Sep 21, 2005

As stock markets reach a peak, they start to lose momentum something that the residents of Texas and Louisiana wish Hurricane Rita would exhibit. What hurricanes often do instead is build momentum after they cross an island and then move back over water. Just as meteorologists can use instruments to measure the changing strength of an approaching hurricane, traders can use Elliott wave analysis to take the measure of waxing and waning markets. And one of the best uses for the Wave Principle is to identify when a bull market is topping. In this excerpt from Bob Prechter’s question-and-answer book, Prechter’s Perspective. he talks about bull markets of the past.

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Would you describe what it feels like when a bull market in stocks tops?

Bob Prechter: Unlike commodities, stocks don’t just blow off. If you throw a ball into the air, it has to slow down before it comes down. The market doesn’t exactly follow the laws of physics, but its action does seem to reflect this one. Even the 1929 high was accompanied by ‘top building,’ that is, a glaring divergence in the six-month percentage rate of change. In the stock market, the idea is a psychological feeling more than a true description of a stock market chart formation. The market slowed into the 2000 top, too. The advance/decline line topped in April 1998, and the corrections of 1997 and 1998 set up momentum divergences in the first quarter of 2000.

Does this slow topping process serve any function?

Bob Prechter: Many manias in history have outlasted the Cassandras and, in the process, have devastated the finances of the largest possible number of people. The crowd is buying fantasies. When fantasies get far out of line with reality, you’ve been presented with the opportunity to make money, whether it’s on the downside or the upside.

But a contrary stance can’t be rewarding unless one is following the Wave Principle?

Bob Prechter: Precisely. The problem is that contrarianism is only a one-way comment. The observation made by contrarians is that at the top of a market, there will be a substantially greater number of bulls than bears. This is a fact, but it doesn’t tell you how far the pendulum can swing in one or the other direction. That is why the Wave Principle is necessary. It provides a background for knowing when to go with a trend and when to go against it.

In real time, the Wave Principle can be complicated and dealing with corrections is particularly difficult. Why?

Bob Prechter: Five-stage movements (the prevailing trend as opposed to a correction) are generally uniform, with very few exceptions to the rule. When prices are moving with the trend, they are moving very freely, and you get the full five-wave structure. In that case, analysis is not that much harder than it sounds on paper. But when the short-term trend is fighting the intermediate-term trend, it is going against the tide. Corrective processes by their very nature are fighting the larger flow of price movement. When the market is fighting the flow, it can only go so far. It never develops the five waves. In more than 30 years of studying the market, I’ve never seen an exception.

Is this also why there are several different ways that corrections can unfold?

Bob Prechter: Corrections are the point at which the outflowing river meets the incoming tide. The jumble that results is far less uniform than the river’s flow or the tidal force. The analyst knows that moves against the larger trend never develop into a full five waves, but he or she does not know precisely which non-five-wave structure will develop out of this turmoil.

Is there a simple guideline that a novice can follow to help weather corrective Elliott wave patterns?

Bob Prechter: Sure. During these periods, in which Elliott wave analysis is the most difficult, do nothing. It is not necessary to forecast all the time unless you are in the business, like I am. So just wait for the pattern to clear and then take action.

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