Prechter's Elliott Waves Foretell Doom -- After a Nice Little Rally

Here's the second part of the Q & A with Robert Prechter, president of Elliott Wave International and an authority on Elliott Wave Theory, a controversial form of technical analysis based on the notion that the collective mood of investors is the prime mover of financial markets. For a discussion of the basics, have a look at last week's column. Here Prechter answers the theory's detractors and then offers his outlook for stocks in the months and years ahead. Some responses have been condensed to conserve space and to make his views more accessible to novice investors.

Elliott Wavers strike me as being like a group of critics gathered around an abstract painting, each with a different opinion about its meaning and each certain that his is the correct view. Because of its reliance on interpreting the look of chart patterns, is Elliott Wave Theory less rigorous than other forms of technical analysis?
No, it's way more rigorous. But it's also complex, and some people take shortcuts and don't put in the work. Also, as with all market approaches, its results are probabilistic because that's the world we live in.

But let's not use a double standard. Thanks to countless differing interpretations, there are no one-armed economists. To people who complain about uncertainty under wave analysis I always ask, "Compared to what?"

I understand there are rules to the way patterns are categorized, but there still seems to be a lot of gray amid the black and white. Doesn't that leave conclusions susceptible to observer bias, perhaps subconsciously?
Of course; herding impulses impact Elliott wave analysts, too. But the bigger problem is that many analysts ignore wave rules and guidelines, or they reason from outside factors to what the wave count "should" be. Predicting the next wave takes substantial knowledge, skill and experience.

The decline in stocks that began in 2000 looks to my untrained eye to have unfolded in three clear waves, suggesting that it's corrective and therefore the prologue to a major rally, yet you expect substantially lower prices. What do you see that I don't?
That period in isolation can be interpreted that way, but in April 2007 I showed three different ways to label the bull market from 1974-1982 to the highs of 2000-2007. All of them were terminal.

This is also where technical indicators come in: Dividend yield is 3.5 percent; the price-earnings ratio is 60, and mutual funds hold less than 6 percent of their assets in cash. Every one of these indicators has a multi-decade history, and their current readings better fit previous major market highs than lows. Nothing is impossible, but the question is what side to bet on, and for me at least, the answer is clear.

As stocks headed toward their recent low, commentators started using florid phrases like "the Greatest Depression" to describe the economy. Doesn't that reflect the sort of apocalyptic sentiment that occurs near a multiyear bottom?
Wasn't it great? After telling people to hold onto stocks all the way down, suddenly in February some of the most famous investors in the world started saying that the economy was a disaster. People got so bearish that the Daily Sentiment Index got down to just 2 percent bulls among traders, an all-time record. That was the sort of sentiment that helped prompt us to recommend covering all our short sales and call for the largest rally since the bottom, which is working out well. But no, I don't think we saw a bottom leading to a multiyear advance. The recent top is like a combination of 1929, 1835, 1720 and the Nikkei in 1989. It's big.

What signs should investors look for that the rally is close to running its course?
It should unfold in three waves or a combination thereof. It should retrace 30 to 60 percent of the decline, and it should bring a return of optimism. The higher it goes, the more likely we are to hear that March marked the end of the bear market, the government's stimulus package worked, the Fed has been successful at re-liquefying the banking system, the economy is turning up, Barack Obama is an effective president etc. But the next down wave will be a third wave, and they are more severe than first waves. So don't get fooled by the optimism, and don't get caught in the next wave down.

What would make you change your mind and become a long-term bull?
As soon as the market completes five primary waves down and the long-term technical indicators turn bullish, that will do it. That's when we should be able to buy stocks and watch them go up 40 times in value in a year or two. Until then, stay safe.

You've said similar things before and it kept your subscribers out of the stock market when it was making strong, healthy gains, during much of the 1990s, for instance.
I would point out that strong does not mean healthy. When oil went from $10 to $60, it was strong and healthy. When it went up to $147 in the first half of 2008, it was strong but not healthy. The stock market's rise in the last half of the 1990s was deeply unhealthy. Only the tulip bulb mania of 400 years ago came as close to overpricing an investment. As investors in the formerly "strong" market of real estate are finding out, the final run was a credit-fueled house of cards. All these seemingly "healthy" patients were wracked with cancer, but no one knew it. The bigger sin is not bears missing a run-up in an overpriced market but bulls keeping clients in an overpriced market that is about to crash. If the mania resumes, I assuredly will miss it. But I'm confident that we will be buying stocks at truly bargain prices a few years from now.

Let's put it another way: What would it take to get you to concede that you're wrong this time?
A move above the 1999 high in the Dow or S&P in real-money (gold) terms. Or the appearance of Genghis Kahn on the Capitol steps, whichever comes first.