How Do You Get from Dow Theory to Elliott Wave Analysis?

Happy 160th Birthday, Charles Dow

By Elliott Wave International

If you are interested in Elliott wave analysis, odds are that you have also heard of Dow Theory, whose best and longest-lived proponent is Richard Russell. (Best wishes to Richard as he recovers his health.) This excerpt from Prechter’s Perspective explains how Elliott wave analysis and Dow Theory are connected. We wanted to run it now in honor of the 160th anniversary of the birth of Charles Dow, which the Market Technicians Association celebrates on Wall Street on Thursday, November 3, 2011.

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Excerpted from Prechter’s Perspective, 2004

Q: What was R. N. Elliott looking for in the stock market data in the late 1930s? Did he have a model or theory about price behavior?

Bob Prechter: Elliott had no basic premises, just a mind that was open to the idea that the market might be patterned, which he may have adopted from the then relatively new Dow Theory, which was a set of very few and far more general observations about market behavior. Though the Dow Theorists formed only very rough concepts, they broke ground, tremendous ground, in merely coming up with their observations that market behavior was non-random and tied to investor psychology. That was probably the germ of the idea that kicked off Elliott’s research.

Q: What was his procedure?

Bob Prechter: He did what every good researcher must do. First, he recorded the data that reality provided. He looked at the movements on chart paper and wondered, “Can I find forms that occur over and over again?” His answer was, “Yes.” He found that they occurred on hourly moves, daily moves, weekly, yearly. He even plotted moves that were decades long and noticed that they were following the same form. Likewise, the specific market did not matter. It could be the stock market, the gold price, interest rates or any other market. Then he organized the data, which was his talent. He began recognizing recurrences in the data, so it became clear that there were indeed repetitive patterns, which he ultimately organized into concepts.

Q: What exactly is Dow Theory and how does it relate to the Wave Principle?

Bob Prechter: The Dow Theory was developed by Charles Dow in the late 1800s. One of the tenets of Dow Theory is that, in general, a primary bull market runs in three upward phrases. In the initial phase, there is a lot of disbelief, and the markets are at very depressed levels. The middle phase is a kind of recognition phase when people begin to realize that the fundamentals are improving, and the markets are rising in harmony with them. The final stage is when the euphoria and the gambling come in. Elliott discovered that this basic formula of three steps up, separated by two intervening corrections, making five waves, was applicable not just to a primary bull market but to any degree of advance. He then observed that corrections take a different path: a three-wave shape or variation thereof. Then he observed that these cycles were not independent of each other but part of the market’s larger structure, which in turn developed according to these principles.

Q: It is through Charles Collins that we know about the genesis of the theory. He more or less sponsored Elliott’s introduction to Wall Street and helped him think through various aspects of becoming professional. In fact, he was the ghostwriter of a good deal of Elliott’s first important book, The Wave Principle, which came out in 1938. Did Collins make any contribution to the theory itself?

Bob Prechter: Yes. The catalyst for tying the Wave Principle to grander natural forces was Collins’s discovery that the number of waves in Elliott’s idealized pattern reflected the Fibonacci sequence. Collins wrote Elliott during the development of the theory and said in essence, “You ought to read this book by Jay Hambidge on Fibonacci ratios and spirals, because I noticed that when you count the waves through lower and lower degrees of trend, you find the Fibonacci sequence.” That sent Elliott off on the track to his grand conclusion. It is comforting to know that he did not start with the Fibonacci sequence or a theory based on it and then force nature to it. Nature showed its law, and these two men observed it.

Q: Is Fibonacci really that crucial to the theory?

Bob Prechter: It is not crucial to the what, but it is crucial to the why. First, Elliott observed the Wave Principle operate. Then he took the next step and asked, “Why does it exist?” He concluded that there must be some progression that human beings go through as they move overall from a state of deep pessimism to extreme optimism and back again, because they continue to trace out these patterns. His eventual conclusion was that it was a natural law of human behavior, that human beings were part of the natural world, and just like trees and wolves and lemmings and anything else you can name, they have certain ways of acting. It shows up in the charts vividly, making it clear that mass psychology is structured. The unifying conclusion, that mankind’s progress follows a law of nature exhibited by countless forms of life, is a profound and reasonable explanation that fits the facts.

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