(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. See below to find out how to get a copy of the 270-page classic at a special cost. You can see the previous article in this series here.)

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.

Can you illustrate how knowledge of “wave structure” comes into play when trading?

For instance, the bottom of the fourth wave, which is a pullback, cannot overlap the peak of the first rally. If it does, then it’s not a fourth wave. The fourth wave is still ahead of you, and the third wave is subdividing. Knowing this tenet can keep you out of a lot of trouble that an armchair wave counter would encounter. Another very basic tenet is that wave three is never the shortest. It is usually the longest. Wave three is the recognition stage when most people get aboard.

But if there is always a correct pattern, and it is only a matter of seeing it, why aren’t accuracy levels higher than the 40%, 50%, 60% or even the 80% ratios of hits to misses?

First, just because R.N. Elliott discerned that the market follows rules as in a chess game doesn’t mean you can predict the market’s next move. All you can give are probabilities. But the psychological difficulties are at least an equal impediment. Hamilton Bolton once said that the hardest thing he had to learn when using Elliott was to believe what he saw. Despite all I know, I have fallen prey to that problem more than once. The fact that even perfect analysis only results in the best probability provides the uncertainty that feeds the psychological unease. As Frost is fond of saying, “The market always leaves its options open.” So when you combine human weakness with a game of probability, the result is many errors in judgment. Nevertheless, I must stress that the ratio of success with Elliott is better than that with other approaches, and that is the only rational basis for judging its value. Besides, the inestimable value of the Wave Principle is not so much that it provides a high percentage of correct “calls” on the market, but that it always gives the investor a sense of perspective.

Is it possible that the system merely takes into account every possible pattern and thus allows the practitioner to force things into a satisfactory wave count retrospectively — but not prospectively?

No, for two reasons. First, if that were true, then there would be no record of success such as the Wave Principle has over the decades. There are numerological approaches to the market, ones based on fantasy that may as well be dealing with a random walk, and they produce worthless results, as they should. As Paul Montgomery likes to say, a good test of a theory is whether it can predict. Second, there are many non-Elliott patterns that the market could trace out if it were a random walk; but it has never done it. I have never seen a market unfold in other than an Elliott Wave pattern.  

Continue to Part III