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Prechter on The Wave Principle: Part 2

(This is part 2 of a three-part explanation of the Wave Principle by Robert Prechter. This text is excerpted from one of EWI’s most popular titles, Prechter’s Perspective.)

Most people are more interested in how the Wave Principle works than why it works. Is there any one thing people need to remember to make it work for them?

The key to Elliott Wave patterns is that the market goes three steps forward for every two steps back. If you do not get scared by the two steps back, and if you are not euphorically confident after the third step forward, you’re light-years ahead of the pack. Even then, I would add that it is one easy thing to recognize that the Wave Principle governs stock prices, while it is quite another to predict the next wave, and still another to profit from the exercise. There is no substitute for experience, so that you can learn what you feel and when you feel it, with respect to market behavior.

Jack Frost has described the Wave Principle as something that has to be seen to be believed. What does he mean by that?

The principle is complicated to express in words. With the Wave Principle, you are dealing with a phenomenon that reveals itself visually. Try describing the concept and variations of “tree” in detail to someone who’s never seen one and you’ll see that it can be a complex task. Saying, “Look! There’s one,” is a lot easier. The human brain is very good at recognizing a pattern visually. If a computer must be programmed to recognize shapes in the sky, it would be difficult to teach it the difference between a cloud and bird and an airplane. Once you have that programmed, of course, a blimp floats by and the computer is in trouble. The human brain works differently, however, and is extremely efficient at pattern recognition. If you draw out the Principle, it is much more quickly grasped. Then when you compare actual market pictures with the model, you can accept the truth more readily. It is at the perceptual level that it is best presented, then, not the conceptual.

Can you really teach it?

Sure. Video is an excellent approach, for instance. A lot of people have learned how to apply it that way. Some have trouble at first, but then say “Once I saw your video tape, I understood it all.”

What are the Wave Principle’s key strengths?

Frost liked to say, “Its most striking characteristics are its generality and its accuracy.” Its generality gives market perspective most of the time, and its accuracy in pointing out changes in direction is almost unbelievable at times.

Why does the Wave Principle work so well?

Because it is 100% technical. No armchair theorizing from economics and politics is required.

What are its biggest shortcomings?

There is one main weakness, and this accounts for just about all the problems. There are eleven different patterns for corrections. When a correction starts, it is impossible to tell in advance which pattern has begun, so you do not know how it is going to unfold. Therefore, the best that you can do is apply some of Elliott’s observations as guidelines in making an intelligent guess as to what it is.

Another problem is that corrections can do what Elliott called “double” or “triple” — that is, repeat several times. Triple corrections are the largest formations possible, so at least there is a limit. These repetitions can be frustrating because they can last decades. For example, we had a 16-year sideways correction in the Dow Jones Industrial Average from 1966 to 1982. A.J. Frost and I thought it was over in 1974, and the market was ready for another bull wave. To be sure, most stocks rose from that point forward, but the Dow went sideways for another eight years in a doubling of the time element, which caused some frustrations before the next bull wave finally began on August 12, 1982.

It sounds like a chess game. The number of possibilities, and therefore the probabilities of success, vary at certain junctures.

Chess provides an excellent analogy. The market can do whatever it wants, except that it will always do it in an Elliott Wave structure. Similarly, your opponent can move chess pieces wherever he wants, except that he must follow basic rules. On the other side of the board, you still have a lot of hard thinking to do despite your absolute knowledge that pieces must move according to those rules.

Are there situations where the Wave Principle does not hold true?

No, it always holds true. But of course, it is one thing to say the markets will follow the Wave Principle and another thing entirely to forecast the future based on that knowledge. It is always a question of probabilities. Once you have hands-on experience with it, once you understand all the rules and guidelines, it is a lot like becoming Sherlock Holmes. There are many possible outcomes, but guidelines force you along certain paths of thinking. You finally reach a point where the evidence becomes overwhelming for a certain conclusion.

Have you ever had a case where you thought the probability of a certain outcome was high, say 90%, but the market went otherwise from your expectation? What did you do then?

Of course it happens. But you should never be wrong for long relative to the degree that you are trying to assess. One of the terrific things about the approach is that it’s price that tips you off. With other approaches, price can go a long way before the reason behind your opinion changes, if it ever does. No matter how difficult the pattern is to read sometimes, it always resolves satisfactorily into a classic pattern.

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