Riding the Waves of Irrational Behavior


Riding the Waves of Irrational Behavior

When times are good in financial markets, we’re willing to convince ourselves that they’re good for a reason. The fundamentals are great, the experts tell us. Innovation is creating new opportunities and new wealth. We’ve gotten better at managing risk. After a few years of market trouble, though, the tone changes. “When the trend is sideways to down, they think the machine is broken,” says Robert Prechter. “Jeez, it can’t be us.”

Wanna bet Prechter does. He has made a career out of his belief that financial markets are ruled not by fundamentals but by waves of irrational behavior. Lately, after a long run of relative obscurity, he’s been getting lots of attention. So have other believers in cycles and waves: the New Yorker recently expended 10 pages on Martin Armstrong, a self-taught forecaster who made several eerily on-the-mark calls using a formula based on the mathematical constant pi. Prechter appeared in that piece too, but only briefly. He comes across as too reasonable to play a starring role in such a contorted tale. Prechter, a soft-spoken, thoughtful, engaging 60-year-old, believes that the bull market of the past eight months that pushed the Dow past 10,000 will inevitably give way to a crash that will drag prices well below the level of early March. He believes this because theories of market behavior put to paper by a guy who died in 1948 tell him so. Yet he makes it all sound perfectly plausible. After studying psychology at Yale and then playing drums in a pop-music group that never hit it big, Prechter joined Merrill Lynch in 1975 to do technical analysis, also known as chart-reading — the search for patterns in the movements of securities. The most famous of technical approaches is Dow theory, a rough model of market waves originally described by Wall Street Journal co-founder Charles Dow at the turn of the 20th century and refined and popularized in the subsequent decades by Journal editor William Peter Hamilton. Prechter studied Dow theory but soon moved on to the mostly forgotten work of Ralph Nelson Elliott, an accountant who, while bedridden in the 1930s, charted stock-price movements and found intricate patterns based on the Fibonacci number sequence . The Fibonacci series, like pi, appears frequently in nature. Prechter republished Elliott’s books and in 1979 went into the forecasting business for himself at what he dubbed the Elliott Wave Institute. In 1981 he moved his operation to Gainesville, Ga., an hour north of Atlanta, and he’s been there ever since. His accurate forecasts of a stock-market boom in the 1980s and a crash in the autumn of 1987 made him, for a time, one of the most influential Wall Street gurus. After the market started its 1990s bull run, though, Prechter seemed to lose his touch. In 1995 his book At the Crest of the Tidal Wave predicted the onset of a “great bear market.” The bear arrived, but not for five years. In 2002’s Conquer the Crash he predicted the onset of a “deflationary depression.” Again, he was years early. Prechter readily admits that he’s far from infallible. The standard he says he wants to be held to is similar to that of a hitter in baseball, in which batting .300 makes one a star and .400 an immortal. He has concluded that time is a “quite elastic” variable when it comes to Elliott’s waves. In other words, he’s wrong a lot. But so are conventional economic forecasters, especially at the market turning points that can have the biggest impact on investors’ portfolios. This is because, Prechter argues, standard economic models of financial markets depict prices as reflections — imperfect, perhaps, but still reflections — of true value. He believes instead that “waves of social mood are the driving factor” of both market moves and, to a certain extent, economic reality. He calls this approach socionomics, and he’s doing what he can — his Georgia operation now includes a socionomics institute — to push it onto academic curriculums. So far that’s happened only at a few off-the-beaten-track colleges. But mainstream economists, who had long dismissed market cycles as nonsense, have begun to come around at least a little. Yale’s Robert Shiller describes market booms and busts as the product of fashion and animal spirits. A trio of academics revisited a famous 1934 paper that debunked the predictions of Dow theorist Hamilton and found that, adjusted for risk, Hamilton’s predictions beat the market. MIT’s Andrew Lo, a top finance scholar, has made technical analysis one of his main research topics. So maybe there is something to it. Or maybe this is just evidence of a social wave in action. See how Americans are spending now.

See pictures of retailers which have gone out of business.

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