Limitations of the Elliott Wave

A large number of investors rely on Elliott wave theory as part of their market trend analysis to help them make good decisions, and it is a very good, very accurate tool. But it is merely one tool, and as with anything, it is unwise to become over reliant on any single tool or

methodology. At the root, Elliott wave theory revolves around the idea that by and large, people tend to react to stimuli in the same, predictable ways, and that by identifying the stimuli (either specifically or in broad categories), it then becomes possible to predict market movements. Its namesake, Ralph Nelson Elliott, developed the theory and the analytic tools that surround it in the 1930’s, proposing that market prices unfold in accordance with specific patterns. Although the theory has an enormous number of practitioners, and although it is used as part of the analytic methodology of a number of the most successful fund managers in the business, it is not without its critics and drawbacks. Of those criticisms, there are three primary ones, and they must be understood before deciding if this particular analytic tool is right for you. The first of the three objections is simply that the theory contradicts the Efficient Market Hypothesis. The counter argument goes that if Elliott’s theory were true and correct then all investors wise to the “trick” would act on it, and in doing so, destroy the very waves they had measured and discovered. The second is simply an observation that wave principle in general is too vague to be of specific use since it cannot consistently identify when a wave begins or ends, and that forecasts using this methodology are prone to subjective revision. Finally, there are some who believe that the principle is “too dated” to be of use, or even applicable in today’s markets. That technological, governmental, regulatory, economic and social changes have all occurred since the theory was first put forward, but that the theory itself remains unchanged and thus, unable to adapt to its new environment, or serve as a reliable predictor. Despite these objections, it should again be noted that many of the top performing fund managers use the theory as part of their own analysis, and it is hard to argue with their success. Whichever side of the fence you’re on regarding the methodology, one thing remains clear. It is unwise to place absolute faith or reliance in any single method, but as part of a larger set of analytic tools, and despite the various criticisms leveled against it, it is impossible to deny its record of success. What we do at is add additional technical analysis tools to our Elliott Wave views to keep ourselves in check. We also tend not to try to label every single squiggle or wave pattern as they occur. Taking a more big picture approach in our opinion works better than getting bogged down in the short term wave counts and details. Often, using a weekly chart can be of help in identifying obvious patterns, which is what I call “zooming out”. We also look at sentiment indicators such as the investment advisor surveys, or what we see on the cover of major media publications for example. In addition, we use Fibonacci analysis of prior wave patterns to help identify the most likely foreward scenarios. If we feel that a view we have is getting off track, instead of staying stubborn we will quickly analyze other potential wave counts to see if perhaps we were off the tracks, and then quickly re-adjust and get back up on the rails. We are also not fans of having multiple alternate counts, as that only serves to confuse the investor. Taking one quick example, the first Primary Elliott Wave of this Bull Market from 2009 was 704 points. Our opinion then was that Primary wave 3 which we have beginning at 1074 would have to be 704 points multiplied by a Fibonacci 1.618% factor as most likely. From that calculation we can work backwards in our other wave patterns to identify where we are at. Elliott Wave Theory in our opinion was a working blueprint, but not a bible either. You can take the basics of Elliott Wave Theory and then add in a few more elements to improve your results.

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