Elliott Waves and the Juniors – A Book Review
November 12, 2007
Friends,
I have now finished reading through a book recommended by a friend. It’s called Elliott Wave Principle. This is very interesting stuff, indeed. Worthy of greater pursuit, in my judgement. As far as its utility for small cap stock charting, the jury’s still out for me. I have no doubt that it offers something of value for us, but at the same time requires much caution in its application. In a word, on a go forward basis, this is more craft than science. The greatest challenge, as I see it, is in knowing where to start counting your waves. If you’re off on the starting point, of course, you’ll necessarily be off in your conclusions. Moreover, even if you’re correct at the outset, the number of possible variations demands that you be constantly prepared to re-assess the pattern and count. In projecting form, I believe Elliott Waves can be quite useful. In projecting time and degree, their forecasting success faces much greater variability. It is this dispersion of possibilities that creates mayhem in projecting upward movement.
Frost and Prechter’s book points to one of the great challenges stemming from this variability. To illustrate, 5-part uptrend waves (3 up and 2 down) can be considered as a totality, enjoying a rise that we will index at 100 (regardless of its magnitude). Then they explain that if one were able to pick the tops of Waves 1 and 3 and the bottoms of Waves 2 and 4, buying and selling with perfection, one would hope to end up at the top of Wave 5 with a gain of 161.8 (not coincidentally, an extension of the Fibonacci ratio, 1.618). In other words, with perfect wave identification and prediction of turning points, and the liquidity to act on these predictions, we could hope for a bonus rise of some 62% over what the buy-and-hold method would yield. The key here, of course, is to be able to predict with perfection and to be able to act on these predictions. “If” really is the biggest word in our language. Happy to sit on my investments, rather than risk missing the volatile jump that may come while I sit on the sidelines. Of course, if one is capable of using idle funds profitably, this 62% potential bonus can rise measurably.
The utility of Elliott Waves (according to the authors) is greatest when applied to the general market, and secondarily to individual growth stocks… and then, only when the pattern is ‘unmistakeable’.
Now to the part of this which I find most interesting. Elliott Waves are an interpretive extension, using as the primary building block the Golden Ratio (originating in Euclidean days, around 300 BC). As a piece of trivia, Fibonacci was the one who introduced the Hindu-Arabic number system (0 through 9) to Europe at around 1200 A.D., replacing the more cumbersome Roman numerals (I, II, III, IV, etc).
As for the Fibonacci sequence, he articulated this progression (of a number equal to the sum of the previous two numbers) as the answer to a problem, as follows:
How many pairs of rabbits placed in an enclosed area can be produced in a single year from one pair of rabbits if each pair gives birth to a new pair each month starting with the second month?
The answer is expressed as the Fibonacci sequence – 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…
Where this starts to get particularly interesting is in the understanding that, after about eight of these numbers, a number divided by the next number in the sequence can be calculated constantly as equal to .618. Of equal interest, a number in the sequence is equal to the previous number times 1.618. For the mathematicians among you, this should immediately invoke Rod Sirling’s theme song from The Twilight Zone. Turn the volume on this theme up loudly with the understanding that the Fibonacci ratio is the basis for many relationships in nature. These include: the spiral formations of petals in a daisy, the arrangement of seeds on a sunflower, the shape of a sea horse’s tail, the ‘construction’ of a pine cone, a whirlpool, shells, a hurricane, and ocean waves.
This ratio is argued by some to be captured in the construction of the Great Pyramid of Gizeh, in Egypt, 5,000 years ago. Its significance was not missed on Bernoulli (co-founder of much of what we now call calculus), who had the Fibonacci spiral (also called the Golden Spiral) carved into his headstone. Sir Isaac Newton had it carved into the headboard of his bed. Leonardo da Vinci used Fibonacci in many of his paintings, believing it to provide the most pleasing look. The thinking of Elliott Wavers is that the power of this ratio extends to aggregated human behaviour, as reflected in the stock market. I do not dispute this application, nor do I proffer it as a robust, reliable tool for the progress of small cap stocks.
Here are a few of the relationships touching the Golden Ratio (1.618), as described by Frost and Prechter:
1 - .618 = .382 (pretty basic)
1.618 x .618 = 1 (hmmmm…)
2.618 x .382 = 1
2.618 x .618 = 1.618
.618 x .618 = .382 (I really like that one)
1.618 x 1.618 = 2.618 (bizarre)
1 + .618 = 1/.618 (my favourite)
I see great potential value in using Fibonacci as a calculating tool for price retracements into territory already travelled. This said, the variability in the calculation is compounded exponentially when applied to upward travel of price into previously uncharted territory. Suffice to say, I won’t be using Elliott Waves to project new highs in my investments anytime soon. At the say time, the discounting of Elliott Waves as a tool for small individual stocks should not bear a matching dismissal of the Fibonacci ratio. I find the Fibonacci relationships (on which Elliott Waves are piggybacked) to be remarkable, and worthy of staying in the corner of any inquisitive eye.
Understand me well not to be dumping on anyone’s work with Elliott Waves. Au contraire. I applaud efforts to constantly study and learn, advancing craft. More among us could do well to undertake to learn as much, rather than dismissing ideas out of hand, owing to our lack of related understanding. Stop learning and stop living, I say.
Cheers,
Kevin