The elliot wave theory is
1) Human emotion is predictable.
2.) Stocks are priced on our own confidence or emotion in our ability to produce.
If we as a society are getting more confident, we not only believe we will be able to produce more, but because of the confidence, we may in fact produce more during that time period. However, if the cycle occurs, that means that there will be down waves as well.
Lots of studies are done, but the basics are that there are cyclacal waves.
There are 5 waves with 3 up and 2 down in a bull market, with waves 1,3,5 upwards and 2 and 4 as corrective waves.
If an individual time frame shows this pattern, that may just be one particular “1 wave” within an even larger wave.
The first wave at the top may be the general trend. Within that trend will be smaller movements of the same pattern.
The issue with this is you often will be uncertain if a move in the market was due to human psychology, or because of random news events. There for example will be people who say that the markets won’t match up like that all of the time, and some of the corrective waves will be unnatural. The recovery after the flashcrash is due to what many believe to be because of the plunge protection team. However, some Elliot Wave theorists will say that what seems unnatural is actually just a clash of collective psychology that results in the patterns forming. Either way, it’s often difficult to identify whether you have completed an up cycle, or if it just appears that way.
Within Elliot wave analysis, you also have fibbonacci sequences that assist in levels of support and resistance.
The Elliot wave came from Ralph Nelson Elliott.
Tutorial:
http://www.elliottwave.com/tutorial/
http://www.elliottwave.com/club/protected/pdf/Investor_eBook.pdf
The idea is that everything about finance cannot be applied to the stock market. Where someone might be frugal so they can have enough food to survive, someone in the stock market is not worried about ability to eat or even thrive. They are acting upon impulsive emotions with a “follow the heard” mentality. It’s unavoidable, the emotion occurs first, the rational occurs afterwards. This is the problem with trying to invest in stocks. If other people are buying there is always a bullish case to be made just as there always was both a bearish case and a bullish case when markets were falling and rising. However, what leads stock prices is the action of people willing to sell stocks at lower prices than they bought them, or to continue to buy at higher prices. Collectively demand is highest at market peaks and people get spooked and avoid stocks at market bottoms.
If you doubt you are ruled by your emotions, go to a scary movie. Watch it and actually pay full attention to it. You can consciously tell yourself not to get spooked, but if you see a large image jump out at you you will jump along with everyone else in the audience…
If you ask someone why they swerved off the road rather than slam on the breaks when something jumped out at them, they will try to give you a logical response. The truth is, it was an emotional response and their line of reasoning is only explained after the fact. The markets often work the same way.
That’s not to say that if you own good predictable companies that eventually they will trade higher. If you follow Buffett’s application to buy stocks you still can win. Buffett still does have a buy low sell high (if you even sell at all) attitude. It’s not to say that good rational along with mathematical logical analysis can be a reason why you behave in a certain way in the market, and as a result you make money. In fact, that is exactly why Buffett has been able to beat the market. He is often the contrarian. Buying when others have sold out.. The problem is that much of the “valuations” are based upon recent history, and if recent history overvalues them because of an increase in credit to the point where people have excess money and credit, the valuations are going to be rich historically if you go back far enough, but after awhile, a small decrease can make them seem cheap. You can convince yourself that it’s a “new economy” and that “this time it’s different”, but the truth is, if credit starts to collapse, deflation starts to exist and people begin to lose faith and ability to purchase stocks, they will start to go down. Economic indicators can be great BEFORE stocks crash and only after they start to do the economic indicators indicate a problem.
It is going to be very difficult to trade against your emotions. When the stock plunges when everyone else has large levels of cash and when the economy reports news that seems bearish may in fact be a time where it’s better to buy than before.
Think about it, when you find out about the news, it isn’t as if it’s anything new. If you hear about the credit tightening and the GDP number is lower, it’s not as if that just occurred, it’s that you just found out that things have been bad. It’s not an indicator of future results. If you notice a correlation it’s not necessarily going to continue. If stocks are trading cheaper they generally should be bought if they are historically really cheap and everyone else is selling or hoarding cash. If the impulse of others is to buy, you should move in the other direction. If you can track what others have done and you can start doing the opposite, eventually they will follow you, rather than you following them. Even so, it’s possible the markets remain irrational for long periods of time. So that means either you have to understand how human emotions will occur in the future, or you have to be more patient, or both. I will explore Elliot wave more in the future.