(Author's note: This article was originally published in May 2012.)
In this series, I’m going to attempt to explain a bit about
market analysis, with a focus on Elliott Wave Theory. Later
in the series (after we’ve covered the
basics), I’ll share some ways to utilize these tools for your own
benefit. A small portion of this has been reprinted from some of
my earlier articles, so if it sounds familiar, that's because I
plagiarized myself. My attorney assures me that I am immune from
litigation, but I have filed suit against myself anyway, because I can't
have people stealing my work!
Anyway... First, I do want to briefly address fundamental analysis. My primary focus as a trader involves
technical analysis, for reasons I will explain shortly – however, unlike many
technical analysts, I do believe that fundamental analysis has value. I believe it
serves as a foundation to interpreting charts across the longer time-frames,
and aids in understanding what is possible and likely.
Conversely, some fundamental analysts seem to believe that
projecting the market using price charts is some kind of “voodoo.” I suppose this is understandable; most things
we don’t understand carry a certain mystique to them. It’s important to realize that price charts,
all by themselves, contain all the collective
knowledge about a stock or index.
People act on what they know or believe, so it stands to
reason that people buy or sell securities based on what they know and believe
-- thus(and here’s the critical point about technical analysis) everything known about a given security by
all the shareholders collectively
is reflected in a price chart. When an
insider makes a trade, it influences the price of that security, and leaves a clue
which can be read on the chart. When a
huge hedge fund gains a piece of critical information (usually well ahead of
the public) and starts buying or selling a specific stock or commodity, that
action leaves its mark on the charts… and so on. Thus the charts point the way ahead.
The goal of a fundamental analyst and a technical analyst
(one who studies charts) is the same:
they both seek to project the future.
Their methods, while seemingly different, are also quite similar in many
respects. For example, a fundamental
analyst might look at Apple and try to project how many iPhones and iWidgets
will be sold next quarter, and how that will influence profits, growth, etc. Then he takes all his research numbers and
derives a projection of the company’s outlook -- largely based on what’s
happened in the past. He then plugs
that projection into a formula to arrive at a future share price target, which is
also based on how things have performed in the past.
A technical analyst does the same thing, except he looks at
the charts directly (which, as we just learned, contain all the knowledge of
the collective) and cuts out the middle man.
He seeks patterns which convey information: When price has moved up by x number of
dollars, and then moved down by x percent to create a certain pattern, how has
the market usually performed in the past?
Both forms of analysis are
based on past performance and on future probability – they just get there
by different means.
The weakness to fundamental analysis is that there are a
great many variables which the analyst simply cannot foresee. Study what happened in 2007-2008 for an
example. Many stocks looked great, and
projected earnings looked great, and their futures looked so bright that
everyone was wearing shades – but their share prices collapsed anyway, in a
spectacular fashion. In September 2008,
did anybody care about how many iWidgets any given company was projected to
sell in the fourth quarter of that year?
Some fundamental analysts saw what was coming back then;
others didn’t. Likewise, some technical
analysts saw what was coming (myself included) and others didn’t. But the
probability of a crash was all telegraphed well in advance on the price charts –
one didn’t even need to turn on the TV to see it coming ahead of time.
The big advantage to technical analysis: we technical
analysts were able to arrive at actual price-targets for the crash, in
real-time, while it unfolded.
Fundamental analysts knew it was “gonna be bad!” but that type of
analysis is simply unable to time the market with that degree of accuracy. This is why the majority of fundamental
analysts don’t even try to time the market, except in broad strokes: their
system is ill-suited to it.
So, now that we’ve gotten that out of the way, let’s discuss
a more detailed form of technical analysis, called Elliott Wave Theory.
On the surface, Elliott Wave is a unique way to understand
why the market does what it does, and a detailed tool that allows us to project
future price moves by extrapolating the fractals and patterns found on the
charts. The theory runs far deeper than that, though.
At its core, Elliott Wave helps us to understand something
much more meaningful than markets: it helps us to understand human nature. The
patterns formed in the market are, in part, a direct reflection of investor
knowledge, and more importantly, investor sentiment. Like most things in the world, sentiment
fluctuates in cycles.
You can observe the symptoms of this cyclical tendency in
the news reports. One week, you’ll see
nothing but happy headlines, as sentiment hits a positive cycle and everyone
forgets about all the troubles in the world:
“Rally Takes off as
Market Cheers Job Report”
“Stocks Rise as Greece
Agrees to Austerity Measures”
“Dow Closes Higher
after Bernanke Announces He’s Dying His Beard”
(If you were rooting for that sentence to end without the last two
words – shame on you!)
Then a short time later, it’s as if everyone forgot how “good”
everything was just a few minutes ago, and suddenly it’s nothing but bad news
again:
“Rally Crumbles as
Market Boos New Jobs Report, Which Was Pretty Much Exactly the Same as the One
They Cheered Last Month”
“Stocks Collapse as
Investors Realize They Don’t Actually Know What Austerity Means”
“Dow Suffers Biggest
One Day Loss on Record when the Market Realizes It’s Afraid of Snakes”
As I’m sure you’ve seen, even the exact same news item can be received well on one day and poorly on
the next – highlighting my point that sentiment is cyclical. In reality,
outside of certain “black swan” events, the news doesn’t drive the market
directly -- it merely reports what the market did after the fact and attempts
to explain it. Otherwise, good news
would always cause the market to go up, and bad news would always cause it to
go down. But as you’ve certainly
noticed, it doesn’t work that way.
The other problem with news is that, even if it was a prime mover for the market, it
always arrives too late for you to make use of it. If you’re dead set on trying to assign a “reason”
for what the market did that day, you could simply look at the closing prices
to figure out whether sentiment was good or bad (up = good; down = bad), and
then make up your own random explanation, just like the news does: “Market Crashes As Investors Realize that
Your and You’re Are Actually Two Different Words.”
Fortunately, we don’t need to pay attention to the
lagging-indicator news, because these sentiment cycles often leave clues
telegraphing their arrival and departure.
These clues are found in the price patterns. As we discussed, all the collective knowledge
of investors is reflected in the numbers on the charts. By tapping into that knowledge, Ellliott Wave
Theory can, at times, recognize and anticipate the sentiment and cycles in
advance. And since sentiment goes a long
way toward driving the price, we can then either:
1. Anticipate
the market’s future price movements before the moves actually occur, or;
2. Gain a reasonably accurate window into what’s
likely to occur if the stock or index crosses a certain price threshold.
The market's price movements are, in the end, a reflection
of human nature. And here’s where things
become truly fascinating:
By rule of intrinsic design, human nature must be
universally reflected in all human constructs, be they markets,
governments, or otherwise. Once you
unveil one universal aspect of human nature, you are often able to locate the
same common thread running throughout other human activities. This is one of
the fascinating things about Elliott Wave Theory:
it seems to apply to patterns found not only in markets, but in the rise
and fall of nations, and even entire civilizations (as well as the ebb and flow
of many other things in the natural world). I have studied and applied it for
many years, and continue to be in awe of its frequently-uncanny ability to
anticipate the future.
It is important to note that Elliott Wave Theory was derived
from back-testing. Back in the
1930’s, R.N. Elliott studied decades of charts at various time frames, and
discovered that there were certain patterns which repeated across all time frames. These patterns were of a fractal nature; in
other words, the patterns on the one-minute chart join together to make up
identical larger patterns on the hourly charts, which in turn make up identical
larger patterns on the daily charts – and so on. He
developed Elliott Wave Theory as an attempt to quantify and explain these
patterns.
In the next chapter, we’ll examine the underlying patterns
that form the basis of Elliott Wave Theory.
Part II can be found here.
