Elliot Waves and the Fibonacci Sequence By James A. Maccaro This article was published in slightly different form on Traders.com. It is copyrighted, 2006, by Technical Analysis, Inc., and is used with the permission of the original publisher. Ralph Nelson Elliot was born in 1871 in Marysville, Kansas, lived for much of his childhood in San Antonio, Texas, and became an accountant in the closing years of the 19th century. He worked for several Western railroads, as well as other businesses over the years, and eventually carved-out a successful career in Mexico and Central America, auditing railroads and other enterprises for their American investors. In the 1920’s, he returned to the United States and gained experience advising restaurant owners on business matters. He wrote a column on the subject for many years for a trade journal, Tea Room and Gift Shop magazine, and wrote Tea Room and Cafeteria Management, a well-respected manual published in 1926. In the late 1920’s, Elliot developed anemia, probably as a result of an infection sustained in Latin America. He was apparently bedridden for several years and during this period began his study of the stock market. Elliot subsequently declared that he had deduced “a law-abiding rhythmic pattern of waves,” which he explained in the late 1930’s in articles for Financial World (a leading stock market magazine of the time) and in a book published in 1938, entitled The Wave Principle. From 1938 to 1945, he wrote a newsletter issued on an irregular basis, which he initially called Educational Bulletins but latter entitled the Interpretive Letter. He died in 1948. In common with William Gann, a contemporary and the developer of “Gann angles” and other technical concepts, Elliot believed in spiritualism and mysticism and, as alluded to above, had roots in Texas. Both men developed trading methods that are complex and at-times difficult (if not impossible) to fully understand and they also both asserted that they uncovered broad philosophical insights into the meaning of life. However, while Elliot was successful in building a career as a market analyst late in his life, he did so to a much more limited extent than Gann, who was significantly more adept at self-promotion. Elliot believed that the stock market moves through a “Super Cycle” of from 15 to 20 years, which in turn moves within a “Grand Super Cycle” of at least 50 years, which moves within an even longer cycle of approximately 200 years. Each cycle contains smaller cycles, ending in the “sub- Minuette,” which lasts only a few hours. A cycle, according to Elliot, is formed by movements of stock prices that occur in patterns that he called waves, hence his approach is known today as Elliot Wave Theory (although the formal titled adopted by Elliot was the Wave Principle). Each cycle contains eight waves, declared Elliot, five of which are dominated by “impulse waves,” that is, waves that push prices up, and three of which are bearish, i.e., dominated by “corrective waves,” during which gains are lost to varying degrees. To anticipate waves, Elliot cited the Fibonacci sequence of numbers, which begins with “0” and “1,” followed by the sum of the two preceding numbers, i.e., 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 133, 233, 377, 610, 987, 1597... There are scattered references to this sequence in the literature of ancient India, but the concept was independently introduced to Western civilization in the early 13th century by an Italian mathematician, Leonardo Fibonacci, also known as Leonardo of Pisa. He put forth the concept to predict the growth of a hypothetical population of rabbits. Over the past century, Fibonacci’s discovery has found many uses in high- level mathematics and the sciences. Article Continues After Sponsor's Message Elliot wrote that stock prices follow the pattern set forth by the Fibonacci sequence, but his explanations of the process are contradictory in many details and do not strictly adhere to a Fibonacci analysis. Elliot, as noted above, asserted that a price cycle will have five waves that are primarily bullish (that is, dominated by “impulse” waves) and three waves that are bearish (that is, with “corrective” waves predominating). This does not mean that the first five waves will be uniformly upward and followed by three downward waves. Rather, the first waves will consist of a sequence of upward movements followed by relatively shallow pull-packs. The market will then peak, to be followed by a period of price declines with temporary bear rallies during which prices will regain some lost ground only to return to the downside. By writing in terms of waves within cycles, which in turn are in larger cycles, and by introducing Fibonacci numbers into the discussion, Elliot broke new ground. However, his general idea was not new. In fact, it is standard Dow Theory in that it reflects that a bull market will have a series of peaks that reach new highs, interspersed by declines that stay above previously lows, until such point that the bull market peaks. At this juncture, some of the gains of the bull market will be surrendered (there will be a correction) as prices decline but with the decline interrupted by a bear rally of limited duration (reaching a point below the previous high). While traditional technicians explain this phenomenon by speaking in terms of market psychology inducing changes in the supply and demand of stocks, Elliot cited “the laws of nature” as reflected by, among other factors, Fibonacci numbers. Wave theory was popularized among the general public in the early 1980’s by Robert Prechter, the author of an investment newsletter who made headlines when he correctly anticipated the start of the bull market in 1982. However, Prechter was blindsided by the market crash of October 1987 and further damaged his reputation when he subsequently became inordinately bearish, going so far as to predict that the Dow Jones indexes would bottom-out at levels not seen since the Truman Administration. Thereafter, Elliot’s renown has been essentially limited to committed technicians. Elliot took a very long-term view of cycles, which might be easy to dismiss; after all, 200 years seems to be beyond the concern of even the most steadfast of “buy and hold” investors. Nonetheless, Elliot must be given credit for introducing a broad historical approach to stock market analysis. An extensive literature now exists around the idea that price movements and other historical trends move in cycles of years, generations and even centuries. The leading proponent of this idea as it applies to economics was clearly Elliot’s contemporary, Nikolai D. Kondratieff, a brilliant Russian academic, but his research was hijacked and stunted by Soviet authorities. They used Kondratieff’s work to promote the idea that capitalism’s days were numbered and, to prevent any contradiction, silenced him in 1930 by imposing a prison sentence of eight years. Shortly after Kondratieff’s release from confinement in 1938, he was executed by firing squad at Stalin’s direct orders. A more recent proponent of very long-term cycles is the historian David Hackett Fischer. In a recent book, The Great Wave: Price Revolutions and the Rhythm of History, Professor Fischer reviewed the historical literature on the subject and argued that the rate of general inflation (and the health of an economy) can be predicted through a study of cycles dating back to the 14th century. Elliot's analysis is flawed in that it does not provide a clear roadmap as claimed (and I would argue that any such roadmap is an impossibility) and, moreover, his writings are nebulous, contradictory or non-objective on many points. Nonetheless, Elliot broadened the field of stock market analysis by introducing a very long-term historical viewpoint and he also deserves credit for introducing Fibonacci numbers, which subsequently developed into a fertile ground for investment research. |
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