|This essay by Robert R. Prechter, Jr. originally appeared in
The Elliott Wave Theorist in August 2005.
This paper addresses the question of whether the Wave Principle is a set of market patterns separate from those asserted in other forms of “technical” chart analysis. If the Wave Principle is a separate set of patterns, then we are challenged to show which set or subset is correct, if either. If multiple sets of proposed market patterns exist, then the probability increases that they are all simply human constructs imposed upon random, chaotic or otherwise indefinite price movements in markets. Proponents of the Wave Principle assert that it isthe primary market pattern. If so, then all other proposed market patterns either must be spurious or must fall within the structure of the Wave Principle. Are there any valid technical chart patterns distinct from the Wave Principle?
The traditional areas of technical analysis that depend upon market patterns are Dow Theory, chart patterns and cycles. We will review each of these areas one by one.
William Peter Hamilton, editor of The Wall Street Journal from 1902 to 1929, developed a list of tenets from the observations of market behavior published by the newspaper’s founder, Charles H. Dow. He published a summary of these tenets in The Stock Market Barometer (1922). Investment analyst Robert Rhea refined those observations in The Dow Theory (1932).
Elliott read Rhea’s book, so we may presume that some of the observations within Dow Theory led him to investigate market patterns of this type in the first place. When he saw error or superfluity, however, he said so and crafted his description of market behavior according to what he saw and what he thought mattered. As Collins put it, “Dow painted with a broad brush, and Elliott in detail.”1 As Frost and Prechter said, “The Wave Principle validates much of Dow Theory, but of course the Dow Theory does not validate the Wave Principle,”2as the latter is a much more comprehensive and detailed description of market behavior and does not require two averages for analysis. There are six tenets of Dow Theory that matter for our purposes.3 Those tenets and the pertinent observations with respect to the Dow Theory’s tenets and how they fit—or fail to fit—into the Wave Principle are as follows:
(1) There are three sizes of market movement: “the day-to-day movement,” called the “daily trend;” swings that last from “one month to three months,” called the “secondary movement;” and “broad market movements [that] may continue for years and are seldom shorter than a year at least,” called the “primary movement.”4
Dow Theorists’ observation of three sizes of trend constitutes a limited portion of Elliott’s observation that the market’s total movement comprises multiple degrees, or relative sizes, of trend. Dow Theory’s primary, secondary and daily trends are rough expressions of Elliott’s more specifically delineated Primary, Intermediate and Minor degrees. (See Figure 1 and Table 1.) Dow made his observations during a period when “bull markets” lasted only about two years on average, not decades, so the idea of even larger degrees apparently did not occur to him.
(2) Counter-trend swings lasting one to three months within a primary movement are called “secondary reactions.”
Dow Theorists’ observation that secondary reactions punctuate the primary trend is a quantitatively limited version of Elliott’s observation that corrective waves punctuate motive waves at all degrees of trend, per Figure 2.
(3) A “line” is a period of narrow price action following a persistent trend. When prices move beyond the boundaries of a line, they tend to move significantly further in the same direction.
A “line” in Dow Theory is simply an elongated “sideways” correction under the Wave Principle, i.e., a “double three” or “triple three,” per Figures 3 and 4, from Elliott Wave Principle (1978). The text makes this observation:
Corrective processes come in two styles. Sharp corrections angle steeply against the larger trend.Sideways corrections, while always producing a net retracement of the preceding wave, typically contain a movement that carries back to or beyond its starting level, thus producing an overall sideways appearance.5
Figure 3 & 4
Under the Wave Principle, a sideways correction always precedes a resumption of the previous up or down trend, while under Dow Theory, a line apparently may occur at a trend reversal. See the later discussion under “Rectangle” and Figure 14d in Part II for an accounting of a similar event and its accommodation under the Wave Principle.
(4) Both the Dow Jones Industrial Average and the Dow Jones Transportation Average must “confirm” an ongoing primary bull or bear market by jointly making new highs or lows in each secondary movement that is in the direction of the primary movement. Otherwise, the primary trend is likely to reverse direction.
As Elliott said, “The Wave Principle does not require confirmation by two averages. Each average, group, stock or any human activity is interpreted by its own waves.”6 This statement does not challenge Dow Theory’s observations about the confirmation or non-confirmation of its two averages, but it does say that dual-average confirmation or non-confirmation is not fundamental to market patterns. Every stock market top, for example, does not display a non-confirmation between the Industrials and the Transports, as Dow Theorists were disappointed to discover during the 1940s and 1950s. Nevertheless, as Frost and Prechter noted, “third waves,” which are mid-trend waves, “are strong and broad,” and “virtually all stocks participate in third waves.” In contrast, “fifth waves,” which are ending waves, are “less dynamic than third waves in terms of breadth.”7Speaking directly to the question at hand, they add, “When corrective and ending waves are in progress, divergences, or non-confirmations, are likely.”8 This is a broad statement that includes divergences in “momentum indicators” — which measure breadth, the speed of price change and other trend factors — and non-confirmations between or among the indexes of market prices under observation. Therefore, Dow Theory’s observation about confirmations and non-confirmations of two specific averages are subsumed under the Wave Principle and relegated to its proper position as a guideline but not a rule of market action.
(5) “There are three phases of a bull period.” They are psychological and reflect “reviving confidence in the future of business,” “the response of stock prices to the known improvement in corporation earnings” and “a period when stocks are advanced on hopes and expectations.”9
Dow’s “three phases of a bull period” are equivalent to the three motive waves within a larger motive wave under the Wave Principle, per Figure 5. Their psychological aspects are essentially identical, as described in Elliott Wave Principle (pp.76-79). Specifically, in advancing third waves (Dow’s second phase), “increasingly favorable fundamentals enter the picture as confidence returns,”10 and in advancing fifth waves (Dow’s third phase), “optimism runs extremely high.”11
(6) “There are three principal phases of a bear market.” They are “the abandonment of hopes” from the third bull phase, “selling due to decreased business and earnings” and “distress selling of sound securities, regardless of value.”12
The Wave Principle challenges Dow’s claim that there are “three principal phases of a bear market.” While it has no quarrel with Dow Theory’s description of the psychological changes that investors undergo, the Wave Principle describes only two essential declining waves — A and C — within corrections. Some corrections, specifically triple zigzags, triple threes and triangles, sport three or more downward waves, but the simpler forms do not. (See Elliott Wave Principle, pages 41-54, for a complete list of corrective forms.) Dow’s “third phase” is simply a description of investors’ apparent motivation during the latter portion of a corrective wave, per the notes on Figure 6. Dow Theory’s second phase is an erroneous justification (per Endnote 3), but more important for our immediate discussion, it is inadequate for delineating any such purported middle phase of a bear market. Business conditions virtually always continue to deteriorate further during Dow’s “distress” phase of a bear market and in fact beyond, so there is no actual delineation between a second and third phase with respect to that presumed motivating factor. As you can see in Figure 7, recessions and depressions have always continued right through and past the end of bear markets, with the one weird exception of 2001-2002. Observe further in Figure 7 that in two cases (1937-1942 and 1959-1962) a recession occurred during wave A,not wave C, counter to the presumption of Dow Theory.
The Wave Principle, then, subsumes five of the six listed tenets of Dow Theory and challenges the remaining one. Dow Theorists’ comments on trading volume are similar to Elliott’s, and their comments on double tops and bottoms are similar to those of Edwards and Magee (see next section). These are not tenets of Dow Theory so much as adjunct observations of market behavior. Thus, the Dow Theory offers no challenge to Elliotticians’ claim that the Wave Principle is the primary market pattern.
The acknowledged “bible” of traditional chart interpretation is Technical Analysis of Stock Trends (1948) by Robert Edwards and MIT alumnus John Magee. The book has sold continuously since it was published and is currently in its eighth edition. The discussion here utilizes the fifth edition (1966).
Edwards and Magee collected others’ observations about chart patterns and added their own, producing a comprehensive list of forms against which we may compare related aspects of the Wave Principle. It may not be necessary that we undergo this exercise, as these authors observed and displayed these patterns exclusively in charts of individual stocks, not in the averages where the Wave Principle is deemed best to apply. Nevertheless, because many chartists use the same forms for general market interpretation and since the Wave Principle has some applicability to individual stocks,13 this exercise is important in order to determine if there are any valid market patterns outside the forms of the Wave Principle.
We will now examine each chart pattern that Edwards and Magee described and determine whether it falls within the net of Elliott’s observations. To simplify this presentation, we will limit our prose and let the graphs speak for themselves to the extent possible.
Head and Shoulders Top
Figure 8a shows Edwards and Magee’s depiction of a head and shoulders top, and Figure 8b is Figure 7-4 from Elliott Wave Principle. In a normal wave development, wave five of 3 and wave 4 form the “left shoulder” of the pattern, wave 5 and wave A form the “head,” and wave B and wave one of C form the “right shoulder.” Wave two of C creates the return to the neckline that is typical of the pattern.
Head and Shoulders Bottom
A head and shoulders bottom is formed nearly the same way. Within wave C, wave five of 3 and wave 4 form the left shoulder, wave 5 of C and wave 1 form the head, and wave 2 and wave one of 3 form the right shoulder. Figures 9a and 9b show the same result from a different set of waves in which wave five of A and wave B form the left shoulder, wave C and wave 1 form the head, and wave 2 and part of wave one of 3 form the right shoulder.
Edwards and Magee list both “rounding bottoms” and “rounding tops,” but they give no illustrations of real-life rounding tops, probably because they don’t exist apart from the creative wielder of a pencil. The authors do show several examples of rounding bottoms, for example the one shown in Figure 10a. As revealed in Figure 10b, however, this purported form is simply an artifact of using arithmetic scale for major movements in price. In other words, these apparent patterns are spurious.
The Wave Principle covers the chartist’s “symmetrical triangle.”14 As you can see in Figures 11a and 11b, Edwards and Magee’s example is a perfect rendition of Elliott’s description, right down to the five subwaves.
Edwards and Magee claim, “Prices may move out of a Symmetrical Triangle either up or down. There is seldom if ever…any clue as to the direction….”15 Elliott’s form is more specifically defined, and its position in the market structure and therefore its implications are more definite.
Elliott observed that triangles occur only as or within corrections, per the labeling in Figure 11c, where one appears as a wave 4 correction. Edwards and Magee saw triangles at bottoms and tops as well, but as you can see in Figure 11d,16 such apparent triangles may be seen as epiphenomena attending normal Elliott wave development at market tops and bottoms. As Elliott himself stated, “All waves in a triangle must be part of a movement in one direction [i.e., a single correction]; otherwise the “triangle” is only a coincidence.”17
For a continuation of this report, read Does the Wave Principle Subsume All Valid Technical “Chart Patterns” – Part II.
1 Charles J. Collins, in the foreword to Frost and Prechter’s Elliott Wave Principle, p.13.
2 Frost, Alfred John, and Robert R. Prechter, Jr. (1978/2005). Elliott Wave Principle — Key to Market Behavior. Gainesville, GA: New Classics Library, p.184.
3 There are two important tenets of Dow Theory that do not pertain to market patterns per se but do pertain to theory attending the Wave Principle’s patterns. The Wave Principle and socionomics challenge both of these assertions, namely: (1) “The averages discount everything [and] afford a composite index of all the hopes, disappointments, and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement.” (Rhea, p. 12) and (2) “Manipulation is possible in the day to day movement of the averages, and the secondary reactions are subject to such an influence to a more limited degree, but the primary trend can never be manipulated.” (Rhea, p. 16) The reader will find a thorough discussion and refutation of the first idea in pages 379-384 of Pioneering Studies in Socionomics (2003) and a challenge to the idea of any consequential manipulation of the averages in pages 365-370 of The Wave Principle of Human Social Behavior.
4 Rhea, Robert. (1932). The Dow Theory. New York: Barron’s Press, p.33, quoting William Peter Hamilton.
5 Frost and Prechter, p.41.
6 Elliott, Ralph Nelson. (1938). The Wave Principle. Republished (1980/1994): R.N. Elliott’s Masterworks. Robert R. Prechter, Jr., Ed. Gainesville, GA: New Classics Library, p. 91.
7 Frost and Prechter, p. 80.
8 Ibid., p. 183.
9 Rhea, Robert. (1932). The Dow Theory. New York: Barron’s Press, p. 13.
10 The Dow Theory’s explanation for the cause of the middle phase of a bull or bear market is utterly different from the Wave Principle’s. Socionomics, a theory developed around the Wave Principle, postulates that stock averages never “respond” to changes in corporate earnings. Rather, they reflect the fluctuations in social mood that motivate those very changes.
11 Frost and Prechter, p. 80-81.
12 Rhea, p. 13
13 See Frost and Prechter, p. 169-173.
14 Elliott used the same term a decade before Edwards and Magee’s book was published, but the term may have been in use prior to that time.
15 Edwards, Robert D. and John Magee. (1966, 5th ed.). Technical Analysis of Stock Trends. Springfield, MA: John Magee, p. 92.
16 To keep these illustrations simple for non-Elliotticians, the wave labels in Figure 11d reflect a simplistic analysis of a pattern that in fact is probably in the early stages of a long advance, beginning (1)-(2), 1-2, 6-7, (i)-(ii).
17 Elliott, Ralph Nelson. (1939). The Financial World articles. Republished (1980/1994): R.N. Elliott’s Masterworks. Robert R. Prechter, Jr., Ed. Gainesville, GA: New Classics Library, p. 175.
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events of history—such as investment booms and busts, political events,
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