Robert Prechter authored the “industry standard” literature on Elliott wave theory back in 1978 and subsequently founded Elliott Wave International, which today employs 80 people in Gainesville, Georgia, providing research around the clock to subscribers throughout the world. Mr. Prechter has updated Elliott Wave Principle (1978/2005) to include new guidelines for each wave formation; he has also published The Wave Principle of Human Social Behavior (1999) and Conquer the Crash (2002). Currently, Mr. Prechter is furthering his research on his theory of socionomics. He recently co-authored a paper with psychologist Wayne Parker for The Journal of Behavioral Finance (2007, Vol. 8, No. 2, 84-108) to illustrate the conceptual framework for examination by scholars and academics. The paper points out that traditional economic theory does not account for financial markets’ price action – which can more reliably be attributed to the new paradigm of socionomics. He has long held that events do not influence social mood, but rather social mood, which is endogenously regulated, motivates social action. The hypothesis is that humans’ unconscious impulses to herd lead to the emergence of social mood trends, which in turn shape the tone and character of social action. This perspective applies across all realms of social activity related to decision-making under uncertainty, including economic, financial, political and cultural.
NOTE: This interview is taking place as an online email exchange conducted over several days in early October 2007. Bob Prechter is in his office in Gainesville Georgia, and I’m in my office in Westport, Connecticut. This is a high-tech-world collaboration….
MS: Bob, thanks for doing this interview today. First, because this is an audience of technicians, and because you are famous for your Elliott wave work, how do you feel about the market in general right now – where do you see it in “Elliott wave” terms?
RP: It’s still in a bear market.
MS: What do you mean? The Dow is at all-time highs.
RP: In dollar terms it is, but in terms of real money and its ability to buy gold, oil and other things it’s been crashing.
MS: As a result of inflation?
RP: No, as a result of a change in psychology. Inflation has been progressing consistently since 1933, but the market still rises and falls relative to real money, by which I mean gold. The Dow and S&P rose persistently in value relative to gold from 1980 to 1999. That was the real bull market, the biggest in history over just a two-decade period (Figure 1). Since then, investors have switched to preferring real money. These averages have lost 65 percent of their value in gold terms, and the NASDAQ even more. No one notices because optimism has yet to yield.
MS: So how does this relate to Elliott waves?
RP: The Wave Principle explains why the latest new high is not part of the old bull market but is in fact a bear market rally. In January 2000, the Dow completed five waves up from 1932, thereby registering its “orthodox top,” the true end of the great bull market. The decline into 2002 was wave A of a bear market, and this rally is wave B. Wave C down is coming.
MS: Has this happened before?
RP: Yes, a smaller version happened from the 1970 low to the 1973 high. In 1973, the Dow and S&P made new all-time highs in nominal terms but were below their 1966 highs in terms of real money. The aftermath was a 45 percent drop in nominal terms. We face the same juncture today but on a much larger scale.
MS: That sounds bearish.
RP: You don’t know the half of it. Sustained optimism has created the greatest credit bubble in history. Credit and leverage have financed the bull market. But leverage works both ways. When the trend changes toward pessimism, the result will be something to see.
MS: When will wave C begin?
RP: The “when” of the collapse in dollar terms has eluded me. As a student of history, I have relied upon past extremes in trend, sentiment and valuation as a guide to indicating a major top. To give you some perspective, stocks rose by six times in the Roaring ’Twenties and ten times from 1942 to 1966, in terms of both dollars and gold. Those were big moves. But from 1980 to 1999, the Dow rose an amazing 32 times in terms of gold, and as of today it’s up 24 times in dollar terms since 1974. In 1929, the dividend yield for the Dow fell below 3 percent for a couple of months, and the market crashed. In 1992, the dividend yield fell below 3 percent and has stayed there ever since, for 15 years. In 2000 it was as low as 1.5 percent, half the level of 1929. And there have been more bulls than bears among advisors in 457 out of the past 466 weeks—a nine-year stretch. The percentage of bearish weeks over this period is below the average by a factor of ten, producing the most lopsided ratio ever. So this period of optimism and overvaluation has dwarfed all others in extent and duration, by many multiples.
MS: I can see where that might throw you off.
RP: At least my short term skills have been intact lately. Each time the market made an intermediate peak in the past three years, I saw the signs and said so. But these historic extremes in valuation and optimism convinced me that each peak was the last, and the market has continually recovered. Yet the piper always gets paid, and when payment is delayed he generally charges you more. So I expect a long, deep price collapse, and the longer it takes to arrive the worse it will be.
MS: How does socionomics fit into this?
RP: Among many other things, socionomics explains why the market reaches valuations that later generations describe as absurdly low or absurdly high, like today.
MS: But that’s not so unusual.
RP: That’s exactly the point. It’s normal for financial markets to careen wildly from overvaluation to undervaluation. But can you recall this kind of thing happening in markets for sandwiches or lawnmowers?
MS: Well, Starbucks is expensive.
RP: So is everything else, thanks to inflation. But the price of a cup of coffee is not volatile, either over time or relative to other things, such as fried eggs and toast. Investment prices leap and fall continually, over time and relative to each other. But in the market for goods and services, prices are relatively stable. You don’t see the price of pistachio at the Westport ice cream shop soaring and crashing every few days or months. You pretty much know what the price of a scoop will be before you walk in.
MS: I wouldn’t buy pistachio if it were twenty dollars a scoop. I’d buy something else. But if it were a nickel, I’d stock the freezer.
RP: Precisely. In the marketplace for goods and services you use your reasoning power to decide whether a purchase is a good use of your money. This is called “maximizing the utility of your resources.” When steak gets too pricey, you buy chicken, and vice versa. When there’s a sale on, you rush out to buy more. But—and this is crucial—when prices go down in the stock market—in other words, when there’s a sale— almost everyone wants to own fewer shares. And when prices go up, investors buy more. See the difference? Theoreticians either ignore this fact or call buying high and selling low a “temporary anomaly,” but it is the rule in financial markets. And it’s the opposite of the rule that holds in economic markets. This is a fundamental difference between the two.
MS: O.K., so that’s why your paper is titled “The Financial/Economic Dichotomy.”
RP: Right. And in the world of financial theory, this is a radical idea. For half a century the reigning model, called the Efficient Market Hypothesis, has said that financial markets are just like economic markets: People take all information into account and buy or sell according to what’s reasonable. But if they did that, they would buy more when prices were low and less when prices were high, wouldn’t they? But they don’t.
MS: Is that the only thing wrong with the old theory?
RP: Oh, no. It’s full of errors.
MS: Like what?
RP: Economic theory says that prices seek equilibrium. It says they are random. It says they are objectively determined. It says they are completely unpredictable. None of this is true. So the old theory is broken. We need a new theory.
MS: Which is…?
RP: My colleague Wayne Parker and I call it the socionomic theory of finance, or STF. Under our model, prices are dynamic, not stable; they are subjectively, not objectively, determined; they are not random but patterned; they do not seek equilibrium but instead conform to the Wave Principle; and they are probabilistically predictable because herding is patterned. We have a table (Table 1) expressing ten stark theoretical differences between STF and traditional theory.
Table 1. Contrasting Models of Finance
MS: That’s a lot of differences. And what’s this about the law of supply and demand not pertaining? That sounds really radical.
RP: No kidding. But the law of supply and demand is irrelevant to financial markets. There are no producers and consumers in financial markets, just investors. So there are no balancing forces on price. The law of supply and demand reigns at the shopping mall because consumers are pretty certain of their needs and resources, so they can reason their way through the decision process. But investors are uncertain because they have no basis to decide a fair price. In the financial context, knowing what you think is not enough; you have to try to guess what everyone else will think. It’s not easy to use reason to figure that out. When everyone faces this dilemma, the result is herding. Herding is an unconscious impulsion, not a reasoned response to prices and values. So financial markets follow a different law. We say that economic prices conform to the law of supply and demand but financial prices conform to a law of patterned herding.
MS: Then what makes prices fluctuate?
RP: The herd has little basis to judge what others will think about values in the future, so the main determinant of aggregate prices is the mood of the crowd, the social mood, whether it is optimistic or pessimistic, hopeful or fearful. Social mood as a fractal structure, little waves inside bigger waves, which accounts for the fluctuations in the market of all different sizes.
MS: What do you mean when you say that social mood is “endogenously regulated”?
RP: Social mood does not react to current events, as most people think. Its fluctuations result from the internal mental processes of members of the herd.
MS: I thought events like wars and scandals affected social mood.
RP: Everyone thinks that. When the Enron scandal hit, the media all said it was affecting investors’ mood negatively. But I did a study showing beyond question that the Enron scandal did not have a negative effect on investors’ mood, which in fact got more positive throughout the whole episode. There is no correlation between wars and the direction of social mood as recorded by stock prices, either. Sometimes it’s up, sometimes down and sometimes net sideways. But there is a great correlation in the other direction. When the social mood gets more negative, it triggers scandals and wars.
MS: Does research back this up?
RP: In our paper we cite research showing that humans herd, that they are under the influence of powerful unconscious motivations, and that outside events have at most transient effects on stock prices. I’ve done a lot of correlation studies, but as yet they are not peer-reviewed.
MS: Are you saying that news doesn’t matter to stock prices at all?
RP: We have to be careful to distinguish between social mood, which is endogenously regulated, and emotions, which are transient, usually conscious, reactions to outside stimuli. Dramatic news can affect market prices for a few minutes or a day because they temporarily trigger emotional reactions. But news—no matter how dramatic—doesn’t change social mood. People have said, “Come on, Bob, what if a nuclear war broke out?” But the answer is the same. People never seem to ask where the war would come from in the first place. War doesn’t happen by chance but as a result of a trend toward negative social mood. So you can use social mood to predict social events but not the other way around. Even if you knew every news event in advance, you couldn’t predict the stock market. This is a counter-intuitive claim, because we hear about supposed news causality all day long on financial TV and in newspapers.
MS: It seems a lot of thought goes into all those explanations.
RP: Which brings up another aspect of STF. We argue that most of the talk about where stock prices are going is rationalization. People have no idea where prices are going, so to satisfy the reasoning portions of their brains, they make up reasons to justify their buying and selling actions, which are in fact motivated unconsciously by social-mood herding.
MS: Are you saying all that talk is just air? So much of it seems to be high-level reasoning.
RP: The lack of proper reasoning is palpable. When markets are hot, commentators can talk all day long about reasons to own investments. But when stocks are cheap, almost no one talks about the stock market; they talk about something else. Is that high-level reasoning? But it’s more serious than that. We have graphed the market relative to all kinds of causal claims, such as that stocks respond to economic figures, political trends, peace and war, trade deficits, federal spending, scandals, demographics, you name it, and there is no consistent causal relationship between any of these outside factors and the future course of stock prices. None of it affects how investors really behave.
MS: So there is no correlation at all?
RP: On the contrary, there is an excellent correlation! But it is in the opposite direction of what everyone thinks. Stock price changes precede changes in economic production, election results and peace and war. They also coincide with changes in fads and fashions. All of these correlations show that social mood, which propels stock prices, is also manifest in many other areas of human expression. Economic and political trends lag the stock market because it takes time for people’s decisions to affect those areas. So again, social mood is primary; it determines social actions.
MS: What does all of this mean for technicians?
RP: It’s the basis for the whole profession.
MS: What do you mean?
RP: Economists have long judged technicians as delusional. And if economic theory pertained to finance, they would be! Think of it this way: Wouldn’t it be crazy to study past prices of shoes as if they meant anything about the future prices of shoes? That’s how economists view technicians studying patterns of prices and other investor behavior. And their view logically follows for economists, because their premise is that stock prices are no different from shoe prices: economics and finance are the same. But the socionomic theory of finance erases such objections and justifies technicians’ pursuits. Investors are not reasoning but unconsciously herding, and unconscious processes aren’t random; they proceed according to mental constructs. That’s why financial markets display patterns such as persistent trends, head and shoulders formations, trend channels, Elliott waves, and so on. Of course, it is also possible to perceive patterns that don’t exist, but economists are hardly immune from that problem.
MS: So it’s really economists trying to explain stock price movements in terms of outside causes who are delusional?
RP: Well, I would say they are laboring under a misconception. Let’s look at some examples, and you can decide. Economists have repeatedly stated that expanding trade deficits are bearish. But a graph of the U.S. trade deficit shows that for 30 years a widening trade deficit has coincided with a stock market boom and an expanding economy. Still, economists keep making statements contrary to the evidence. Why? Because their argument seems logical — to hell with the data. The same thing is going on right now with respect to the Fed’s latest discount-rate cut. Economists quoted in the news say that such a cut is a stimulus and is therefore bullish. But falling interest rates throughout the early 1990s didn’t stop the Japanese stock market from having its biggest decline ever, did it? Interest rates fell throughout the bear market of 2000-2002, but that didn’t stop the S&P from sliding 50 percent, in nominal terms, mind you, despite continuing inflation. And rising rates have accompanied the stock market recovery since 2003. If you were to look at only these data, and if you had no idea what they represented and had no prejudicial beliefs about causality, you would conclude that stocks tend to fall as long as the interest-rate line falls, and stocks tend to go up as long as the interest-rate line rises. The last time the Fed surprised the market with an interest-rate cut was January 2001. The S&P had one of its biggest one-day rallies ever. Then it immediately turned down and fell in the biggest decline in over 60 years as rates fell all the while. None of this fits the “stimulus” theory of falling rates. Chartists tend to be empiricists. They look at data, which puts them way ahead of the game. Traditional economic theorists ignore a lot of data. They have to in order to keep believing in their model of outside causality. So who are more useful, economists who devise theories of external causality or the chartists who study history?
MS: But economists know a lot about their subject.
RP: Yes, they do. But again, that’s the point of our paper: Economics and finance are completely different fields. Economists are highly useful in their own field, where the law of supply and demand rules. But in the field of finance, where the law of patterned herding rules, they are lost.
MS: But technicians are often lost, too.
RP: Sure they are! I’ve proved that one myself. But socionomic theory properly elucidates the problems we face as analysts and investors. Herding is non-rational, which means it has its own curious illogic. Our minds are well suited to work out logical problems, but it is poorly trained in guessing the future course of crowds. Our brains are designed to participate in crowds, not analyze them. And the herding impulse is also immensely powerful. So it’s nearly impossible for an analyst of any type—economic, fundamental or technical—to overcome his own impulses to herd and just perform cold, impassionate analysis. The socionomic theory of finance explains why most investors lose money over the long run: They are herding, so they buy high and sell low along with the crowd.
MS: But doesn’t traditional theory account for this by saying no one can beat the market?
RP: Yes, the random walk and unpatterned multifractal models also account for the failure of most investors to succeed, but they do not explain why a tiny handful of investors gets super-rich. Our theory allows for the success of a few investors, namely, those who learn a lot about market behavior and who can also overcome their own herding impulses to some degree. It’s a rare combination, but it exists.
MS: Technicians, and even the Grahamand-Dodd fundamentalists, have always operated under the belief that random walk is wrong. They both believe that the market provides buying and selling opportunities.
RP: Yes, and now they have a theory of market behavior to back them up.
MS: Do you think more universities will teach technical analysis?
RP: Academics and practitioners seem to be coming closer together, and the field of socionomics provides a new basis for understanding finance and therefore a scholarly basis for teaching technical analysis.
MS: Maybe someday the herd will get it.
RP: The herd never gets it, but a thoughtful individual can always learn something new.
MS: Where can readers get a copy of “The Financial/Economic Dichotomy”?
RP: The Journal of Behavioral Finance wants a few bucks for it, but the price is reasonable; after all, it’s an economic market! To order it, just go to http://www.leaonline.com/toc/jpfm/8/2.