Elliot Wave Theory and Robert Prechter’s theory of Socionomics: A Question of Causality
Robert Prechter, CEO of Elliot Wave International, a financial market forecasting firm, has devised a theory called “Socionomics”. One may hypothesize that markets and trends in society move in random patterns and are impossible to predict. More importantly, people say that news (i.e. failing banks, news of contracting economy) forms trends in the market. Robert Prechter would say otherwise. Instead, he believes that Social Mood governs trends in the stock market as well in as in society in general, but more on that later. The basis of this theory is, in my opinion, simply astonishing and more interesting than any theory I have ever come across. Let me start by explaining Elliot Wave Theory, a form of market technical analysis. Ralph Nelson Elliot in the 1930’s developed a theory that stock prices do not move in random movements but rather in defined patterns called Elliot Waves. These “Elliot waves” consist of 5 waves in one direction, called motive waves (i.e. up if the trend is up, down if the trend is down), which is then followed by a 3-wave corrective move in the opposite direction, called corrective waves. Fluctuations in the stock market can be labeled as either impulsive or corrective, with either a 1-2-3-4-5 labeling (motive changes in stock prices) or as an A-B-C move (corrective). Elliot Wave International utilizes Elliot Wave theory to forecast trends in the stock market. However, Robert Prechter developed a theory called Socionomics based on Elliot Wave theory. This theory mainly concerns causality of events in society, and presents ideas contrary to what many people believe. He himself has a contrarian view on things, and has been consistently accurate in his predictions; most notably in the stock market (he called the bull market beginning in 1982 and ending in 2000, as well as the 1987 crash just 2 weeks prior). How? His contrarian view on things allows him to identify changes in trends in social mood and in quantifiable terms the stock market. For example, the Daily Sentiment Index (DSI) a technical indicator, indicates the percentage of traders that believe the stock market is headed higher. In March 2009, when the stock market put in an intermediate term bottom, only 2% of traders thought the market was headed higher. One of those people was Robert Prechter. When the majority of people believe something is going to happen, it usually doesn’t. Almost nobody was buying stocks in March 2009, except with the exception of Prechter. Similarly, almost nobody was selling stocks in October of 2007, when the market was making new nominal highs, as well as peaking, except Robert Prechter and his clients. The tendency of people to want to buy stocks as price increases can be modeled by the supply and demand curves. For normal goods and services, the lower the price, the more likely one is to buy a product (the more demand there is). However, with stock prices, generally the opposite is true on a long term basis: the lower the price, the less people want to buy stocks and the higher the price, the more people want to buy stocks. At market peaks everybody is eager to buy stocks, taking out home equity loans on their house, thinking the value of their houses will go up indefinitely, not thinking of the fact that a trend reversal could be imminent. Similarly, at market bottoms, after the market has fallen tremendously, everybody is afraid to buy stocks, and sell the stocks they do own, in fear they will lose money, however it is precisely at this time that people should be looking for bargains in all asset prices, not just stocks. This “norm” is what causes people to lose money investing. So, along with what Prechter calls “herding” (doing what everybody else is doing) most people would say that an event occurs, and people react to those events and their mood changes accordingly. Socionomics claims something completely different. According to the theory, changes in social mood move in patterns, similar to the stock market. These changes in social mood precede events in society, not the other way around. There is ample evidence, in my opinion, to suggest that this is true. In a presentation to the London School of Economics, Prechter showed a series of charts pertaining to his theory. One of the charts was of the Dow Jones Industrial Average since the 1930’s. During the Great Depression, the chart shows, as the stock market was trending down, people were not playing rock music, but depressing music instead. Women were wearing long black dresses as opposed to short skirts. Conversely, the chart shows that during the 1950’s, a time of economic prosperity, when the stock market was trending up, much more upbeat music found its way into society, women were wearing short skirts and other “hip” clothing, and social mood in general was much more upbeat. It is precisely that, social mood, which the theory of Socionomics maintains determines trends in society. As for current social trends, we are, and have been, in a bear market since 2000. Another common belief is that the stock market made new highs in 2007. This is true, in nominal terms (the Dow priced in dollars). However priced in terms of real money (gold) the stock market has been in a consistent downtrend since 1999, even before the cyclical (as well as secular(long term)) bear market was to ensue in nominal terms starting in 2000 and ending in 2003 following the bursting of the tech bubble. The following link is to a chart showing the Dow priced in terms of gold: http://static.seekingalpha
What does all this suggest about future trends? Nobody can say for sure. However, Elliot wave theory suggests society is going into a long term correction, in which a secular bear market in stocks should ensue (really just one large corrective A-B-C pattern, except on a larger scale than intraday). Elliot wave cites an article as evidence social mood is changing: http://www.elliottwave.com
Another piece that I find quite interesting is this YouTube video, including an interview with Prechter, that suggests elements in nature, not just the stock market, move in fractals, or in other words Elliot Waves.
If you want to hear more of what Robert Prechter has to say, go to www.elliottwave.com. there are also many interviews of Prechter on youtube.