WASHINGTON, Nov. 27, 2002 (UPI) — The Efficient Market Hypothesis, under which market movements are random and investment analysts futile, won a total of six Nobel prizes for its inventors. Robert Prechter, author of Conquer the Crash (Wiley, 2002, $27.95), is regarded by Wall Street an eccentric, who need not be taken seriously. Yet on the major market moves it is Prechter’s track record that impresses.

Prechter, who has been active as investor and analyst since the 1970s (in itself a considerable achievement in this business) has a unique approach to market forecasting. He believes that market moves are governed by Elliott Waves, first discovered by Ralph Nelson Elliott (1871-1948), in many ways the godfather of technical financial analysi

For many people, this is the problem. Even the weak form of the Efficient Market Hypothesis, which many people accept, states that technical analysis, the forecasting of stock or other prices through knowledge of past price movements, doesn’t work. Whereas the Efficient Market Hypothesis is on the whole rigorously derived from its underlying assumptions (many of which are however false) the theoretical underpinning for Elliott is pretty shaky. Prechter claims that Elliott understood that the stock market was fractal — similar in pattern when regarded at both the largest and smallest scales — but this has to be wrong, as the concept and word “fractal” was only coined in 1975 (in Benoit Mandlebrot’s “The fractal geometry of nature”) — 27 years after Elliott’s death.

However, because the Elliott Wave Theory is unproven doesn’t make it false. It is pretty clear that the stock market is both fractal and chaotic (apparently random, but driven by governing deterministic laws) — people have made money trading off both characteristics, which each negate the random walk theory. A fractal, chaotic market is very likely to have some complex underlying “driver” — a mechanism governing major price movements that is born of the interactions between fear, greed, economic reality and the passage of time. Elliott Waves, together with the qualitative explanation of the forces behind them provided by Elliott and Prechter, are one plausible such model, which appears to fit the observed realities with considerable elegance.

The Efficient Market Hypothesis is rigorous but false because it is an artifact of the early years of econometrics, in which economists sought to fit economic models into equations they could solve, possibly not realizing — being at best mediocre mathematicians — that linear and exponential equations, those soluble by mid-century economists, represented only a tiny fraction of the possible mathematical relationships that occur in nature. Only after 1970, with the “Catastrophe theory” of the late Rene Thom, followed by Mandlebrot’s fractals and chaos theory did the general public, including economists, come to realize that the simple equations they had studied in school adequately reflected reality in only a small fraction of situations. Like the ecological catastrophes predicted in the 1970s by the Massachusetts Institute of Technology and the “Club of Rome,” the Efficient Market Hypothesis rested on a number of assumptions, made to simplify the equations into solubility, that were in fact demonstrably untrue.

The Elliott Wave Theory states that financial markets move in a cycle consisting of a five-wave primary phase (three up interspersed by two down), followed by a three-wave reaction (down-up-down), after which another primary trend begins. This pattern repeats itself at several scales, from short term trading patterns to the overall market trend, thus fulfilling the market’s overall fractal nature. The waves differ in kind. Of the three upward phases, the first is hesitant, the middle phase three is the strongest, while phase five ends in an orgy of speculative excess. The first downward phase two ends at a point where the market comes to believe that the overall trend is downward.

This fits well the pattern since the bottom of the 1929-32 bear market, which considering that Elliott wrote in the 1940s is fairly impressive. More impressive is that, at the beginning of the 1980s, Prechter was forecasting a huge upward Elliott Fifth Wave, ending in an era of speculative excess, which of course is what occurred. He currently believes that the Fifth Wave peaked in March 2000, and that we are now in a downward “supercycle” having ended the primary up-trend that began in 1932.

Prechter was mocked at various points in the last two decades, having forecast a further sharp market rise just before the 1987 crash, and latterly because he predicted the imminent end of the Fifth Wave in his previous 1995 book “At the crest of the tidal wave.” To be fair, however, the Elliott Wave Theory does not purport to indicate the timing or even the exact size of market moves, merely their general direction, type and sequence. The 1995 call was reasonable at the time; it simply did not account for the size of the 1996-2000 speculative blow-off.

There are a number of features of recent markets that Prechter has successfully predicted. Most impressive is that the fifth wave, in spite of its enormous size, was far less whole-hearted than the third wave in the Elliott cycle. This was predicted by Prechter in 1978, and validated by the extraordinary fact that, in spite of the market’s huge rise since the late 1970s, the cumulative advance/decline line (number of shares rising minus those declining each day, cumulated from day to day) is almost flat in 1976-2000, with advances and declines being nearly evenly matched — in the third wave (1942-66) it was hugely positive.

Prechter provides a further fascinating insight into current market valuations in a chart of the price to book value versus bond yield/stock yield ratio of the S&P 500 share index, plotted annually. From 1927 to 1990, each annual value falls within a box, with only a few modest outliers in each direction — 1931, 1932 and 1941 on the downside, and 1928, 1972 and 1987-1990 on the upside. Then in the 1990s, the graph takes off diagonally upward; all values in the 1990’s are well outside the box, even beyond the earlier outliers, and as Prechter remarks, the 1999 valuation looks like Pluto on a map of the solar system; 2000 and 2001’s averages return towards the box, but at 2001’s average valuation, the index must drop by two thirds further, below 400 on the S&P 500 Index, even to hit the box’s top right hand corner.

Prechter spends only a small amount of time speculating on where the downswing may take the market, but concludes that, based on the theory and past history, its most likely destination is within the 1970’s Fourth Wave valuations, from 577 to 1,051 on the Dow Jones index.

This is MUCH more bearish than my prediction of 5,000 on the Dow, or indeed than anyone else’s prediction for the market that I know of. It is unsupportable by any reasonable valuation metric, unless you believe that the share of profits in U.S. gross domestic product is going to fall catastrophically and stay there.

However, Prechter’s analysis, and the Elliott waveforms, must have been affected by the fact that, since 1933, the United States has operated on a “fiat money” system, so that strictly speaking index values in such a calculation should be deflated by the overall consumer price index or its equivalent. If we do that, then the 1966-82 bear market is much more impressive, dropping the Dow Jones index from 5,577 (at today’s prices) in 1966 to 1,440 in 1982. A final bottom for this bear market around the middle of that range, say 3,500 on the Dow, would seem reasonable, and compatible with my own view, which is based on valuation considerations.

Arguing from Elliott Wave principles, Prechter then outlines his case for a severe deflation, making an excellent case for a credit deflation, similar to that of Japan in the 1990s, in which banks suffer repeated huge bad debt write-offs and become inordinately conservative in their lending. He does not in my view successfully make the case for a severe deflation in prices themselves, because the abandonment of a fixed money standard, and the ability of the Fed to “drop money from helicopters” make such a prolonged price deflation very unlikely. Much more likely, in my view, is a possibly more economically severe repeat of the 1970s, with rising consumer prices, but generally falling asset prices. Gold and real estate rose in price in the 1970s, but in Prechter’s view (with which I concur) they are unlikely to do so this time around. Prechter ends the book by giving some simple but sound rules for investment and lifestyle patters in a deflationary depression.

As I said, Prechter does not prove the Elliott Wave Theory, or his view that we are at the beginning of a huge “supercycle” stock market and economic downturn. Nevertheless, his book provides a great deal of impressive evidence to bolster his case, as well as a substantial amount of good advice to follow if he is right. Stock market investors would do well to read it, and to consider carefully its recommendations and insights.

Some day, it would be nice if the Nobel Prize Committee, when looking at financial market analyses, gave a Nobel Prize in Economics for a theory that actually worked. Prechter and, posthumously, Elliott, should be high on the list for the first such award.

(Wing Collar is a biweekly column of personal finance advice, expected to appear alternate Thursdays. It intends to give readers the solid financial advice, tailored for today’s financial needs and markets, that a wing-collared bank manager would have given in the days before bank managers were salesmen. This Wing Collar special reviews Robert Prechter’s Conquer the Crash, a book which may interest retail investors; it is however somewhat more technical than most of these columns.)

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