The Waves of Life

John L. Casti, Technical University of Vienna, August, 2002

When was the last time you bucked a trend? Really swam against the tide? Chances are,
you never really have – at least, not for long. But don’t be down on yourself: it’s not your
fault. You may not have as much free will as you think.

Most of us are pretty much aware of our tendency to go with the herd. We tag along with
fashions: our hemlines rise and fall, our trouser legs widen and narrow, or we buy
technology stocks when others are doing the same. We accept that, much of the time, we’re
not being “individual”. What we’re not really aware of is why.

There are evolutionary arguments, of course: if you haven’t enough information on which to
base a judgement, the next best thing is to assume that the herd knows where it’s going.
But a mathematical analysis of our activities indicates that there may be something deeper
going on. We seem to be fated to act in a way that mimics patterns found elsewhere in
nature.

We already know that some actions of society appear to follow laws that often apply to
otherwise completely unrelated phenomena in the Universe. The numbers behind the fractal
shape of a snowflake can also describe our society’s financial activities, for instance.
Financial data is one thing, but why should the maths that describes a seashell’s spiral also
underlie our technological progress? Why can our shopping habits be described by the same
rules that dictate how galaxies are spread through the cosmos? It’s as though we are
somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we’re all
bound by the same order.

Mathematical laws are already used to describe human activity, of course. There are various
tools such as Bayesian theorems, power laws, hidden Markov processes and cellular
automata, just for starters. All of these have been used in modelling financial markets, with
varying degrees of success – and popularity. But now an old mathematical idea first
dreamed up in the 1930s, has come to the fore again and is proving itself more powerful
than anyone ever thought possible. It has enabled people to make specific predictions about
the financial markets, forecasts that are now unfolding with uncanny accuracy. The fact that
this technique also has say something about what it is to be human makes it all the more
remarkable.

To begin at the beginning, you have to go back to California during the Great Depression.
Ralph N. Elliott, a Los Angeles accountant, is in frail health and unable to find work. While
recuperating, he has plenty of free time to investigate the stock. He becomes convinced
that there are repetitive patterns within market indices such as the Dow Jones index. Of
course, Elliott knows it’s not really saying much to point out that the Dow Jones moves in
cycles. What he needs to understand is how to characterise the kinds of cycles, and then to
look far patterns within them. He realises that such an understanding would enable alert
investors to predict the rising prices of a bull market, foresee the decline of a bear market
and even anticipate great crashes such as those of October 1929.

Elliot, a hands-on specialist in corporate financial rescue, was no stranger to market

analysis or the ebbs and flows of business and eventually managed to fit together the
pieces of a fascinating puzzle. Elliott’s great leap forward was the realisation that the cycles
don’t originate within the financial markets, but are a product of the humans that drive
them. “Human emotions are rhythmical; they move in waves of a definite number and
direction,” Elliott observed. “The phenomenon occurs in all human activities, be it business,
politics, or the pursuit of pleasure.” And so, by analysing stock market data, he picked out
certain fundamental rhythms. Today they are known as Elliott waves.

The theory of Elliott waves is based on patterns of ups and downs, underpinned by a few
basic principles. First of all, action is always followed by reaction: up is eventually followed
by down. At this level, an Elliott wave cycle is composed of two waves, where a “wave” is
simply a change – either and upward “impulse” wave, or a downward “corrective” wave.
However, Elliott found that each wave isn’t necessarily just a straight line. Instead, it can be
subdivided into five smaller waves, so an impulse wave might actually consist of up-down-
up-down-up. Likewise, the data revealed that waves were sometimes subdivided into just
three waves: down-up-down for a corrective wave, for example. So, on closer inspection,
an up-down Elliott wave cycle is actually composed of eight waves. One slight complication
is that the number of sub-waves within a given wave actually depends on whether that
wave is with the overall trend or against it. So if the overall trend is downward, for
example, then corrective waves in that trend have five sub-waves, and impulse waves have
three (see diagram, below).
However, just as “zooming in” on an up-down pattern reveals eight smaller waves, zooming
out shows that it can also be considered as a 2-wave component of a larger 8-wave cycle.
So the wave principle is hierarchical in the sense that the same basic shape appears at all
scales: each wave has component waves and is itself a component of a larger wave. This
self-similarity at different scales is the hallmark of fractal patterns, which are seen all over
the place in nature in things like fern fronds, coastlines and blood vessels.

So how many scales, or “degrees”, of waves, sub-waves, and sub-sub-waves are there—
how far can you zoom in or out? Elliott named nine degrees, from those lasting centuries to
those lasting just hours. But the actual number of degrees may be limitless, since the same
patterns show up even on one-minute graphs of stock prices, and are likewise presumed to
operate over indefinitely large timescales.

As you might expect, the area in which Elliott waves have been most extensively applied is
in finance. For instance, the value of the Dow Jones between 1932 and the present can be
broken down in terms of Elliott waves. If you can identify the waves and sub-waves and if
know where you are on a wave, you know exactly where you’re going next (see “Riding the
wave”). For example, Elliott used his wave theory to announce, in the middle of the worst of
World War II, that a multi-decade stock market rise was about to begin. And financial guru
Robert Prechter did the same during the midst of recession in September 1982 by
announcing that a “super bull market” had begun and forecasting a fivefold increase in
stock values. In both cases, the Elliott waves enabled them to get it right.
 But Elliott waves are something more profound
than just a money-making tool. They have a very
close connection with

the series of numbers known as the Fibonacci

sequence, where each number is the sum of the
two previous ones. This produces an infinite series
of numbers: 1, 1, 2, 3, 5, 8, 13, 21...

The number of waves that comprise the Elliott

patterns at each successive level of detail are
precisely the numbers of the Fibonacci sequence.
It’s easy to see why when you consider how the
pattern builds up. The simplest expression of a
corrective wave is a downward straight line, while
that of an impulse wave is a straight line upwards.
So a complete up-down cycle is just two waves.
At the next level the corresponding number of
corrective and impulse waves are 3 and 5,
respectively: Elliott’s theory says the downward
line has 3 sub-waves, and the upward one has 5.
The total cycle then consists of 8 waves, and we
have the first six numbers of the Fibonacci
sequence (see Diagram). This process continues
indefinitely.

The connection between Elliott waves and the

Fibonacci sequence is intriguing, because it links
the wave principle that underlies the stock market
with other natural patterns and processes found in
living forms. The Fibonacci sequence appears all
over the scientific landscape: it describes the spiral patterns found in seashells and the DNA
helix, as well as the number of spirals on pine cones and sunflower seed heads, to give just
a few natural examples. It also crops up in fractals.

So, according to Prechter, who produces a monthly publication called The Elliott Wave
Theorist, these patterns reveal a direct connection between nature’s numbers and all of
human behavior. Prechter believes the wave patterns are an organising principle for myriad
social behaviors, ranging from newspaper sales figures to the fortunes of national leaders.

The reason Elliott waves can tell us all this is simply because they are a direct reflection of
human psychology – the rhythms of human emotion, as Elliott put it. It doesn’t matter what
the exact mechanism is; the point is that they’re a result of human behavior. Their success
at predicting stock movements stems directly from the fact that price movements in
financial markets mirror the collective beliefs of investors about the future. If the majority
are optimistic, prices rise; if not, they fall.

But the stock market is just one way to take society’s emotional temperature. If you look at
the average length of hemline as fashions change and plot it against the Dow Jones, there
is a striking correlation: the stock market faithfully rises and falls with hemline length. The
obvious explanation is that when people are feeling bold and adventurous, they buy stocks
and wear more revealing clothes. When they feel threatened and conservative, they do the
reverse. The mood is pervasive, and almost everyone gets swept along with it.

Prechter’s theory, which he calls socionomics, is that the units in a social system, whether
they are investors, voters, music fans or shoppers, tend to base their decisions on what
they see others doing. In other words, they herd. These decisions are then translated into a
social mood, which shows up in indicators such as the Dow Jones, hemlines, lyrics in songs,
and so on. Armed with Elliott waves, you can start forecasting all sorts of things. Indeed,
Prechter has had astonishing successes with the method in areas where no one else is even
trying.

Take Major League Baseball, for example. In 1991, the sport enjoyed what some
commentators felt was its most exciting season ever. Fans got so enthusiastic that a record
760,000 of them turned out to welcome the two teams returning to Atlanta and Minneapolis
from the World Series, despite the fact that it was sleeting in Minneapolis. Players, owners
and leagues predicted ever-increasing popularity for the sport, and cities began building
new stadiums.

But socionomics predicted exactly the opposite. Prechter plotted the 90-year annual ticket
sales for Major League Baseball and identified an unmistakable Elliott wave. Immediately
following the 1992 season, he wrote: “If you’re an investor, take profits on baseball cards.
If you’re a player, sign a long-term contract. If you’re an owner, sell your club.” In the
ensuing months, the speculative bubble in baseball-card prices burst, the stock price of card
maker Topps collapsed, a players’ strike cancelled the 1994 World Series and the TV ratings
for the World Series began a steady fall to an all-time low. And he says the retrenchment is
not over yet.

Prechter has also used these principles to anticipate the peak and subsequent fall in the
popularity of a financial guru – himself. Using the number of subscribers to The Elliott Wave
Theorist as a measure of popularity, he saw that the subscription levels obeyed an Elliott
wave pattern of their own. As wave 5 of his overall upward surge began to slow in late
1987, he knew that the end of his ride as a guru was near. And sure enough, despite the
fact that 1988 was one of his best forecasting years ever, various members of the media
had had enough of Prechter and began to attack the persona that they and their colleagues
had over-promoted. He’s now written about far less, and far less lionised.

Setting the mood

Socionomics completely turns on its head the idea that events shape social mood. Since
trends in social mood produce Elliott-wave patterns, the mood itself must follow a definite
pattern. And if that’s true, it certainly cannot be the result of external events, which are
random and don’t follow set trends. The only possible conclusion, Prechter argues, is that
the direction of causation goes the other way: social mood actually shapes events.

The Enron scandal in the US illustrates that socionomic viewpoint very well. For weeks,
newspapers and magazines trumpeted the conventional direction of cause and effect: the
scandal deeply unsettled investors, they said, triggering the collapse. But socionomic
thinkers argue just the opposite: worried investors precipitated the scandalous behavior
(see “Who collapsed Enron?”).

The conclusion of Elliott wave theory is that the herding instinct in society governs events in
economics, politics, and even war and peace – and all these events follow exactly the same
kinds of cycle. This idea has deep implications. If Elliott waves can describe all of human
activity – economic trends, wars, shopping habits and political ideas – and yet a sequence
of numbers that is ubiquitous in nature can describe Elliott waves, is our behavior somehow
dictated by those numbers? Is what we do just a natural process, like the way a snowflake
or a seashell forms?

Conspiracy theorists and fans of science fiction lovers would love to take it as indication that
we’re helping to carry out some cosmic computation. But, whatever the real answer, we
may well not like it. Somehow, for all our cleverness and cherished free will, it seems we
might simply be living by numbers.

RIDING THE WAVE

You can now buy software that will take any series of data, such as stock exchange figures
or CD sales, and use pattern-recognition techniques to pick out the various Elliott patterns
at different timescales.

Spotting Elliott waves within the data is not an entirely mechanical procedure, but there are
some rules of thumb that help. Here are just a few of the characteristics of a 5-wave rise:

- Wave 2 does not fall below the starting level of wave 1

- Wave 3 is not the shortest wave
- Wave 4 does not overlap the range of wave 1
- One impulse wave is usually extended, and it is generally wave 3
- Waves 1 and 5 tend to be of equal length

Wave sizes are often related by “Fibonacci ratios”. The ratio of two successive numbers in
the Fibonacci sequence moves towards the limiting value 0.6180345 as we go further into
the sequence, for example: that value is the inverse of what is often termed the “golden
ratio”. Wave 2 generally retraces 0.618 of wave one, while wave four retraces 0.236 of
wave three, a number derived from the ratios of the sequence’s first two terms.

Who Collapsed Enron?

The accounting scandal that emerged within Enron could not have been what discouraged
investors and collapsed the company. The stock market was declining in the period before
the malpractice came to light, and most investors knew nothing about the shady dealing
prior to or anytime during the stock market’s fall. And while the scandal unfolded, primarily
from November to March, the market actually grew again. It’s clear that even as the Enron
drama developed, investor and consumer psychology actually improved and stock prices
rose.

So what really happened? From the socionomic point of view, it was the investors who
precipitated the Enron scandal, not the other way round. Stock prices had been falling for a
full 18 months prior to the event. Enron stock also retreated, undermining investor support.
By the time the controversy came to light, the trend toward an increasingly negative mood
was already over. In fact, by late September of last year, it was time for the market to
make its largest move upward in over a year-and-a-half. The psychological climate of this
bull market encouraged companies to mislead investors. The mass psychology of the stock
mania prompted investors to accept all manner of corporate falsehoods that reflected and
reinforced their ebullient mood. So it wasn’t misdoings that killed the stock prices, it was
simply that crashing stock prices eventually drew attention to the corporate misdeeds.
That’s socionomic thinking for you.