Saturday, February 13, 2010

Waves, Markets and the Confidence Game

There is a school of thought that sees clear patterns in economic activity, especially as measured by markets in stocks and commodities. One group coalesces around the Elliott Wave Principle. 

In the 1930s, Ralph Nelson Elliot, an American accountant, observed that markets move in clear cycles, commonly called Elliott waves. His analysis identified the key attributes of these cycles -- dominant-trend 5-wave patterns and corrective-trend 3-wave patterns. Moreover, this pattern self-replicates fractally as you move to larger or smaller time scales, from minutes to centuries. The patterns themselves, as it turns out, also reflect some interesting mathematical affinities: fibonacci progressions and golden ratios. 

To his credit, Elliott did not try to identify a cause, other than a collective human personality, or "mood", that reflects the cycles and mood swings of countless individuals. He accepted the fact that the entire system was massively complex, chaotic even, and the cycle was way bigger than any individual actors. His goal was to build in a certain patience, as observers use an understanding of the cycles to pursue their own ends.

In the ‘70s his work was rediscovered by Robert Prechter, a trader at Merrill Lynch, who published Elliott’s findings and became an important theorist for the stock market for the last three decades.

What really interests me about the Wave Principle is that it assumes the dominant role of the collective (un-)consciousness, and that the market indices, like the Dow, are accurate indicators of the general mood.

In the online journal The Scionomist ( , an article I found by Euan Wilson, "A Parting of Peaceful Ways: A Socioeconomic View of Civil Wars," correlates market performance and/or GDP per capita to major social events, like civil wars, back as early as 1695 (pretty much the beginning of capitalist markets). The point was that major disruptive events, like wars, follow market declines, and declines follow gains. And that these declines are then manifested in popular fashion and entertainment (“news”), and then, eventually in indicators like peace and war. 

The cycles work in both directions, in terms of mood, in a dynamic pattern: every movement is a correction, positive to negative to positive, down to the smallest scale. If you get the scale right, you might have a picture of the next week, or decade, or century, and place you bets accordingly. Wilson also recreates Robert Prechter’s timeline for these peaks and valleys stretching  back to 0 AD.

I can not judge the accuracy of Elliott’s theory or Wilson’s vision, either as a look backwards or as it comments on our current situation and outlook. In the numbers-driven world of financial markets it seems to have been well tested and is still highly regarded. That said, I’m still not sure that it doesn’t work better after the fact than as a predictor. Or wouldn’t there be a sizable group of people who made a lot of money on this last finance kerfuffle? Oh, wait, there were some people who made a LOT of money on the “meltdown,” weren’t there. Lol.

Looking at these graphs, it’s hard not to think that the “market” is not just analogous to the general mood, it is inseparable from it. The larger the market, the more widespread the cycle. As soon as Rome started to depend on grain from Egypt and other colonies, it was pretty much downhill for the Empire. A bad harvest on the Nile affected the price of grapes in Germany, as well as confidence in the future. "Maybe those barbarians at the gate wouldn’t be such a bad change." Enter, stage right, Dark Ages.

I also get from these graphs that the trend is remarkably up. There is something that drives human beings to consume more, to have more. We have not got past the lesson of the cave: life is fragile and we are in a constant battle for an advantage just in case the harvest does fail. And the cycles tell us the harvests will fail, sooner of later. The models also suggest that this particular crisis has a long way to fall to actually reset to Zero.

By the way, other research I’ve done into these cyclical patterns suggests that perhaps an even better indicator than the Dow or S&P indices might be the ratio of employment to population. Not many of us actually buy or sell equities, but we are all aware if we are employed or not. And it might give us a more meaningful metric in this oxymoronic “jobless recovery.”

In the meantime, this constantly competitive market means there always losers as well as winners. And concentrations of capital mean many more losers, though in capitalist democracies there is also turbulence, so even a loser might think he’s going to be a winner in the future. 

And, that I think, is the driver behind public “mood” -- Confidence. As in, this is in fact a confidence game. The declines we see in financial markets are closely related (if not identical) to confidence in the future -- "this time the lottery will give me what I deserve." So what disruption are we heading for? What sack of Rome awaits us?

I didn’t find much idea in that article of what we should actually do if we do recognize the current trend as a decline. But another Socionomist article, “Sports Scandals and Signs of Shifting Mood” by Gary Grimes, might give us some guidance. Especially if we are celebrities.

Grimes starts by tracking the Tiger Woods story, and especially the point that a number of people knew something about Tiger’s extra-curricular sex life five or six years ago, but the stories never gained any traction with the press or the public until recently. He also makes the point that Tiger began to lose endorsements after the stock market started its decline in 2007. People in a more negative mood were more willing to believe the worst and so his current crisis is another reflection of the deepening bear-market mood.

In fact, Grimes sees a general trend of disillusionment with sports and its stars tracking the emergence of the down market. And he points to one star -- Andre Agassi -- who played the cycles in significant ways. In the bear-market ‘80s he was the wild-child rebel. As the market turned positive he wore white at Wimbeldon and founded a charity. And now he’s back with a tell-all autobiography just right for declining market -- sex, drugs and attitude. Grimes’ advice to Tiger is to consider toughening up the ol’ image, Tiger as predator, perhaps (like the recent Vanity Fair cover shot?).

My advice would be aimed more at the political arena. If we see this as a period of decline, then we understand the appeal of any mad-as-hell rabble rouser. That’s how Obama ran, even if he was an unusually academic sounding rabble rouser. So all that anger may be swirling around out there, and while it hasn’t yet coalesced around anything, it doesn't need to coalesce to disrupt. The wave theory tells us increased bad news will give more credence to somebody who can focus that disaffection. So, we're looking at either chaos or a despot.

Looking at the data, the only thing that really matters is the public mood, and the one way to swing public confidence is to increase employment (and not necessarily GDP, for instance). That would be good for incumbents, and for the country. But for the current opposition party what’s good for the country would be bad for their ambitions, and would be playing against the cycle. And I think we can see how that’s working.

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