Follow The Market Herd With Elliott Wave

Of course, there’s an outside chance you’ll uncover a stock that is going to explode regardless of what the market is doing. But there’s also an outside chance you’ll find a briefcase full of money. It might happen, but in both instances, it’s not something you should bank on.

The real key to successful investing is determining the direction of the market current and swimming in that direction. The majority of stocks will move with the market, so if we can figure out where the market is headed, finding winning stock investments becomes easier.

Fortunately, market direction is not a function of the newswire; much greater forces are at work. The stock market, like anything else that involves millions upon millions of people, is subject to a herd mentality. You’ve most likely read that you don’t want to be a part of the herd when it comes to investing because the herd is usually wrong. That may be true, but that statement misses the real value in understanding herd behavior.

The real value lies in the fact that herd behavior is predictable. Herds repeat the same behavior over and over again. Like human nature itself, the way herds behave cannot be changed. That is exceptionally valuable information when it comes to investing in the stock market, so much so that we can use it to classify where the stock market has been, and also to determine where it is going.

Let’s look at the anatomy of a new downtrend to illustrate how the predictable herd behavior plays out. It starts with the completion of an uptrend and a small decline that only a few investors take seriously. This initial move is wave 1. The underlying momentum has changed, but this is the last thing on most investors’ minds since the rosy times of the uptrend are still fresh in their minds.

Once the initial decline runs out of gas, a small advance appears that we’ll call wave 2. This advance has most investors thinking that the uptrend has resumed and the recent decline was only there to refuel the uptrend. This creates the ideal environment for the new downtrend to pick up steam. The small rally fades, ushering in the heart of the market descent. This is wave 3. A big down move takes place, and it grabs the herd’s attention. This is when most investors take notice and behave accordingly. This only adds fuel to the fire as market participants go about shorting or selling into the growing downtrend.

The decline resumes, allowing the slowpokes who missed the last down leg to get involved. This final phase of the decline is wave 5. It continues only as long as new participants are willing to get involved in what is now a well-established downtrend.

Most investors believe that the downtrend will continue, leading to a very high level of bearish sentiment. The move has exhausted itself. The early arrivals are already invested, as are the trend riders and latecomers. Absent any new participants, the downtrend finishes and a new uptrend begins, following the exact same progression.

Why does this progression keep repeating? Because it’s human nature. The headlines change, monetary policy changes, most things change; human nature, however, does not. The Elliott wave theory is based on determining the market’s location within this ever-repeating five-phase pattern. If that can be determined, then we will know exactly where the market is headed.

This is more than just some theoretical mumbo-jumbo. Look at a chart of the 2007 to 2009 decline in the Dow Jones Industrial Average (DJIA) in Figure 1 to see how this five-wave progression looks in the real world.

FIGURE 1: FIVE-WAVE DECLINE. The Dow Jones Industrial Average followed a textbook five-wave Elliott wave pattern during the 2007–09 bear market decline.

FIGURE 2: FIVE-WAVE ADVANCE. The 2009–10 advance also followed a very clear five-wave progression.

FOLLOW THE HERD
The market adage “Beware the stock market herd” may have the right intentions, but it misses the point. By identifying the repetitive and predictable behaviors of a herd, we can determine where the stock market is headed. This, in turn, allows us to make the timeliest of investments.