How To Use Market Sentiment To Improve Your Trading/Investing (Part 3)

In an essay published by R.N. Elliot – the discoverer of Elliott Wave analysis - on October 1, 1940, he opened with:

“Civilization rests upon change.   This change is cyclical in origin and characteristics.  A rhythmic series of extreme changes constitutes a cycle.  When a cycle has been completed, another cycle is started.  The rhythm of the new cycle will be the same as that of the previous cycle, although the extent and duration may vary.  The cycle progresses in accordance with the natural law of movement.”

The first chapter of The Wave Principle, written by Frost & Prechter, summarized Elliott’s perspective as follows:

“No truth meets more general acceptance than that the universe is ruled by law.  Without law, it is self-evident there would be chaos, and where chaos is, nothing is . . . Man is no less a natural object than the sun or the moon, and his actions, too, in their metrical occurrence, are subject to analysis . . . Very extensive research in connection with  . .  human activities indicates that practically all developments which result from our social-economic processes follow a law that causes them to repeat themselves in similar and constantly recurring series of waves or impulses of definite number and pattern. . .  The stock market illustrates the wave impulse common to social-economic activity . . . It has its law, just as is true of other things throughout the universe.”

So, Elliott recognized that life, as we know it, is cyclical, and constantly rhymes, if not repeats. But, Elliott went so far as to question the causes of these cycles, and has actually turned the common conception of “causation” on its head:

“The causes of these cyclical changes seem clearly to have their origin in the immutable natural law that governs all things, including the various moods of human behavior. Causes, therefore, tend to become relatively unimportant in the long term progress of the cycle.  This fundamental law cannot be subverted or set aside by statutes or restrictions.  Current news and political developments are of only incidental important, soon forgotten; their presumed influence on market trends is not as weighty as is commonly believed.” 

In fact, Elliott even went so far as to state that “At best, news is the tardy recognition of forces that have already been at work for some time and is startling only to those unaware of the trend.”  In effect, what Elliott is saying is that news does not “cause” the cycles, as most believe.  Rather, news falls within the cycles.  While this clearly challenges the common perceptions of what moves markets, I would suggest that all those reading my words at least open their minds to this possibility, and it may very well change the way you invest forever.

As we noted last week, during his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Green- span noted that markets are driven by “human psychology” and “waves of optimism and pessimism.” Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain.  (See last week’s example as to how sentiment leads fundamentals).

Ultimately, we really have to begin to question whether exogenous events actually “cause” moves markets, rather than act as a catalyst to a move which was already set up. And, often the catalyst will seemingly “cause” a move in the opposite direction assumed by most market participants.  Don’t you ever question why markets go up after seemingly bad news or go down after seemingly good news?

Social experiments have actually been conducted which resulted in price patterns that mirror those found in the stock market, yet the patterns develop without exogenous factors being introduced into the test subjects. In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”

One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy,“ wherein the price distributions were based on Phi (.618).

Their ultimate conclusion would surprise the most avid trader today:

In spite of the simplicity of our model and of the strategies of the single participants, and the outright exclusion of economic external factors, we find a market which behaves surprisingly realistically. These results suggest that a stock market can be considered as a self-organized critical system: The system reaches dynamically an equilibrium state characterized by fluctuations of any size, without the need of any parameter fine tuning or external driving.

Marsili was quoted as saying that “the understanding that we got is that the statistics of price histories in financial markets can be understood as the result of internal interaction and not the fundamental interaction with the external world.”

So, I am sure some of you are now saying “well, that does not take into effect surprise news events which take the market by complete shock. Those certainly cause market moves.”

In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news.  Based upon Walker's study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.

Robert Prechter Jr., in his book The Wave Principle of Human Social Behavior, in which he cites many of these instances, concludes:

once you realize that even if you got [the news] in advance, you could not forecast the stock market. Though these facts are counter-intuitive, it does not take a dedicated market student long to observe the acausality of news to the stock market.

Next week, I will provide a basic summary of the Elliott Wave analysis system, along with its interaction with Fibonacci mathematics, which is used to track the sentiment movements within the market. And, the final article in this series will explain how we use our Fibonacci Pinball method to frame our Elliott Wave analysis into a more accurate methodology.

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See Avi’s charts illustrating the wave counts on the metals at https://www.elliottwavetrader.net/scharts/Charts-on-GDX-GLD-YI-20150405692.html  .

Avi Gilburt is a widely followed Elliott Wave technical analyst and author of ElliottWaveTrader.net (www.elliottwavetrader.net), a live Trading Room featuring his intraday market analysis (including emini S&P 500, metals, oil, USD & VXX), interactive member-analyst forum, and detailed library of Elliott Wave education.