Tuesday, March 24, 2009

A Comment On Elliott Wave Forecasts

For those of you who use elliott wave theory to analyze the markets and who follow the various forecasts of advisors that use it, I want to add a word of caution. As the market decline accelerated into March, I noticed that the number of forecasts from a variety of sources showing the Dow heading to much lower levels (below 4000) began to mushroom. This is a little surprising on the one hand, but not so much on the other. One might expect those who are well versed in elliott wave theory to be somewhat more aware of the human tendency to extrapolate trends indefinitely, but being human it is not surprising that they might fall prey to this fallibility.

It is certainly possible that the markets could continue to much lower levels from this point, even though the current cycles do not support such a move, but traders and investors should be cognizant of possible outcomes other than the most obvious. While I am in no way trying to criticize Robert Prechter's work, as he has been the leading proponent of elliott wave theory and the author of the book that brought it to the attention of so many analysts, Mr. Prechter has forecasted that we are in wave c of a large flat correction that began at the 2000 high and that primary wave 1 of c has just been completed. This, of course, should lead to waves 2, 3, 4 and 5 with wave 3 of c being the most severe.

This may be the ultimate resolution, but another solution exists which could take the markets down to Prechter's forecasted levels, namely Dow 400, in a less impulsive manner. It is reasonably clear that the recent March low, having completed 5 waves down from the October 10, 2007 high, has completed a valid flat correction from the 2000 high. If we take that to be the case, then there are several options available to the markets from here other than a large impulse wave. The least probable option is an impulsive move to new highs. In my view, this is a valid solution, but it does not fit the current cycles that are in force, and therefore, is extremely unlikely. This leads us to the most probable alternate option which is a combination.

A combination beginning with a flat, another 3 wave movement, followed by a zigzag seems to me to be the best alternate solution. (Please see Elliott Wave Principle by Frost and Prechter, pg 53.) The intermediate 3 wave movement could be a zigzag or a flat, but a zigzag would fit better with the current cycle.

Currently, there is no way to know which solution will play out as both are now calling for a 3 wave upward correction. After the upward correction is over, both solutions would suggest an impulsive decline. However, the combination alternate solution would suggest perhaps a less severe decline to just below the March 2009 lows, probably around Dow 5000, as opposed to a huge crash to below 3000 as would be implied by Prechter's forecast. This may not seem like a significant difference, but in reality one is more like a retest of the March lows versus an extended impulse wave. The combination alternate would also allow for a larger intervening rally before the final low.

The reason that I am bringing this alternate to your attention is that if it proves to be correct, the trading environment from this point forward until the completion of the correction in 2010 to 2014 will become increasingly difficult with many reversals, punctuated by occassional strong trends in either direction. I am concerned that many traders may be preparing to bet the farm on a third wave decline that never comes. While Prechter's forecast appears seductively elegant, we must remain mindful of other valid interpretations as we navigate this historic bear market. And this is why it is imperative that traders have a clear set of trend following rules that keep them on the right side of the market regardless of the forecast.

1 comment:

dave said...

Craig,

i left a question about CME candlesticks yesterday. Did it not transmit ?

Regards,
dave