trend. This is the stage where companies write off their
excess goodwill and similar transactions.
Elliott placed no time frame on the wave movements.
He felt that waves have various cycle times, ranging from a few hundred
years to a few minutes. He labeled the cycles as: Grand Supercycle,
Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuet, and
Sub-Minuet.
The underlying premise of the wave theory is that for
every action (wave) in the market, there is a reaction (correction). The
wave theory nicely ties together some of the basic rules of the universe
with the behavior of the stock market.
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