Do Elliot Wave and Other Predictive Stock Indicators Work?

A wise older man is consulted regarding a problem the client is having: he is in danger of losing his job and his wife, and he doesn't know why.

The older man pours a cup of strong turkish-style coffee while he chats with his client. While sipping the coffee, he notices that the client has bags under his eyes, but that his eyes are bugged out somewhat. He also notices that the client appears nervous and fidgety, his hands dart manically through the air, and he keeps shifting his legs. Also, he notices that the client frequently rubs his nose, and that a hint of white powder on the client's shirt cuff, which is smeared as though the client tried to wipe it off but didn't do a thorough job.

The older man makes a big show of pouring the dregs from the coffee cup (turkish coffee has coffee grounds in the bottom of the cup) onto the table, moving them around with a finger, and squinting at them.

He then says - peering into the coffee grounds the whole time - "I see that you have a drug problem. The coffee grounds say that you . . . let me look closer at the grounds . . . are spending all of your money on cocaine, and that your job and family problems stem from your impulsive behavior. The grounds say that - unless you stop using cocaine - you will suffer worse problems."

The moral of the story is that the old man was observant, and he could tell from clues in his client's behavior that the client was using cocaine. He was merely using the coffee grounds as a "prop" to tell his client what he needed to hear.

Technical Indicators as Coffee Grounds

Similarly, if a market analyst is wise, he could spot trends using his own skills, but ascribe it to technical indicators like coffee grounds. Due to substantial trading experience or a a particular type of genius, some people are good at spotting trends.

But "I have a strong gut feeling" doesn't sound very good in an investment newsletter or blog, and so it is easier to couch it in terms that a technical indicator is generating a "buy" or "sell" or "short" signal

Is There Any Merit To Elliot Wave Theory?

PhD economist Marc Faber and investment advisor Mike "Mish" Shedlock are both guys who have been right about a lot of things. Faber predicted the '87 crash and the current economic crisis. A quick search of Mish's past articles (type in any economic phrase you like) shows that he has been consistently a lot more accurate than not in predicting how things would shake out.

Both Faber and Mish - as well as many other leading market analysts - use Elliot Wave theory.

On the other hand, critics say that Elliot Wave theory can't be true, because the interpretation of when waves start and when they end is so subjective. Ask 10 Elliot Waver theorists when a wave started, and you'll get 10 different answers. For example, Elliot apparently believed that "Grand Supercycle IV" started with the founding of the United States, while Robert McHugh believes it started before then, in 1718.

Critics also say that Elliot Wave theorists "spot the trend" in hindsight, adjusting their Elliot Wave count so as to conform to the trend after it is established. Moreover, since Elliot Waves are based on fractal patterns, it is possible to spot waves on different scales, and so it is hard to know what level one is looking at.

But what do scientific studies show?

Statistical analysis shows that Elliot Wave theory can be useful, but only:

(1) In markets with high volume of trading;

(2) in markets moving according to key forces of fear and greed on the part of many participants;

(3) when computers are used to analyze the data; and

(4) when people spend a lot of time learning what does and doesn't work in wave theory.

Statistical analysis also shows that many Elliot Wave theorists' calls on when waves started and ended is wrong. And see this.

In other words, Elliot Wave theory can provide useful information, but you have to really know what you're doing, and it is not useful except in certain circumstances.

There are numerous other cyclical prediction systems, including for example the Kondratieff Cycle (which Faber and Mish both also follow), and many others based on psychology, sociology or other factors. Of course, some indicators - for example those looking at volume and volatility - are more grounded in reality than others.

Not Coffee Grounds, But Weather Patterns

Because many of these predictive systems may have some real ability to track trends, perhaps they are more useful than staring at coffee grounds.

A more accurate analogy may be weather patterns. A long time ago, before the discovery of high and low pressure systems, chaos physics and other factors which contribute to our understanding of weather, people whose job it was to forecast weather (say those planning shipping dates) would try to make sense of complex weather patterns and make predictions about the future. With the very incomplete tools they had, some people were better at spotting patterns than others, and so made better predictions.

Unlike coffee grounds, looking at complex weather patterns actually does have something to do with predicting future weather. Some people are better at getting a coherent picture and trend out of the chaotic picture than others.

The same is true with the stock market and other markets. Some people are more skilled at picking patterns out of noise. But again, they might ascribe to technical indicators what they are really picking up using their own mental and intuitive pattern-spotting abilities.

And just like meteorologists get better at predicting the weather as they understand the science behind what causes different weather, market predictors might get better as they refine their knowledge of the psychology of markets.

Don't Forget Macroeconomics

Market predictions using technical indicators which takes macroeconomic and political realities into account should be more accurate than ones which uses the indicators alone.

For example, while in 1995 Robert Precther predicted that the Dow could crash well below 1000 in the financial crisis, Marc Faber wrote:

I have my doubts whether some of [Prechter's] price targets will be fulfilled. I rather believe that in the next recession, governments will immediately reflate massively, which will quickly lead to rising inflation rates and, eventually, hyperinflation. As a result, I doubt that the Dow Jones could fall much below 1000 -the level from which the bull market started in the early 1980s -and, according to Mr Prechter, a strong support level.

And while Precther has at times had great success using Elliot Wave Theory (he set the all-time record in the United States Trading Championship by returning 440% in a monitored real-money options account in the four month contest period), Mish has pointed out that Prechter called a Depression-level crash using Elliot Wave theory decades too early because he failed to take into account the Fed's ability to blow new bubbles:

Robert Prechter ignored and/or did not foresee many things that could keep the credit bubble expanding. Let's start with a flashback to conditions of the 70's and 80's.

Why The Credit Bubble Lasted For Decades

• Single household breadwinner became two household bread winners
• Interest rates were at 18% headed to 1%
• Internet revolution provided tremendous numbers of jobs
• Lending standards declined
• Housing boom provided jobs
• Rising asset prices supported consumption

Like a meteorologist who checks technical readings but doesn't actually look out the window (and satellite photos), people who use only technical indicators and not also macroeconomic information are trying to navigate with one eye closed.

Two Final Thoughts

Marc Faber said that - in this crazy market - you have to be a genius to make money. Faber himself may be a genius, so that is quite a statement.

In addition, with all of the bailouts and other government intervention recently, we are not really still in a "free market". Trillions of dollars of government intervention is presumably unprecedented in history - even including communist and fascist systems. Whether Elliot Wave analysis aand other technical indicators will continue to work in this environment remains to be seen.

Note: I am not an investment advisor and this should not be taken as investment advice.