Elliot Waves and the Fibonacci Sequence

Born in 1871 in a town called Marysville, Kansas, Ralph Nelson Elliot lived for most of his youth in San Antonio, Texas, becoming an accountant in the late 19th century. Over the years he worked for many Western railroads and other companies, and ultimately built out a lucrative career in Mexico and Central America, auditing railroads and other businesses for their American investors. He returned to the U.S. in the 1920s and gained experience advising restaurant owners on business concerns. For several years he wrote a paper for a trade newspaper, Tea Room and Gift Shop paper, and Tea Room and Cafeteria Administration, a well-respected textbook written in 1926.

In the late 1920s, Elliot contracted anemia, perhaps from an illness in Latin America. He was reportedly bedridden for many years, and his financial sector analysis started during this time. Elliot later announced that he had inferred “a law-abiding rhythmic pattern of waves,” as he described in articles for Financial World (the leading stock market publication of the time) and in a book published in 1938, The Wave Theory. From 1938 to 1945 he published an infrequently issued newsletter, originally called Educational Bulletins but later entitled Interpretive Letter. He expired in 1948.

Together with William Gann, a futuristic and “Gann angles” creator and other technological ideas, Elliot believed in spiritualism and mysticism, having origins in Texas as described above. Both men developed trade strategies that are complicated and at times difficult (if not impossible) to completely comprehend, and both believed to have discovered deep metaphysical insights into life’s purpose. Although Elliot succeeded in developing a career as a market analyst late in his life, he did so to a far more limited degree than Gann, who was considerably more adept in self-promotion.

Elliot claimed the stock market goes through a “Super Cycle” of 15-20 years, which in turn moves within a “Grand Super Cycle” of at least five decades, going within a much longer cycle of around 200 years. Each loop includes smaller loops, culminating in “sub-Minuette,” which only lasts a few hours.

According to Elliot, a cycle is created by motions of market prices in patterns he called waves, thus his method is now regarded as Elliot Wave Theory (although the formal titled adopted by Elliot was the Wave Principle).

Every cycle comprises eight waves, Elliot said, five of which are dominated by “impulse waves,” i.e. waves driving up rates, and three of which are bearish, i.e. dominated by “corrective waves,” during which profits are lost to different degrees.

To foresee waves, Elliot quoted the Fibonacci number series beginning with “0” and “1,” followed by the sum of the two preceding numbers, i.e. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 133, 233, 377, 610, 987, 1597…

There are sporadic references to this series in ancient India literature, but the idea was originally introduced in the early 13th century by an Italian mathematician, Leonardo Fibonacci, also known as Pisa’s Leonardo. He put forward the idea to forecast a hypothetical rabbit population’s rise. Fibonacci’s invention finds numerous applications in high-level mathematics and sciences over the past century.

Elliot wrote that stock prices obey the trend set by the Fibonacci series, but his method descriptions are inconsistent in certain details and do not specifically follow a Fibonacci analysis.

As mentioned above, Elliot believed that a market cycle will have five waves mostly bullish (i.e. driven by “impulse” waves) and three bearish (i.e. mainly “corrective” waves). It doesn’t say the first five waves will be evenly upward, followed by three downward waves. Rather, the first waves are a series of upward movements accompanied by comparatively shallow pull-packs. The market then peaks, accompanied by a phase of stock losses with brief bear rallies during which stocks reclaim some lost ground only to move to the downside.

By writing waves in cycles, which in turn are in greater cycles, and incorporating Fibonacci numbers into the debate, Elliot broke new ground. His basic concept wasn’t new, however. In reality, it’s typical Dow Theory as it reflects that a bull market would have a sequence of peaks that hit new highs, interspersed with falls that remain above previously lows, before the bull market peaks. At this juncture, some of the profits on the bull market will be surrendered (there will be a correction) as stocks dip, but with the downturn disrupted by a restricted bear rally (reaching a point below the previous high). Although conventional technicians describe this phenomena in terms of consumer psychology causing shifts in stock supply and demand, Elliot cited “nature laws” as reflected by, among other influences, Fibonacci numbers.

Wave theory was popularized by Robert Prechter, the editor of a finance newsletter, who made headlines after he accurately predicted the onset of the stock market in 1982. However, Prechter was blindsided by the October 1987 market collapse and further hurt his image when he later turned unnecessarily bearish, forecasting that the Dow Jones indices would bottom-out at lows not seen since the Truman Administration. Then Elliot’s renown was largely limited to engaged technicians.

Elliot took a very long-term view of trends, which may be quick to dismiss; after all, 200 years is beyond the worry of even the most steadfast “buy and hold” buyers. Nonetheless, Elliot wants credit to incorporate a broad historical approach to stock market research.

The theory that market fluctuations and other historical patterns shift in periods of years, decades, and even centuries now has a comprehensive literature. The leading proponent of this theory as it relates to economics was obviously Elliot’s contemporary, Nikolai D. Kondratieff, a brilliant Russian scholar, but Soviet authorities hijacked and shocked his study. They used Kondratieff’s work to spread the belief that capitalism’s days were numbered and silenced him in 1930 by imposing an eight-year jail term to escape any inconsistency. Shortly after Kondratieff’s 1938 release from prison, he was executed by firing squad at Stalin’s express orders.

A younger supporter of rather long-term periods is historian David Hackett Fischer. In a recent novel, The Great Wave: Market Revolutions and the Pace of History, Professor Fischer studied the historical literature on the topic and concluded that the rate of general inflation and economic health) can be forecast by a 14th century study of cycles.

Elliot’s research is incomplete in that it does not include a straightforward path as claimed (and I would contend that any such roadmap is impossible) and in many ways his writings are nebulous, inconsistent or non-objective. Nonetheless, Elliot extended the area of stock market analysis by introducing a very long-term historical outlook, and he also deserves praise for introducing Fibonacci numbers, which later became a fertile ground for investment research.