🔸7.1 Their Relationship To The Wave Principle

Dow Theory

According to Charles H. Dow, the primary trend of the market is the broad, all-engulfing "tide," which is interrupted by "waves," or secondary reactions and rallies. Movements of smaller size are the "ripples" on the waves. The latter are generally unimportant unless a line (defined as a sideways structure lasting at least three weeks and occurring within a price range of five percent) is formed. The main tools of the theory are the Transportation Average (formerly the Rail Average) and the Industrial Average. The leading exponents of Dow’s theory, William Peter Hamilton, Robert Rhea, Richard Russell and E. George Schaefer, rounded out Dow’s theory but never altered its basic tenets.

As Charles Dow once observed, stakes can be driven into the sands of the seashore as the waters ebb and flow to mark the direction of the tide in much the same way as charts are used to show how prices are moving. Out of experience came the fundamental Dow Theory tenet that since both averages are part of the same ocean, the tidal action of one average must move in unison with the other to be authentic. Thus, a movement to a new extreme in an established trend by one average alone is a new high or new low that is said to lack "confirmation" by the other average.

The Elliott Wave Principle has points in common with Dow Theory. During advancing impulse waves, the market should be a “healthy” one, with breadth and the other averages confirming the action. When corrective and ending waves are in progress, divergences, or non-confirmations, are likely. Dow’s followers also recognized three psychological “phases” of a market advance. Naturally, since both methods describe reality, the Dow Theorists’ brief descriptions of these phases conform to the personalities of Elliott’s waves 1, 3 and 5 as we outlined them in Chapter 2.

Figure 7-1

The Wave Principle validates much of Dow Theory, but of course, Dow Theory does not validate the Wave Principle since Elliott’s concept of wave action has a mathematical base, needs only one market average for interpretation, and unfolds according to a specific structure. Both approaches, however, are based on empirical observations and complement each other in theory and practice. Often, for instance, wave counts for the averages will forewarn the Dow Theorist of an upcoming non-confirmation. If, as Figure 7-1 shows, the Industrial Average has completed four waves of a primary swing and part of a fifth, while the Transportation Average is rallying in wave B of a zigzag correction, a non-confirmation is inevitable. In fact, this type of development has helped the authors more than once. As an example, in May 1977, when the Transportation Average was climbing to new highs, the preceding five-wave decline in the Industrials during January and February signalled loud and clear that any rally in that index would be doomed to create a non-confirmation.

On the other side of the coin, a Dow Theory non-confirmation can often alert the Elliott analyst to examine his count to see whether or not a reversal should be the expected event. Thus, knowledge of one approach can assist in the application of the other. Since Dow Theory is the grandfather of the Wave Principle, it deserves respect for its historical significance as well as its consistent record of performance over the years.

The “Kondratieff Wave” Economic Cycle

The fifty- to sixty- (averaging fifty-four) year cycle of catastrophe and renewal had been known and observed by the Mayas of Central America and independently by the ancient Israelites. The modern expression of this cycle is the “long wave” of economic and social trends observed in the 1920s by Nikolai Kondratieff, a Russian economist. Kondratieff documented, with the limited data available, that the economic cycles of modern capitalist countries tend to repeat a cycle of expansion and contraction lasting a bit over half a century. These cycles correspond in size to Supercycle degree (and occasionally Cycle degree when an extension is involved) waves under the Wave Principle.

Figure 7-2, courtesy of The Media General Financial Weekly, shows the idealized concept of Kondratieff cycles from the 1780s to the year 2000 and their relationship to wholesale prices. Notice that within the Grand Supercycle wave shown in Figure 5-4, the beginning of wave (I) to the deep low of wave a of (II) in 1842 roughly tracks one Kondratieff cycle, the extended wave (III) and wave (IV) track most of two Kondratieffs, and our current Supercycle wave (V) will last throughout most of one Kondratieff.

Figure 7-2

* April 6, 1983, Special Report (see Figure A-8 in the Appendix) recognized that the last contraction ended later than depicted in this standard illustration, in 1949, pushing all forecast dates forward accordingly

Kondratieff noted that “trough” wars, i.e., wars near the bottom of the cycle, usually occur at a time when the economy stands to benefit from the price stimulation generated by a war economy, resulting in economic recovery and an advance in prices. “Peak” wars, on the other hand, usually occur when recovery is well advanced and, as the government pays for the war by the usual means of inflating the money supply, prices rise sharply. After the economic peak, a primary recession occurs, which is then followed by a disinflationary “plateau” of about ten years’ duration in which relatively stable and prosperous times return. The end of this period is followed by several years of deflation and a severe depression.

The first Kondratieff cycle for the U.S. began at the trough that accompanied the Revolutionary War, peaked with the War of 1812, and was followed by a plateau period called the “Era of Good Feeling,” which preceded the depression of the 1830s and ’40s. As James Shuman and David Rosenau describe in their book, The Kondratieff Wave, the second and third cycles unfolded economically and sociologically in a surprisingly similar manner, with the second plateau accompanying the “Reconstruction” period after the Civil War and the third aptly referred to as the “Roaring Twenties,” which followed World War I. The plateau periods generally supported good stock markets, especially the plateau period of the 1920s. The roaring stock market of that time was followed ultimately by collapse, the Great Depression and general deflation until about 1942.

As we interpret the Kondratieff cycle, we have now reached another plateau, having had a trough war (World War II), a peak war (Vietnam) and a primary recession (1974-75). This plateau should again be accompanied by relatively prosperous times and a strong bull market in stocks. According to a reading of this cycle, the economy should collapse in the mid-1980s and be followed by three or four years of severe depression and a long period of deflation through to the trough year 2000 A.D. This scenario fits ours like a glove and would correspond to our fifth Cycle wave advance and the next Supercycle decline, as we discussed in Chapter 5 and further outlined in the last chapter.

Marketdavinci Home