Tuesday, October 12, 2010

The Elliott Wave Theory of Fractals

As most people who frequent this blog might have noticed, I avoid long term counts because I don't think the Fractal concept can be applied to Elliott Wave Principle as reflected in stock prices in the long term. For me, the Elliott Wave Principle is a way to predict investor sentiment at different periods of time. And while the concept of fractals applies to investor sentiment at the multi-year level, it is impossible to assign prices to these levels because the theory in its orthodox form ignores inflation and other factors such as GDP growth and global money flows that can distort prices. It's similar to the RSI in the sense that a market can be oversold or overbought at the minute, hourly, daily, monthly, etc. but prices are never the same when same levels are reached during an extended period of time. So for instance, the RSI on the monthly can be at 70 (an overbought level) and the stock market can indicate 1000 today but it doesn't mean that it will be 1000 in 5 years time when it reaches 70 again. Same with the Elliott Wave Principle, markets might peak on a Wave 5 of some degree and then correct but the inflation and fundamental factors will be reflected in price. Therefore, using this theory for short term trades is useful but in long term it's questionable at best.

As examples of when Elliott Wave Theory fails as an investment tool, I'll show two examples. That of Zimbabwe in 2007 where then market went up 12,000% because of monetary policy that led to hyperinflation and the ultra bearish predictions of Robert Pretcher from Elliott Wave International.

In the Zimbabwe case, inflation that was created by loose monetary policy that led to a complete debasement of the currency.This devaluation was reflected in the stock market in nominal terms as well as other assets in that economy. And had Elliott Wave Theory been applied to that market, the waves would have gotten stuck in a forever "W3" wave.

Another great example and one that many EW followers are familiar with are the predictions of DOW 400 by Pretcher from EWI. Essentially, by failing to factor in inflation and fundamental changes in the economy such as GDP growth, the "cycle wave" Pretcher is waiting for will never materialize. In 1980's, after predicting the stock market was going to rise. Pretcher called for the DOW to enter into a cycle correction assuming the fractal theory of Elliott Wave. Pretcher then called for the DOW to plunge 100-400 when the DOW was at 3,600. The reality however was the complete opposite. Because of the economic fundamentals at the time and inflation, the market kept going up four fold. And now, 20 years later we are seeing the same calls for a DOW 400 but because of the factors mentioned, these predictions will never come true.

Here is an article I found from 1993 and the thinking of Pretcher, who is arguably the authority on orthodox Elliott Wave Theory:


No comments:

Post a Comment