|This essay by Robert R. Prechter, Jr. originally appeared in
The Elliott Wave Theorist in February 2006.
Waves have moderately reliable quantitative relationships. One of them is that in impulses, wave 3 is almost always longer than wave 1. Another is that in zigzags, waves A and C tend to be about equal in terms of price extent. These two observations are echoed in these words from Edwards and Magee about forecasting the extent of a move following a flag or pennant:
In applying the measuring rule, go back to the beginning of that immediately preceding move…and measure from there to the Minor reversal level at which the Flag or Pennant started to form. Then measure the same distance from the point where prices break out of the Flag or Pennant, and in the same direction. The level thus arrived at is the minimum expectation of this type of Consolidation pattern. As a matter of fact, advances from Flags or Pennants in an up trend generally go farther (in terms of points or dollars) than the preceding move, while declines may not carry quite so far.25
The fact that “advances…in an up trend generally go farther than the preceding move” is perfectly compatible with Elliott’s observations that third waves in impulses are typically longer than first waves. Once the flag or pennant for wave 2 is complete, the next move is typically longer. The fact that “declines may not carry quite so far” is perfectly compatible with Elliott’s observation that in corrections, the two downward waves are about equal. Once wave B is complete, wave C is typically much shorter than a third wave would be. Figure 20, “A Realistic Elliott Wave,” is reprinted from The Wave Principle of Human Social Behavior. Observe that the first “flag” delineated, wave B, precedes a wave C decline, which is the same length as wave A, a moderate move. The second “flag” delineated, wave 2, precedes a wave 3 advance, which is longer than wave 1. Elliott’s detailed observations encompass Edwards and Magee’s more general ones.
Edwards and Magee claim, “When a stock …emerges from a long-time bottom…it will often make a long Major advance in a series of ‘saucers.’”26 As with the “rounding bottom,” this development is simply an artifact of arithmetic scaling when prices emerge from a low level. There is no reason to believe that this supposed pattern is anything other than spurious. Figure 21a shows an example of Edwards and Magee’s “scallops.” Figure 21b re-graphs the same data on log scale, in which the rounded forms disappear.27
Edwards and Magee describe (1) “common” or “area,” (2) “breakaway,” (3) “continuation” or “runaway” and (4) “exhaustion” gaps. The first three types are all accounted for, and more accurately described, under a single observation under the Wave Principle:
“High volume and volatility (gaps) are recognized characteristics of ‘breakouts,’ which generally accompany third waves….”28
“…the third wave of a third wave, and so on, will be the most volatile point of strength in any wave sequence. Such points invariably produce…’continuation’ gaps….”29
Edwards and Magee’s examples of area and breakaway gaps all occur at the “third of the third” wave, i.e., roughly in the middle of a trend. Figure 22 is one of Edwards and Magee’s examples of a breakaway gap, with labels added to show its appearance precisely at the “third wave of a third wave” position. An area gap occurs within sideways corrections precisely where Frost and Prechter indicate, in wave 3 of A or C within them.30 A continuation gap is the same event but within a powerful impulse wave whose center marks the middle of the third wave at multiple degrees of trend, thus explaining Edwards and Magee’s comment, “The runaway gap…occur[s] in the course of rapid, straight-line advances or declines.”31 From the standpoint of the Wave Principle, then, these three types of gaps are all manifestations of the same phenomenon but within different types of waves and different sums of third-wave degrees.
Chartists and Elliotticians agree on the position of exhaustion gaps. Edward and Magee say succinctly, “the exhaustion gap comes at the end.”32 Elliott Wave Principle shows in a “real-life example” that a gap sometimes occurs near the peak of the final near-term subdivision of a diagonal-triangle fifth wave, indicating “dramatic reversal ahead.”33 (See Figure 23.) The authors’ description of a “throw-over,” or penetration of the outer line of a trend channel at the very end of an impulse, implies a gap in that position:
If volume is heavy as the fifth wave approaches its upper trendline, it indicates a possible penetration of the upper line, which Elliott called a “throw-over.” Near the point of throw-over, a fourth wave of small degree may trend sideways immediately below the parallel, allowing the fifth then to break it in a final burst of volume. …A throw-over can also occur, with the same characteristics, in a declining market.34
Edwards and Magee’s depictions of “islands,” which are market tops or bottoms with a gap on both sides of a period of price congestion, show that each gap occurs in the third wave of a near term impulse, the first in wave three of 5 of the old trend, and the second in wave three of 1 of the new trend.35
We may conclude, then, that the observations of chartists regarding gaps are compatible with what the Wave Principle more specifically describes.
The Wave Principle not only agrees with chartists that trend channels occur but also corrects an error that results from chartists’ crude application of the idea. As described in Elliott Wave Principle.
Elliott noted that a parallel trend channel typically marks the upper and lower boundaries of an impulse wave. [C]onnect the ends of waves two and four. If waves one and three are normal, the upper parallel most accurately forecasts the end of wave five when drawn touching the peak of wave three.36
A key observation here is that channels delineate impulse waves, which are five-wave sequences following certain rules, as described in the text.37Chartists draw channels regardless of wave patterns. Figure 24a shows Elliott’s depiction of an impulse within a channel. Both Elliott and Edwards & Magee recognize the channel that contains the 1932-1937 bull market in the Dow, as shown in Figure 24b, from Elliott’s Financial World articles of 1939.38,39 But Edwards and Magee also observe channels at times when relying on them as providing price boundaries would prove harmful. Figure 24c, from Edwards and Magee, depicts a channel from which prices eventually collapsed. The Wave Principle does not recognize a channel in this situation because these prices do not trace out a completed impulse. As Frost and Prechter explain, “In an impulse, wave 4 does not enter the territory (i.e., ‘overlap’) wave 1.”40 I have left Edwards and Magee’s dashed channel lines on the chart but added the proper Elliott wave labeling to show that no impulse was ending in late August. Anyone buying at the presumed support line of that improper channel would have lost a lot of money fast. Once again, the Wave Principle not only subsumes the observation from chartists but does so more accurately and exclusively.
Three Peaks and a Domed House
Technical analyst George Lindsay published a stock-market newsletter from 1951 to 1975. In 1968, he postulated a pattern he called “three peaks and a domed house,” which is illustrated in Figure 25a.41 The pattern has proved useful enough that some technicians have continued to apply it, often with success. The pattern comprises a series of 10 points in a “sideways” trend, 13 points in an uptrend and then 5 points that bring prices below point #10.
Lindsay asserted that the “3 peaks” portion should last 6 to 10 months and the “domed house” portion 7 1/3 months, although most analysts today focus on the shape of the pattern regardless of the time element. Either way, the Wave Principle easily subsumes Lindsay’s observation. Others have seen the connection. For example, analyst Barry Ritholtz comments as follows:
Lindsay’s three peaks and a domed house looks like a 4th wave triangle and a 5-wave impulse in Elliott wave analysis. A triangle for the 4th wave is usually the last correction in an advance, and the 5 waves up from the 4th wave low is, then, a peak of the advance.42
In a 2000 paper, Barclay Leib made compatible comments in this regard:
After a sharp reverse from the point 10 low, first there is a small requisite double test of that low. This transpires during the period labeled points 12 and 14 (which in traditional Elliott wave analysis terms would typically be labeled wave ii of 5). After point 14, the market shoots higher into point 15. Lindsay labeled this advance the “Wall of the First Story.” Elliott would undoubtedly have called it a wave iii of 5. The “Roof of the First Story” follows, and typically takes the form of a flat or expanding zigzag with at least 5 reversals (down into point 16, up to 17, down to 18, up to 19, and down to 20). After the fifth reversal is achieved at point 20, the main uptrend is resumed into what Lindsay referred to as the “Wall of the Second Story.” In Elliott terms, the diagonal triangle43 would of course be labeled a iv of wave 5, and the “Wall of the Second Story” would be the beginning of the final v of 5 advance.44
Figure 25b labels waves closely reflecting Ritholtz’s and Leib’s prose. The message from “Three Peaks and a Domed House” and that from the Wave Principle are identical at each stage.
Other Chart Patterns
There are other purported patterns of market behavior, with names such as “catapult,” “cup-and-handle” and “inverted bat-wing formation.” One has to stop somewhere. I hope that the preceding review puts the burden of proof upon others to show that an observed chart form falls outside the Wave Principle.
Which Is a Better Description of Market Behavior?
In most cases described above, patterns under the Wave Principle are more specifically delineated than those of the chartists, so the descriptions are rarely identical. For example, a triangle under chart analysis is any sideways price action between two converging lines, and a wedge is any progressing price action between two converging lines. Under the Wave Principle, each of these forms must comprise five waves,45 no more and no less. Similarly, a trend channel under the chartists’ approach can encompass any price action, while a trend channel under the Wave Principle is valid only if it derives from a line touching the ending points of waves two and four of an impulse or the starting points of waves A and C in a zigzag. Regarding the difference between these two sets of description, Frost and Prechter expressed this opinion in Elliott Wave Principle:
Despite this compatibility, after years of working with the Wave Principle we find that applying classical technical analysis to stock market averages gives us the feeling that we are restricting ourselves to the use of stone tools in an age of modern technology.46
This difference leads to a question, namely, which analytical description is more accurate? Do triangles, wedges and channels occur in all kinds of places (per the chartists) or only specific ones (per the Wave Principle)? Either chartists’ patterns subsume some of the Wave Principle’s forms, and the Wave Principle is incorrect in its relative specificity, or the Wave Principle subsumes the chartists’ forms, and chartists are incorrect in their relative generality.
Three relevant observations tilt the balance decisively in favor of the Wave Principle’s descriptive primacy. First, the Wave Principle is a far more thorough description of market behavior than are chart patterns. Chart patterns describe a few forms, while the Wave Principle attempts to account for all market movement. Such a description is more likely to subsume chartists’ forms than vice versa. This fact leads to another question, which is whether the Wave Principle’s more encompassing description is valid. Perhaps, one might venture, chartists’ patterns are all that exist, and the Wave Principle’s greater scope is an invalid construct. A second observation answers this question to the extent possible. A study of 70 years of Elliotticians’ predictions47 supports the validity of the Wave Principle by showing that its practitioners have produced an exceptional level of predictive success. We are aware of no similar study relating to the success of chartists. Finally, Elliotticians provide evidence that the chartists’ less precise approach can lead to prediction errors that analysis under the Wave Principle would avoid, per the preceding discussion under “Trend Channel.” Therefore, until a better conclusion comes along, it appears that the best way to summarize the difference is to say that both R.N. Elliott and Edwards & Magee recognized real patterns, but Elliott was more meticulous in his observation of them and in his description of the contexts in which each pattern appears. Thus, the Wave Principle more properly subsumes chart patterns, not vice versa.
Chart Patterns Attending Special Plotting Methods
There are various rules for interpreting “point and figure” plots, an approach to charting that uses no time axis, and “candlestick” plots, which incorporate trading volume in each expression of a market’s daily price range. As plotting methods depart from those used to express only price in a temporal context, the task of relating purported patterns to the Wave Principle becomes more complex and perhaps inapplicable. Nevertheless, as for candlestick charting, Chapter 16 of Steve Nison’s Japanese Candlestick Charting Techniques (2001, Prentice Hall) discusses “Candlesticks with Elliott Wave,” and Chapter 11 of Stephen Bigalow’s Profitable Candlestick Trading (2002, Wiley) is titled, “Using Candlesticks to Improve Elliott Wave Analysis,” so apparently this method of charting is compatible with the Wave Principle. It is even possible, as one of these authors claims, that studying candlesticks could enhance our knowledge of the Wave Principle, as might empirics from any new perspective. The research underlying the Wave Principle is undoubtedly incomplete and may turn out to be only a small part of what remains to be discovered.
The Tautological Question
One might ask whether the Wave Principle is so encompassing that it subsumes every possible chart pattern, thus making the conclusion in this study a tautology, i.e., the Wave Principle subsumes all patterns because it isall patterns. Perhaps the best reply to this potential objection is the discussion in Elliott Wave Principle, under the heading “Erroneous Concepts and Patterns,” which shows why it is necessary to discard one of R. N. Elliott’s own claims to a pattern he called an “A-B base.” Frost and Prechter explain, “In fact it cannot exist,” because “such a pattern, if it existed, would have the effect of invalidating the Wave Principle.”48 In other words, the Wave Principle has a special integrity and is not an infinite catalog of forms. The authors further explain why Elliott’s description of a “half moon” is an epiphenomenon, like many chartists’ patterns, and why his observations regarding “irregular tops,” “irregular type 2 corrections” and “double retracements” are “erroneous concepts.” They conclude in their first chapter, “Under the Wave Principle, no other formations than those listed here will occur.”49
Numerous books assert that stock prices reveal or react to cycles of fixed periodicities. These ideas include fixed-time cycles, seasonal patterns, the “Decennial Pattern,” the presidential cycle, astro-economics and all other assertions that markets adhere to patterns based upon regular time periodicity. The Wave Principle does not (currently) recognize any cyclic patterns. Therefore, what appear to be cycles are either (1) epiphenomena of the Wave Principle, (2) the result of undiscovered forces within the Wave Principle or (3) the result of forces additional to the Wave Principle. No one has done the research to make this determination.50
As a result of this study, we may conclude as follows:
(1) The Wave Principle subsumes all valid tenets of Dow Theory.
(2) The Wave Principle subsumes all valid technical chart patterns.
(3) The only pattern approach to market analysis that the Wave Principle does not subsume (at least at the current time) is cyclic analysis.
Editor’s note: If any reader is aware of a valid visual pattern of financial price behavior that is not subsumed by the Wave Principle, please let me know.■
25 Edwards, Robert D., and John Magee. (1996, 5th ed.). Technical Analysis of Stock Trends. Springfield, MA: John Magee, p. 177.
26 Ibid., p.184.
27 Generally speaking, curved lines in the stock market are in the eye of the beholder. Straight lines appear naturally when delineating waves.
28 Frost and Prechter, p. 195.
29 Ibid., p. 80.
30 For example, see the gaps in the month of May in Figure 122 of Edwards and Magee, p. 193.
31 Edwards and Magee, p. 198.
32 Ibid., p. 202.
33 Frost and Prechter, p. 40.
34 Ibid., p. 73-74.
35 For example, see Edwards and Magee, Figure 133 on p. 208.
36 Frost and Prechter, pp. 71-73.
37 Ibid., pp. 31-36.
38 Elliott, Ralph Nelson. (1939). The Financial World Articles. Republished: (1980/1994). R.N. Elliott’s Masterworks—The Definitive Collection. Robert R. Prechter, Jr., Ed. Gainesville, GA: New Classics Library, p. 166.
39 See Edwards and Magee’s version in Figure 179 on p. 268.
40 Frost and Prechter, p. 31.
41 Investors Intelligence (New Rochelle, NY) offers several of George Lindsay’s essays.
42 Ritholtz, Barry L. (2003, October 24). “Three Peaks and a Domed House?” The Big Picture, http://bigpicture.typepad.com.
43 He means corrective form, not diagonal triangle.
44 Leib, Barclay T. (2004, January 14) “Three Peaks and a Domed House—Revisited,” Sand Spring Advisors, http://www.sandspring.com
45 One of these waves may itself be a triangle.
46 Frost and Prechter, p. 195.
47 Prechter, Jr., Robert R. (2004, December 10 and 2005, January 14). “A Track Record of WP Application to the Stock Market.” The Elliott Wave Theorist.
48 Frost and Prechter, p. 60 for all these quotes.
50 While open to competing theories, The Elliott Wave Theorist (July 16, 2004) offered this view: “Cycles are not waves; they are probably transient epiphenomena of the Wave Principle.” Prechter has also commented that the occasional appearance of cycles within the Elliott wave structure of the stock market may be analogous to the perfect ellipses and circles that sometimes appear in plots of fractals such as the Mandelbrot set.
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