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The Elliott Wave Theory and Long Term Market Cycles



This post is part of our mini-series on technical analysis which covers exactly how this material might show up on the Level 1 CFA exam.

In our last three posts we covered the 4 major charts used in technical analysis, then dove into how to interpret the major types of chart patterns before turning to cover the other major technical indicators used.

This post rounds out the series by talking about the Elliot Wave Theory, which is a long-term technical explanation for market cycles.

How does the Elliot Wave Theory fit into Technical Analysis?

Before we get into specifics, however, recall that proponents of technical analysis believe that the chart of a securities price over time conveys a real-time snapshot of supply and demand and hence encapsulates the necessary information to predict future prices. Put differently, since price and volume are the representation of the collective action of buyers and sellers it tells you everything you need to know about the market.

A lot of the technical trading reports, research etc that you see refers to technical analysis as a short-term trading strategy.

But many proponents of technical analysis actually argue that markets generally operate in long-term cycles (much like many natural phenomena).

Some examples of cycles thought to impact the markets include the presidential cycle, the decennial pattern and the Kondratieff Wave (54 year up-cycle). Note that because many of these cycles are long the sample size presents a serious constraint (and different cycle theories can conflict).

The most important and most likely to be tested long-term cycle is called the Elliot Wave Theory.

What is the Elliot Wave Theory?

The Elliot Wave Theory predicts that markets move in a series of regular and repeated waves or cycles. The basic pattern consists of eight waves—five up waves and three down waves (or vice versa). Each of those eight waves is in turn composed of smaller yet identical waves.[1]

 Elliot Wave Theory on the CFA Exam

The size of the waves is supposed to correspond to Fibonacci ratios which technical analysts use to forecast price targets. (Note for L1, be broadly familiar with the Fibonacci sequence).

 

[1] http://www.forexhit.com/images/basic-elliott-wave-pattern.gif