The Hindu Business Line : Deconstructing the market, One wave at a time

Shanky and Harry were lying on the beach under sun-umbrellas. The salty tang of the sea breeze was most refreshing after the smoke and dust of the city that they had left behind for the weekend. Harry was absorbed in a book while Shanky lazily watched the wave breaking on the seashore. He turned to his friend, "You know what these waves bring to my mind, the stock markets."

Harry looked up from his book, "That reminds me, how is your study of technical analysis coming along."

"Not bad. I have just started to read about the stock market theories. The first one in my book is the Dow theory."

"Oh yes! The `grand-daddy' of technical analysis. Charles Dow was a brilliant man. He was one of the founders of the Wall Street Journal and also its first editor. He wrote a series of editorials on stock market behaviour in it between 1851 and 1902. This work was reprinted after his death in 1902 as the Dow theory. He was also the creator of the Dow Jones index."

"But I have read that the Dow theory has scant value in the present times."

Harry closed the book he was reading, "Every field of thought has its supporters and detractors. The Dow theory was among the first to identify that the market moves in trends. He identified two types of trends, the primary and the secondary movement. The first defines the bull or the bear market and lasts from a few months to many years. Moves in the direction opposite the primary movement are called the secondary movement.

The three phases

"He further divided the primary moves in to three phases. In a bull phase, the first one is that of accumulation. In this phase, the speculative froth is entirely out of the market. Investors are dejected after having sold their holdings at a big loss. The larger players start accumulating stocks at this juncture. There is no perceptible price movement though things start stabilising.

"The second phase is the big move in which prices start zooming upwards and there is a rush to climb on to the bandwagon, pushing prices higher and higher. The third phase is the distribution, where the early entrants book profits and exit. The less informed investors enter in this stage. There is euphoria and overwhelming optimism all around."

Shanky interposed, "I suppose the reverse would happen in a bear market. It would start with a feeling of euphoria which would also be the distribution phase, followed by a big move down and then there would be the great despair which would actually be the beginning of the next bull market."

"And so the undulating cycle of ups and downs in the stock markets go on," said Harry. "Do you know that Elliott used the psychology of the waves laid down by Dow to define the first, third and fifth waves of the Elliott Wave theory?"

"We don't seem to get too far from waves. So, what is this Elliott Wave theory all about?" asked Shanky.

"R. N. Elliott based his theory primarily on the Dow theory and went on to fine tune it to such an extent that it became one of the finest tools available in technical analysis as far as forecasting abilities go. His work was published in a book called The Wave Principle in 1938 and in a series of articles in Financial World magazine in 1939. I remember the words from the opening chapter of this book where he writes about how it has been proved over and over again that the universe is ruled by law. If there were no law, there would be chaos and nothing survives chaos. Human behaviour too follows a law and study of all developments in the social-economic processes show that they follow a law that causes them to repeat themselves in recurring patterns. The stock market illustrates the wave impulse common to other socio-economic activity. These words form the basis of Elliott's work. It is impossible to progress in the study of Elliott theory unless the above words are completely understood and accepted."

Shanky looked surprised. "That will take some accepting! No wonder that most Elliott Wave analysts do not lay emphasis on the laws governing the wave patterns. Are Elliott wave patterns similar to the primary and secondary movements in the Dow theory?"

"Elliott Wave theory proposes that prices move in five upward moving waves and three downward moving waves. These waves are fractal in nature and occur across all the time durations at the same time. The waves moving in the direction of the trend are called impulse waves and the waves moving against the trend are called corrective waves." The sun had begun to set.

"I will have some more questions for you once Are there any more wave theories?"

"There is the Kondratieff Wave theory", said Harry. "Nikolai Dmyitriyevich Kondratieff wrote the Long Waves in Economic Life in 1926. The Kondratieff wave cycle goes through four distinct phases of beneficial inflation (spring), stagflation (summer), beneficial deflation (autumn), and deflation (winter). Since, the last Kondratieff cycle ended around 1949, we have seen beneficial inflation 1949-1966, stagflation 1966-1982, beneficial deflation 1982-2000 and according to Kondratieff, we are now in the (winter) deflation cycle which should lead to depression."

"All these wave-oriented theories seem to have been penned at the beginning of the 20th century. Now that people no longer go to the sea shore, due to lack of free time, I guess waves have stopped being the focal point of the recent stock market theories! I have been lying down for too long. I want exercise my legs. Want to come for a walk on the water's edge?" said Shanky.

"Great idea. We can ruminate about the random Walk theory as we enjoy the stroll," quipped Harry.

Racy@thehindu.co.in

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Deconstructing the market, One wave at a time