The Stock Market is Not Physics - Part I

By: Robert Prechter | Sat, Jun 5, 2004
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From the May 2004 Elliott Wave Theorist

See if you can answer these four questions:

1) In 1950, a good computer cost $1 million. In 1990, it cost $5000. Today it costs $1000. Question: What will a good computer cost 50 years from today?

2) Democracy as a form of government has been spreading for centuries. In the 1940s, Japan changed from an empire to a democracy. In the 1980s, the Russian Soviet system collapsed, and now the country holds multi-party elections. In the 1990s, China adopted free-market reforms. In March of this year, Iraq, a former dictatorship, celebrated a new democratic constitution. Question: Fifty years from today, will a larger or smaller percentage of the world's population live under democracy?

3) In the decade from 1983 to 1993, there were ten months of recession in the U.S.; in the subsequent decade from 1993 to 2003, there were 8 months of recession. In the first period, expansion was underway 92 percent of the time; in the second period, it was 93 percent. Question: What percentage of the time will expansion take place during the decade from 2003 to 2013?

4) In 1970, Reserve Funds kicked off the hugely successful money market fund industry. In 1973, the CBOE introduced options on stocks. In 1977, Michael Milken invented junk bond financing, which became a major category of investment. In 1982, stock index futures and options on futures began to trade. In 1983, options on stock indexes became available. Keogh plans, IRAs and 401k's have brought tax breaks to the investing public. The mutual fund industry, a small segment of the financial world in the late 1970s, has attracted the public's invested wealth to the point that there are more mutual funds than there are NYSE stocks. Futures contracts on individual stocks have just begun trading. Question: Over the next 50 years, will the number and sophistication of financial services increase or decrease?

Observe that I asked you a microeconomic question, a political question, a macroeconomic question and a financial question.

Trend Extrapolation

If you are like most people, you extrapolated your answers from the trends of previous data. You expect cheaper computers, more democracy, an economic expansion rate in the 90-95 percent range, and an increase in financial sophistication.

It appears sensible to answer such questions by extrapolation because people default to physics when predicting social trends. They think, "Momentum will remain constant unless acted on by an outside force." This mode of thought is deeply embedded in our minds because it has tremendous evolutionary advantages. When Og threw a rock at Ugg back in the cave days, Ugg ducked. He ducked because his mind had inherited and/or learned the consequences of the Law of Conservation of Momentum. The rock would not veer off course because there was nothing between the two men to act upon it, and rocks do not have minds of their own. Earlier animals that incorporated responses to the laws of physics lived; those that didn't died, and their genes were weeded out of the gene pool. The Law of Conservation of Momentum makes possible our modern technological world. People rely on it every day. Despite its use in so many areas, however, it is inapplicable to predicting social change. For most people in most circumstances, the proper answer to each of the above questions is, "I don't know." (Socionomics can give you an edge in social prediction, but that's another story.)

The most certain aspect of social history is dramatic change. To get a feel for how useless - even counterproductive - extrapolation can be in social forecasting, consider these questions:

1) It is 1886. Project the American railroad industry.

2) It is 1970. Project the future of China.

3) It is 1963. Project the cost of medical care in the U.S.

4) It is 1969. Project the U.S. space program.

5) It is 100 A.D. Project the future of Roman civilization.

In 1886, you would have envisioned a future landscape combed with rail lines connecting every city, town and neighborhood. Small trains would roll around to your home to pick you up, and a network of rail lines would help deliver you to your destination efficiently and cheaply. Super-fast trains would make cross-country runs. You could eat, read or sleep along the way.

Is that what happened? Would anyone have predicted, indeed did anyone predict, that trains in 2004 would often be going slower than they did in 1886, that they would routinely jump the tracks, that they would be inefficient, that they would have little food and few sleeper cars, that the equipment would be old and worn out?

In 1970, the Communist party was entrenched in China. Over 35 million people had been slaughtered, culminating in the Cultural Revolution in which Chinese youths helped exterminate people just because they were smart, successful or capitalist. Would anyone have imagined that China, in just over a single generation, would be out-producing the United States, which was then the world's premier industrial giant?

In 1963, medical care was cheap and accessible. Doctors made house calls for $20. Hospitals were so accommodating that new mothers typically stayed for a week or more before being sent home, and it was affordable. Would anyone have guessed that forty years later, pills would sell for $2 apiece, a surgical procedure and a week in the hospital could cost one-third of the average annual wage, and people would have to take out expensive insurance policies just in case they got sick?

In the space of just 30 years, rockets had gone from the experimental stage to such sophistication that one of them brought men to the moon and back. In 1969, many people projected the U.S. space program over the next 30 years to include colonies on the moon and trips to Mars. After all, it was only sensible, wasn't it? By the laws of physics, it was. But in the 35 years since 1969, the space program has relentlessly regressed.

In 100 A.D., would you have predicted that the most powerful culture in the world would be reduced to rubble in a bit over three centuries? If Rome had had a stock market, it would have gone essentially to zero.

Futurists nearly always extrapolate past trends, and they are nearly always wrong. You cannot use extrapolation under the physics paradigm to predict social trends, including macroeconomic, political and financial trends. The most certain aspect of social history is dramatic change. More interesting, social change is a self-induced change. Rocks cannot change trajectory on their own, but societies can and do change direction, all the time.

Action and Reaction

In the world of physics, action is followed by reaction. Most financial analysts, economists, historians, sociologists and futurists believe that society works the same way. They typically say, "Because so-and-so has happened, such-and-such will follow." The news headlines in Figure 1, for example, reflect what economists tell reporters: Good economic news makes the stock market go up; bad economic news makes it go down. But is it true?

Figure 2 shows the Dow Jones Industrial Average and the quarter-by-quarter performance of the U.S. economy. Much of the time, the trends are allied, but if physics reigned in this realm, they would always be allied. They aren't. The fourth quarter of 1987 saw the strongest GDP

quarter in a 15-year span (from 1984 through 1999). That was also the biggest down quarter in stock prices for the entire period. Action in the economy did not produce reaction in stocks. The four-year period from March 1976 to March 1980 had not a single down quarter of GDP and included the biggest single positive quarter for 20 years on either side. Yet the DJIA lost 25 percent of its value during that period. Had you known the economic figures in advance and believed that financial laws are the same as physical laws, you would have bought stocks in both cases. You would have lost a lot of money.

Figure 3 shows the S&P against quarterly earnings in 1973-1974. Did action in earnings produce reaction in the stock market? Not unless you consider rising earnings bad news. While earning rose persistently in 1973-1974, the stock market had its biggest decline in over 40 years.

Suppose you knew for certain that inflation would triple the money supply over the next 20 years. What would you predict for the price of gold? Most analysts and investors are certain that inflation makes gold go up in price. They view financial pricing as simple action and reaction, as in physics. They reason that a rising money supply reduces the value of each purchasing unit, so the price of gold, which is an alternative to money, will reflect that change, increment for increment.

Figure 4 shows a time when the money supply tripled yet gold lost over half its value. In other words, gold not only failed to reflect the amount of inflation that occurred but also failed even to go in the same direction. It failed the prediction from physics by a whopping factor of six, thereby unequivocally invalidating it. (I was generous in ending the study now rather than in 2001, at which time gold had lost over two-thirds of its value.)

It does no good to say - as we sometimes hear from those attempting to rescue the physics paradigm in finance - that gold will follow the money supply "eventually." In physics, billiard balls on an endless plane do not eventually return to a straight path after wandering all over the place, including in the reverse direction from the way they are hit. (What physics-minded investor, moreover, can be sure that gold should follow the money supply rather than vice versa? Is he certain which element in the picture should be presumed to be the action and which the reaction? Maybe a higher gold price increases the value of central banks' gold reserves, letting them support more lending. Cause and effect arguments are highly manipulable when using the physics paradigm.)

We do know one thing: Investors who feared inflation in January 1980 were right, yet they lost dollar value for two decades, lost even more buying power because the dollar itself was losing value against goods and services, and lost even more wealth in the form of missed opportunities in other markets. Gold's bear market produced more than a 90 percent loss in terms of gold's average purchasing power of goods, services, homes and corporate shares despite persistent inflation! How is such an outcome possible? Easy: Financial markets are not a matter of action and reaction. The physics model of financial markets is wrong.

Cause and Effect

In the 1990s, a university professor sold many books that made a case for buying "stocks for the long run." In a recent issue of USA Today, he told a reporter, "Clearly, the risk of terror is the major reason why the markets have come down. We can't quantify these risks; it's not like flipping a coin and knowing your odds are 50-50 that an attack won't occur."1

In other words, he accepts the physics paradigm of external cause and effect with respect to the stock market but says he cannot predict the cause part of the equation and therefore cannot predict stock prices. The first question is, well, if one cannot predict causes, then how can one write a book predicting effects, i.e., arguing that stocks will go up? Or down or sideways? A second question is far more important. We have already seen that economic performance, earnings and inflation do not necessarily coincide with movements in apparently related financial markets. In fact, the two sets of data can utterly oppose each other. Is there any evidence that dramatic news events that make headlines, such as terrorist attacks, political events, wars, crises or any such events are causal to stock market movement?

Suppose the devil were to offer you historic news a day in advance. He doesn't even ask for your soul in exchange. He explains, "What's more, you can hold a position for as little as a single trading day after the event or as long as you like." It sounds foolproof, so you accept. His first offer: "The president will be assassinated tomorrow." You can't believe it. You and only you know it's going to happen. The devil transports you back to November 22, 1963. You short the market. Do you make money?

Figure 5 shows the DJIA around the time when President John Kennedy was shot. First of all, can you tell by looking at the graph exactly when that event occurred? Maybe before that big drop on the left? Maybe at some other peak, causing a selloff?

The first arrow in Figure 6 shows the timing of the assassination. The market initially fell, but by the close of the next trading day, it was above where it was at the moment of the event, as you can see by the second arrow. You can't cover your short sales until the following day's up opening because the devil said that you could hold as briefly as one trading day after the event, but not less. You lose money.

You aren't really angry because after all, the devil delivered on his promise. Your only error was to believe that a presidential assassination would dictate the course of stock prices. So you vow not to bet on things that aren't directly related to finance. The devil pops up again, and you explain what you want. "I've got just the thing," he says, and announces, "The biggest electrical blackout in the history of North America will occur tomorrow." Wow. Billions of dollars of lost production. People stranded in subways and elevators. The last time a blackout occurred, there was a riot in New York and hundreds of millions of dollars worth of damage done. How more directly related to finance could you get? "Sold!" you cry. The devil transports you back to August 2003.

Figure 7 shows the DJIA around the time of the blackout. Does the history of stock prices make it evident when that event occurred? After all, if markets are action and reaction, then this economic loss should show up unmistakably, shouldn't it? There are two big drops on the graph. Maybe it's one of them.

The arrow in Figure 8 shows the timing of that event. Not only did the market fail to collapse, it gapped up the next morning! You sit all day with your short sales and cover the following day with another loss.

"Third time's the charm," says the devil. You reply, "Forget it. I don't understand why the market isn't reacting to these causes. Maybe these events you're giving me just aren't strong enough." The devil leans into your ear and whispers, "Two bombs will be detonated in London, leveling landmark buildings and killing 3000 people. Another bomb planted at Parliament will misfire, merely blowing the side off the building. The terrorist perpetrators will vow to continue their attacks until England is wiped out." He promises that you can sell short on the London Stock Exchange ten minutes before it happens and even offers to remove the one-day holding restriction. "Cover whenever you like," he says. You agree. The devil then transports you to a parallel universe where London is New York and Parliament is the Pentagon. It's September 11, 2001.

Figure 9 shows the DJIA around that time. Study it carefully. Can you find an anomaly on the graph? Is there an obvious time when the shocking events of "9/11" show up? If markets reacted to "exogenous shocks," as billiard balls do, there would be something obviously different on the graph at that time, wouldn't there? But there isn't.

Figure 10 shows the timing of the 9/11 terrorist attacks. You may recall that authorities closed the stock market for four trading days plus a weekend. Question: Was it a certainty that the market would re-open on the downside? No! Some popular radio talk-show hosts and administration officials advocated buying stocks on the opening just to "show 'em." You sit with your massive short position, and you are nervous. But you are also lucky. The market opens down, continuing a decline that had already been in force for 17 weeks. You cheer. You're making money now! Well, you do for six days, anyway. Then the market leaps higher, and somewhere between one week and six months later you finally cover your shorts at a loss, disgusted and confused. If you are an everyday thoughtful person, you decide that events are irrelevant to markets and begin the long process of educating yourself on why markets move as they do. If you are a conventional economist, you don't bother.

In case you still think that terrorism is a factor somewhere in the falling markets of 2000-2002, please read "Challenging the Conventional Assumption About the Presumed Sociological Effect of Terrorist News," which is reprinted in Pioneering Studies in Socionomics. It shows unequivocally that the terrorist events and related fears of that time encompassed a period when the market mostly went up and consumer sentiment improved. The graph that accompanies that study is reproduced here as Figure 11.

Now think about this: In real life, you don't get to know about dramatic events in advance. Investors who sold stocks upon hearing of the various events cited above did so because they believed that events cause changes in stock values. They all sold the low. I chose bad news for these exercises because it tends to be more dramatic, but the same irrelevance attaches to good news.

Since knowing dramatic events in advance would produce no value for investing, guessing events is an utter waste of time. There are no "inefficiencies" related to external causality that one may exploit.

If news is irrelevant to markets, how can the media explain almost every day's market action by the news? Answer: There is a lot of news every day. Commentators don't write their cause-and-effect stories before the session starts but after it ends. It's no trick to fit news to the market after it's closed. I am writing this paragraph the day after stocks had a big down day. The news at 8:30 a.m. yesterday was good, a "stronger-than-expected 1.8 percent jump in March retail sales." How, then, did this morning's newspaper, relying on cause and effect, explain yesterday's big drop? (Remember, it's easy to play games with cause and effect under the physics paradigm.) Here is the headline: "Rising-Rates Scenario Sends Stocks Reeling."2 This and other articles present the following ex-post-facto consensus reasoning: Investors appear to have decided that the good news that the economy is "starting to accelerate" might mean higher interest rates, which would be bearish if it happened. This contrived conclusion is doubly bizarre given the century-long history of interest-rate data, which (as the next section will show) belies such a belief. How, moreover, does one explain the fact that the stock market opened higher yesterday, in concert with the standard view of such news being "good"? There was no more big news that day. Had there been some "bad" news immediately after the opening, such inventive reasoning would not have been required. The "reason" for the rout would have been obvious, just as it was on the previous down day of this size, on which terrorists conveniently bombed trains in Spain. (Let me guess. You think that this example of news causality makes sense, don't you? Sorry. Did I mention that the U.S. stock market - fully apprised of the news - rallied until noon that day before selling off?)

[End of Part I; Part II Will Appear In An Upcoming Issue]

1 Shell, Adam. (March 23, 2004.) "Fear of terrorism jolts stock market," USA Today.

2 Walker, Tom. (April 14, 2004.) "Rising rates scenario sends stocks reeling," The Atlanta Journal-Constitution, p.D5.

Financial Markets

The stock market, bond market and precious metals are all on track with expectations, so there is no need for detailed commentary from EWT. The DJIA peaked one day from EWT's ideal date of February 20. It should fall substantially through the third quarter of 2004 before the first rally of consequence begins. Precious metals and mining issues have ended their countertrend rallies and have resumed their long term bear markets. The economy should begin to weaken again in coming months as the stock market falls. The June issue of EWFF goes out in a week.

It's Not Too Late To Do Something Really Stupid!

If you missed out on the Dot-com Debacle, the Silver Slaughter, the Stock Market Massacre, the Junk Bond Swoon, the Collectibles Calamity, the Real Estate Trap and so many other confirmed or looming disasters, do not despair. There is a great one waiting for you, right now! Here's the ticket: Buy the Google IPO. Yes, folks. Don't buy stocks of unknown but brilliant start-up companies that have a chance of making you rich. Buy the stock of a company that has already gotten as big as it can get, buy the stock of a company that could be put out of business in two years by an innovative competitor, and be sure to buy the shares at the top of a year-and-a-half stock market rally to historically overvalued territory, and be sure to buy those shares at top dollar, bidding against a maniacal, know-nothing public in a Dutch auction!

Hey, I love Google, too, but only for Internet searches. Let somebody else buy the stock.

Third Party Resurgence

Remember that great movie, Trading Places? The producer of that movie is running for president. You may recall Aaron Russo from 1994, when he formed the Constitution Party in an effort to get America to return to the values of the Constitution. That party has since been taken over by non-libertarians, so Russo has decided to seek the presidential nomination on the Libertarian ticket. The left outlaws guns; the right favors prohibition. The left takes more of your money; the right restricts your right to marry whom you want. Both sides restrict your access to medicine, jobs, property, imported goods, tobacco, and a thousand other things. Both sides - against the advice of Founding Fathers Washington, Adams and Jefferson - want to send your kids to foreign lands to fight other people's wars. Aaron is different. He wants to defend America will all our might and put only real criminals - murderers, thieves, frauds and rapists - in jail. Other than that, his motto is simple: "All our freedoms, all the time." The last time Libertarians peaked in national support was 1980, the year of the low in the DJIA valued in terms of gold. In other words, bear markets help third parties. The electricity of that time is returning. Endorsements for Russo are pouring in, his website traffic has recently topped Ralph Nader's, and straw polls suggest that he will be chosen the Libertarian Party candidate. I will be delivering an introductory speech for him at the LP convention in Atlanta on the final weekend in May. To learn more, visit www.russoforpresident.com.

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Robert Prechter

Author: Robert Prechter

Bob Prechter, CMT
Elliott Wave International

Robert Prechter, Jr., is a social theorist and market analyst. He is president of Elliott Wave International, a forecasting firm servicing institutional and private investors around the world. Since 1978, Prechter has published the monthly Elliott Wave Theorist and has authored 14 books. His Elliott Wave Principle with A.J. Frost in 1978 predicted the great bull market. His New York Times bestseller, Conquer the Crash (2002), forecast a collapse of the global credit mania and the ensuing period of deflation. His two-book set, Socionomics, presents his seminal hypothesis that endogenously regulated waves of social mood determine the character of social actions.

Prechter attended Yale University on a full scholarship and graduated in 1971 with a degree in psychology. He began his career as a Technical Market Specialist with the Merrill Lynch Market Analysis Department in New York City.

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