The goal of this discussion is to explain the basics of Elliott Wave Theory and how it is compatible with a market which is driven, as a whole, by fundamentals and news. For this article, I am going to assume that the basics of Elliott Wave Theory are understood. It will therefore be very brief.
Reactions to News
There are a few arguments regarding Elliott Wave Theory that I just do not accept. They are all related to the idea that stock market price action is an entirely internal phenomenon, independent of fundamentals and news. One argument is that news has no impact on stocks. However this is not supported by the data. While it is true that stocks do not necessarily move up on good news and down on bad news, there is a statistically significant relationship between stocks and news.
In “Stock Price Reaction to News and No-News: Drift and Reversal After Headlines,” the author suggests that the type of news, good or bad, has a lot to do with how investors react and found that “stocks that experienced negative returns concurrent with the incidence of a news story continued to underperform their size, book-to-market, and event return matched peers. Stocks that experienced good news show less drift. On the other hand, extreme return stocks that had no news headlines for a given month experienced reversal in the subsequent month and little abnormal performance after that.”
Compatibility with Elliott Wave Theory
Below are two example wave systems. I apologize in advance for the poor drawing skills.
As can be seen from the two wave systems, the ending point of a wave system can vary greatly based on the length and angle of each component wave, where that length and angle is determined by the finer wave systems in each component wave. Finally, the wave system shown is really just a single wave of a larger wave system, according to Elliott Wave Theory, and so its form is a factor in determining the ending location of the courser wave system.
Fibonacci retracements and extensions are often used as guidelines for the ending price of each wave. And that still gives a large degree of freedom, both in angle and in length of the wave. From here, it can be seen that if news modulates sentiment as to adjust where each wave is likely to go, it can determine, in the long run, the structure of each wave system. I chose the basic impulse wave as an example, but there are actually many other wave systems in Elliott Wave Theory. Which system occurs at what point of time can also have a major impact on courser systems. This selection can also be modulated by news.
I used the word “modulate” rather than determine, because that is more consistent with our current psychological theories on belief. A lot of research in the area of cognitive bias has been done in the field of political science, and so I will be relying on that field as a source of theory. The citation of the material does not imply that I approve or disapprove of any political views expressed within the works. In “
When Corrections Fail: The persistence of political misperceptions,” novel evidence very often fails to induce a corrective response in individuals. Indeed, in some cases, evidence which contradicts the held belief actually works to strengthen that belief. In order for an investor to respond to novel information in the “correct” way, they must first be open to such information.
In “Paradoxical thinking as a new avenue of intervention to promote peace,” Hameiri et. al. suggest a way to induce openness, by using paradoxical thinking: “the attempt to change attitudes by using new information, which is consistent with the held societal beliefs (narratives), but of extreme content that is intended to lead an individual to paradoxically perceive his or her currently held societal beliefs or the current situation as irrational and senseless.”
This paradoxical thinking apparatus seems to appear naturally in various market conditions. Consider market tops. As new highs are reached, more and more bombastic predictions are made. This could take the narrative to the extreme, which would then cause the investor to incorporate the new information, which they would have otherwise rejected. Not only is this consistent with Elliott Wave Theory, it actually helps to explain components of the system, as the start of wave 1 and wave 5 are often contrary to the prevailing news.
There are two final issues with simply arguing that “good data” does not always produce a positive result in stocks, and vice versa as a reason why fundamentals do not matter, and they again have to do with how news modulates belief. The first has to do with what the “good data” means about other factors. As an example, positive jobs growth lately has also meant that the Federal Reserve is likely to push more rate hikes. This rate hike would have a negative effect on financials, which are a large component of the S&P 500. The second has to do with whether or not the news is already priced in.
None of the arguments presented in this article imply that Elliott Wave analysis is any less useful. The underlying mechanics of why Elliott Wave Theory might work is irrelevant to using it, just as one does not need to be an expert mechanic to drive a car well. However, understanding that stock systems may not be independent of fundamentals can improve judgement about long term price action, and aid in Elliott Wave analysis.