Elliott Wave Theory, usually called the Elliott Wave Principle by its supporters, is a method of forecasting stock market movements. It was first proposed by Ralph Nelson Elliott in the 1930s. In the later 20th century and the first decade of the 21st, the most active proponent is former trader Robert Prechter, who heads Elliott Wave International, self-described as the world's largest market forecasting firm. The validity of the method is disputed.
Essence of the Idea
Prechter claims that by using the Elliott Wave Principle you can identify the most probable market moves and reduce risk. You accomplish this, the theory goes, by identifying wave patterns in stock market price movements that culminate in decisive inflection points, where a rising market turns to a falling market and vice versa. Both Elliott and Prechter see these waves as manifestations of mass psychology, where market movements are manifestations of waves of investor mood, moving from pessimism to optimism in specific patterns.
Elliott, and following him Prechter, identify a five-segment sequence. A bull market sequence of rising optimism has three upswings, with two intervening downswings. The last upswing culminates in the turning point, at which the market begins heading decisively downward, beginning the five-segment bear market sequence.
One of the more controversial aspects of the theory is the claim by proponents that these market swings relate to the Fibonacci series purportedly found in nature. The Fibonacci series, propounded by a medieval mathematician, is a numerical sequence created by selecting two seed numbers of any numeration, then successively adding to them the sum of the two preceding numbers. A Fibonacci series beginning with 0 and 1 has the following numbers: 1, 2, 3, 5, 8 and so on. A series beginning with 3 and 6 has the following numbers: 9, 15, 24, 39, 63 and so on. Elliott Wave proponents argue that the coincidence of turning points in the five-segment wave with Fibonacci numbers further validates the principle, while critics complain it makes no sense.
Real World Results
Prechter has presented abundant evidence that the principle really works. Many market traders, particularly in the Forex currency market, use the theory and claim to make money using it. Some academic studies periodically debunk the theory, pointing out that although it sometimes seemingly predicts major turning points in markets, the incidence of correct results is about what you would expect by chance. A few academic studies support it, including a detailed 2011 Elliott Wave analysis of the market that proposed the financial markets would collapse beginning in May 2012. On the contrary, however, the S&P 500 rose from 1392 on May 1, 2012, to 1652 on July 10.
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