In formulating market theories, economists often make assumptions, especially
when it comes to human psychology. In this regard, economic theorists typically
posit that self-seeking individuals behave "rationally". In other
words, in economics there is a general assumption people efficiently determine
and pursue their interests.
Probably the most widely recognized "market" studied by economists
is the stock market. Thus, one can get a feel for the accuracy of economic theory
by examining how well economists explain and predict the behavior of the stock
market. In this regard, one must delve into the world of the "Efficient
Market Hypothesis" (EMH)- the now dominant theory of stock market behavior
in economics and finance(l).
According to the EMH, stock investors think and behave rationally in seeking
to buy and sell equities. In a nutshell, this means that individual and institutional
investors will seek to buy shares of stocks at low prices and sell at higher
prices such that their net gain is maximized. In order to buy and sell successfully,
therefore, individuals and institutions must anticipate when the price of a
given stock or the price of stocks in general are near relative low points or
high points, respectively. To do this, investors pay attention to those factors
which influence the future earnings and potential growth of given companies
and throughout the economy. If there is reason to expect earnings will rise
or growth may increase, then the price of a given stock, or stocks in general,
should rise; an investor would want to buy. On the other hand, if there is reason
to anticipate a relative drop in earnings or decrease in growth, then stock
prices should fall and an investor will want to sell.
Realizing the important role of expectations in the investment decisions of
market participants, economists introduced a "rational expectations"
assumption in formulating the EMH of financial market behavior (2). According
to this assumption, in the aggregate investors form "rational expectations"
for the future performance of companies and the economy using all available,
relevant information in the context of the most effective models and theories.
Furthermore, investors reflect on past errors and adjust their information and
beliefs accordingly such that no systematic errors are committed.
According to the EMH, assuming financial markets efficiently discount investors'
rational expectations, stock prices will reflect an accurate assessment of intrinsic
value based upon available, relevant information; no "undervalued"
or "overvalued" assets exist. Consequently, only unexpected, new information
that changes the rational assessments of investors, such as a disappointment
in a company's earnings outlook or a surprise interest rate hike by the Federal
Reserve, will move market prices (a movement from a price "equilibrium")
. Thus, stock market prices are expected to follow a
"random walk" in which only unpredictable, random "shocks",
i.e., unexpected news, move prices up and down.
The key implication of the EMH is that it should be difficult, if not impossible,
to anticipate the future direction of a given stock's price or stock prices
in general. According to the weakest form of the Efficient Market Hypothesis,
stock prices fully reflect the information implied by all prior price movements.
Price movements, in effect, are totally independent of previous movements, implying
the absence of any price patterns with prophetic significance; investors should
be unable to profit from studying charts of past prices.
-Price Patterns in the stock Market-
Unfortunately, the EMH that dominates contemporary economic thought simply
does not hold-up in the face of empirical reality. Even its weakest version
is easily shown to be false. The reality is that stock prices, rather than following
a random walk, swing up and down in somewhat regular wave-like patterns. On
Wall street these swings are commonly referred to as "bull" and "bear"
markets, where a bull market involves rising equity prices and a bear market
entails falling prices. These patterns, in turn, are reflections of recurrent
swings in the mood of both investors and society in general which precipitate
the ups and downs in the economy known as "business cycles" (3).
One can get an idea of the cyclical nature of stock price movements by first
considering "Dow Theory". At the turn-of-the-century, Charles Dow
proposed that the there are three types of stock market movements: the major
trend, which can last over a year; a secondary or intermediate trend, which
can move against the primary trend for one or several months; and minor movements
that only last for hours or days. (4)
In association with Dow Theory, a sign that a turning point may be close-at-hand
in the trend of stock prices occurs when "divergences" develop between
the Dow Jones Industrial, Transportation and Utility averages. This happens,
for instance, when the Dow Jones Average of Industrial stocks reaches new highs
in the major trend while the Transports and/or Utilities fail to do so. For
instance, prior to the last major decline (i.e., more than 10 percent) in stock
prices in 1990, the Industrials average reached an all-time high of 3000 in
July of that year while the Transports and Utilities did not; the Transportation
index had peaked back in 1989 and the utilities topped in 1988.
According to Dow Theory, stock market "buy-" and "sell-signals"
occur when, usually following divergences, all the averages confirm a reversal
in stock prices by reaching new highs or lows in the given trend, respectively.
The value of this investment strategy is impressive and statistically significant.
Between 1897 and 1981, an investor who bought and sold stocks according to Dow
Theory buy and sell signals would have reaped a return more than nineteen times
that achieved from buying-and-holding (5).
One should note that the reason the Dow Jones Industrial, Transportation and
Utility Averages appear on top of each other in the Wall street Journal each
day is to reveal divergences and help investors determine Dow Theory buy and
sell signals. Thus, Dow Theory, which has accurately signalled most of the major
turning points in stock market history, uses information from historical price
charts to anticipate the future movement of stock prices; something the EMH
implies is not possible.
While Dow believed that there were three types of trends in stock market movements,
during the 1930's Ralph N. Elliott, an accountant who closely examined long-run
charts of stock prices, proposed that there is virtually unlimited bull and
bear trends of differing scale (6).
Specifically, he asserted that stock prices move in wave-like patterns that
abide by fractal geometry such that any given wave-structure is composed of
smaller wave-structures comparable to the whole. This is shown graphically below:
Thus, any given cycle involves an uptrend (bull market) which consists of five
waves, up-down-up-down-up, and a downtrend (bear market) consisting of three
waves, down-up-down, such that smaller cycles make up the cycle as a whole.
Likewise, each of the smaller cycles are comprised of still smaller wave patterns
and so on and so forth.
A distinctive tenet of Elliott's "Wave Principle" is that the wave-like
uptrends and downtrends in stock prices develop within the context of upper
and lower "channel lines" as displayed below:
Elliott's Wave Principle was popularized during the 1980's by Robert Prechter, a Yale graduate who majored in psychology. In a book he coauthored with a fellow stock market analyst in 1978 called "Elliott Wave Principle: Key To stock Market Profits" (6), Prechter anticipated the roaring bull market in stocks that started in the early-1980's. He then accurately timed most of the major twists and turns in the climbing stock market averages during the 1980's in an investment letter dubbed "The Elliott Wave Theorist" (7).
The reason Prechter achieved such success at calling the market is because a clear-cut, large-scale Elliott Wave uptrend pattern has developed over the last 60 years-or-so that is nearing or past completion:
The price pattern in U.S. stocks above, which developed in the wake of a 90 percent drop in stock prices associated with the Great Depression of the 1930's (a Supercycle bear market), is an example of a "Supercycle" Elliott Wave uptrend (bull market). As can be seen, since 1932 the DJIA has risen according to Elliott's five-wave uptrend pattern presented above. Furthermore, this pattern has developed inbetween upper and lower channel lines as the Wave Principle predicts. The upper channel line drawn through the major stock price peaks in 1937, 1962, 1987 and 1994 is almost exactly parallel the lower channel line drawn through the important lows reached in 1942, 1974 and 1982. Again, this pattern is inconsistent with the random walk stock prices are supposed to follow according to the Efficient Market Hypothesis.
A final example of how stock prices move in cycles that can be
predicted based solely upon historical chart patterns is the phenomenon of "psychological
barriers" in popular market averages. Major turning points in the wave-like
swings of stock prices often occur around round- number levels, like hundred
and thousand marks, in widely followed market averages like the DJIA. For instance,
between 1966 and 1982 the DJIA climbed to the "Magic 1000" barrier
on five separate occasions and then fell, on average, thirty percent over the
course of a year-and-a- half (see the graph above). In July of 1990, this phenomenon
repeated as the DJIA closed at an all-time high of 2999.75 two days in a row
and then sharply reversed course, falling some twenty percent by October of
that year. The last time a psychological barrier was reached in the DJIA was
January of 1994 when the stock market peaked at the 4000 mark. Stock prices
subsequently dropped almost ten percent into the spring and then struggled for
over a year below Dow 4000 (8).
-Business Cycles & The Kondratieff Wave-
The wave-like swings that affect stock prices reflect swings in the general
economy. In other words, cyclical movements in stock prices are associated with
business cycles.
In the same way there are different scale swings in stock prices as described
in Dow Theory and the Elliott Wave Principle, there are varying scale cycles
in economic activity. Economists have identified a 3- to 5-year Juglar cycle,
9- to 10-year Kitchen cycle, 16- to 22-year Kuznet cycle & 50- to 60-year
Kodratieff "long-wave" (each named after their respective discoverer).
Of these cycles, the Kondratieff Wave is of particular interest.
The Kondratieff Wave is a large-scale cycle in general prices that consists
of four major phases:
The first phase is a twenty to thirty year period of steadily climbing prices,
stable growth and rising productivity. It is capped by a spike in general prices.
The surge of inflation is eventually broken by the second phase of the Kondratieff
Wave: a sharp "primary recession". In the wake of the primary recession
prices stabilize and the economy enters a "speculative blow-off"-the
third phase of the Kondratieff Wave. The speculative blow-off last a decade-or-so
and involves price disinflation, general euphoria, heightened consumption and
investment activity, risky speculation, excessive debt accumulation and other
such financial excesses. The bubble eventually pops, however, and social mania
is broken, usually with a sharp panic. A dramatic breakdown in sentiment and
financial conditions hits society and a ten to twenty year period of general
malaise and economic stagnation takes hold that is known as the "secondary
depression". (12)
In American history, there have been three complete Kondratieff Waves and we
are currently in the midst of the fourth:
As seen above, the first wave started in 1789 and peaked in 1814 along with a price spike stemming from the War of 1812. Following a primary, post- war recession, an "Era of Good Feelings" took hold that was eventually broken by a secondary depression that lasted until 1843.
Following the low of 1843, the second long-wave began and brought prosperity
up until an inflationary spike in 1864 associated with the civil War. The price
spiral was broken by a primary recession, and a disinflationary boom got underway
in conjunction with the "Reconstruction" and "Railroad Prosperity"
following the civil War. In 1873, there was a severe financial panic and the
economy sunk into a lengthy secondary depression that lasted until 1896.
After 1896, the third major Kondratieff upswing got underway. It peaked in 1920
along with a sharp spike in prices following World War I. As interest rates
shot up to historic highs, a sharp primary recession hit between 1920 and 1921
and the spike in inflation was broken. Thus began the epic disinflationary boom
of the "Roaring Twenties". The pervasive euphoria, reckless speculation,
and careless overindebtedness of the 1920's ended rather abruptly in 1929 with
the Great Crash on Wall street and the beginning of the Great Depression.
After the long-wave bottomed in 1937, another Kondratieff wave upswing got underway.
Between the late 1930's and the 1970's there was a broad upswing in economic
activity and prices. This topped off with a severe inflationary spiral during
the late 1970's and early 1980's. Surging prices were halted by a severe primary
recession between 1981 and 1982 during which the discount rate peaked at an
historically extreme 14 percent and unemployment rose to its highest level since
the Great Depression. with the spiral of inflation broken, a disinflationary
'plateau' phase got underway along with a classic speculative blow-off which
continues to this day.
-The Coming Collapse-
An important implication of the wave patterns in stock prices and economic
activity overviewed above is that society is currently near a historic cyclical
turning point.
First off, a large-scale Elliott Wave uptrend in stock prices that started in
1932 appears to be near or possibly just past completion. This implies that
a bear market may be near at least as severe as what occurred after the 1929
stock market peak, i.e., one should expect an approaching drop in stock prices
of ninety percent or more.
That an important turning point in the stock market might be close-at-hand is
made more clear by Dow Theory and the psychological barrier phenomenon. At the
present time some divergences are visible between the various indexes which
suggest a major trend reversal is near. First off, while the Dow Jones Industrial
Average has been making all-time highs over the past several months, the utilities
average has not made an all-time high since October of 1993. Furthermore, while
the Transports comfirmed the recent highs in the DJIA last month, now the Transports
are making all-time highs while the Industrials are not. Thus, divergences between
the Industrial, Transportation and utility averages are currently taking place
that often forewarn of important stock market turning points.
Another warning sign that stock prices might be near a critical top is that
the New York stock Exchange Composite index and Nasdaq Composite of over-the-counter
stocks appear to be at psychological barriers.
First off, the NYSE has been flirting with the 300 mark over and over again since mid-July. While it has briefly gone above 300 a couple of times, the index keeps being pulling back below the mark. Likewise, the Nasdaq composite, which now receives probably as much attention as the DJIA since trading in OTC stocks is today *heavier* than trading on the New York stock Exchange, recently reached the 1000 mark. After the first day the Nasdaq Composite closed above the 1000 mark, there was a dramatic reversal and the index fell over five percent in less than two days. The stock market came back, however, and Nasdaq 1000 was penetrated again in late-July after which another sell-off occurred. In recent days the Nasdaq Composite has again climbed above the 1000 mark and, as of today, it reached 1030. Thus, another reversal back below the "magic 1000" barrier could be near-at-hand that might involve a major change in the trend of stock prices and investor expectations.
Clearly any reversal in stock prices here must be closely watched since it might involve a panic and signal the beginning of the Kondratieff Wave "secondary depression" which is now due. The excesses from the speculative blow-off that has been underway since the early- 1980's may soon be paid for in a painful way. A turning point in stock prices at this point could be as important as the top which was reached in early-September of 1929. As is mentioned above, following that peak the Great Crash occurred and the American economy collapsed into the worst depression in history. Wave patterns in prices strongly suggest such a breakdown in collective mood is near once again and, as is implied in Part III of this paper, we are now entering the season when such a downturn is most likely.