The Coming Collapse

According to economic theorists, investors think and behave "rationally" when buying and selling stocks. Specifically, investors are presumed to use all available information to form "rational expectations" about the future in determining the value of companies and the general health of the economy (1). Consequently, stock prices should accurately reflect fundamental values and will only move up and down when there is unexpected positive or negative news, respectively. Thus, economists have concluded financial markets are stable and efficient, stock prices follow a "random walk" and the overall economy tends toward "general equilibrium".

In reality, however, investors do not think and behave rationally when buying and selling stocks. To the contrary, driven by greed and fear, investors speculate stocks between unrealistic highs and lows. In other words, investors, misled by extremes of emotion, subjective thinking and the whims of the crowd, consistently form irrational expectations for the future performance of companies and the overall economy such that stock prices swing above and below fundamental values and follow a somewhat predictable, wave-like path (2). The wave patterns that emerge in stock prices, in turn, reflect general swings in the mood of society as-a-whole that precipitate the ups and downs in the economy called "business cycles" (3). (Footnotes and figure references are below.)

(For evidence of investors' irrational expectations, see figure 1a. To see how these mistaken expectations translate into systematic investing errors, see figure 1b. Click here for recent indicators of investor expectations.)

(For an excellent overview of investor irrationality, see the work of David Dreman. Dreman has popularized a "contrarian investment strategy" which involves buying and selling stocks when they become relatively under- and over-valued. This is done by tracking the price of stocks relative to stable measures of fundamental values like earnings and dividends. When stock prices become relatively low or high versus earnings and dividends, one should buy or sell, respectively. Applying such a strategy, an investor can systematically beat the market, i.e., achieve a higher return than would be possible from simply buying and holding. See figure 2 for evidence which supports Dreman's investment strategy and seriously calls into question the rational expectations and efficient market hypotheses of economics.)

One can get an idea of the cyclical nature of stock price movements by first considering "Dow Theory". At the turn-of-the-century, Charles Dow proposed that there are three types of stock market movements: the major trend, which can last over a year; a secondary or intermediate trend, which can move against the primary trend for one or several months; and minor movements that only last for hours or days. (4)

In association with Dow Theory, a sign that a turning point may be close-at-hand in the trend of stock prices occurs when "divergences" develop between the Dow Jones Industrial, Transportation and Utility averages. This happens, for instance, when the Dow Jones Average of Industrial stocks reaches new highs in the major trend while the Transports and/or Utilities fail to do so. For instance, prior to the last major decline (i.e., more than 10 percent) in stock prices in 1990, the Industrials average reached an all-time high of 3000 in July of that year while the Transports and Utilities did not; the Transportation index had peaked back in 1989 and the Utilities topped in 1988.

According to Dow Theory, stock market "buy-" and "sell-signals" occur when, usually following divergences, all the averages confirm a reversal in stock prices by reaching new highs or lows in the given trend, respectively. The value of this investment strategy is impressive and statistically significant. Between 1897 and 1981, an investor who bought and sold stocks according to Dow Theory buy- and sell-signals would have reaped a return more than nineteen times that achieved from buying-and-holding (5).

One should note that the reason the Dow Jones Industrial, Transportation and Utility Averages appear on top of each other in the Wall Street Journal each day is to reveal divergences and help investors determine Dow Theory buy- and sell-signals. Thus, Dow Theory, which has accurately predicted most of the major turning points in stock market history, uses information from historical price patterns to anticipate the future movement of stock prices; something most economists believe is impossible.

While Dow believed that there were three types of trends in stock market movements, during the 1930's Ralph N. Elliott, an accountant who closely examined long-run charts of stock prices, proposed that there is virtually unlimited bull and bear trends of differing scale (6). Specifically, he asserted that stock prices move in wave-like patterns that abide by fractal geometry such that any given wave-structure is composed of smaller wave-structures comparable to the whole. As can be seen in figure 3, any given cycle involves an uptrend ("bull" market) which consists of five waves, up-down-up-down-up, and a downtrend ("bear" market) consisting of three waves, down-up-down, such that smaller cycles make up the cycle as a whole. Likewise, each of the smaller cycles are comprised of still smaller wave patterns and so on and so forth. (For more information on the Elliott Wave Principle, you might check out the Center For Elliott Wave Analysis .)

Elliott's "Wave Principle" has several important tenets. First off, Elliott Wave uptrends and downtrends are supposed to develop within the context of upper and lower "channel lines" as shown in figure 4. Also, the third-wave in the uptrend is often "extended" as shown in figure 5. Lastly, corrections can take many different forms such as zigzags, double zigzags, flats, running corrections and triangles (see figure 6).

Elliott's Wave Principle was popularized during the 1980's by Robert Prechter, a Yale graduate who majored in psychology. In a book he coauthored with a fellow stock market analyst in 1978 called Elliott Wave Principle: Key To Stock Market Profits (6), Prechter anticipated the roaring bull market in stocks that started in the early-1980's. He then accurately timed most of the major twists and turns in the climbing stock market averages during the 1980's in an investment letter dubbed "The Elliott Wave Theorist" (7).

The reason Prechter achieved such success at calling the market is because a well-defined, large-scale Elliott Wave uptrend pattern has developed over the last 60 years-or-so that is nearing or past completion. This price pattern in U.S. stocks, which is shown in figure 7, developed in the wake of a 90 percent drop in stock prices associated with the Great Depression of the 1930's- a Supercycle bear market (note that the chart is logarithmic- the Wave Principle calls for this when working with long-term market periods). Thus, the rising price pattern over the past 60 years is an example of a Elliott Wave "Supercycle" bull market. As can be seen, since 1932 the DJIA has risen according to Elliott's five-wave uptrend pattern presented in figure 3. Furthermore, this pattern has developed inbetween upper and lower channel lines, has an extended third wave and involves a variety of corrections, just as the tenets of the Wave Principle predict (keep in mind that Elliott developed the Wave Principle during the 1930's and before the pattern in figure 7 developed). Notably, the upper channel line in figure 7, which is drawn through the major stock price peaks in 1937, 1962, 1987 and 1994, is almost exactly parallel the lower channel line drawn through the important lows reached in 1942, 1974 and 1982 (this pattern is also visible in a long-term chart of the broader S&P500 index). As should be clear, the well-defined Elliott Wave pattern which has developed over the last sixty-or-so years is inconsistent with the random walk stock prices are supposed to follow according to economists.

(One should note that the Supercycle pattern in stock prices from 1932 does not show the complete long-wave picture. In figure 7, (IV) & (V) appear at the bottom and top of the Elliott Wave uptrend, respectively. This is because the Supercycle run-up in stock prices since 1932 may have been the final, fifth wave of a "Grand Supercycle" bull market that started in the late-eighteenth century. The Grand Supercycle pattern in stock prices is visible in figure 8. What is even more alarming is that the huge Grand Supercycle upswing in stock prices over the last 200-or-so years might be the fifth wave of a Millenium Cycle upswing in collective expectations reflected in a long-run chart of the general price level for Western Civilization. This rising five-wave pattern is shown in figure 9. If, indeed, the top of the Supercycle being reached at present marks the completion of a Grand Supercycle and possibly Millenium Cycle upswing in market prices and people's expectations, then the approaching cyclical downswing and upset of prevaling expectations could very well be of biblical proportions.)

(For a recent article on a new book about the Elliott Wave Principle written by Robert Prechter, click here.)

A final example of how stock prices move in cycles that can be predicted based solely upon historical chart patterns is the phenomenon of "psychological barriers" in popular market averages. Major turning points in the wave-like swings of stock prices often occur around round-number levels, like thousand marks, in widely followed market averages like the DJIA. For instance, between 1966 and 1982 the DJIA climbed to the "Magic 1000" barrier on five separate occasions and then fell, on average, thirty percent over the course of a year-and-a-half (see figure 7). In July of 1990, this phenomenon repeated as the DJIA closed at an all-time high of 2999.75 two days in a row and then sharply reversed course, falling some twenty percent by October of that year (see figure 10). The last time a psychological barrier was reached in the DJIA was January of 1994 when the stock market peaked at the 4000 mark (see figure 11). Stock prices subsequently dropped almost ten percent into the spring and then struggled for over a year below Dow 4000 (8).

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In the same way there are different scale swings in stock prices as described in Dow Theory and the Elliott Wave Principle, there are varying scale cycles in economic activity. Economic observers have identified a 3- to 5-year Juglar cycle, 9- to 10-year Kitchen cycle, 16- to 22-year Kuznet cycle & 50- to 60-year Kondratieff "long-wave" (each named after their respective discoverer). Of these cycles, the Kondratieff Wave is of particular interest.

The Kondratieff Wave is a large-scale cycle in general prices that outlines changing conditions in the economy. As shown in figure 12, the first phase is a twenty- to thirty-year period of steadily climbing prices, stable growth and rising productivity. It is capped by a spike in general prices. The surge of inflation is eventually broken by the second phase of the Kondratieff Wave: a sharp "primary recession". In the wake of the primary recession prices stabilize and the economy enters a "speculative blow-off"- the third phase of the Kondratieff Wave. The speculative blow-off lasts a decade-or-so and involves price disinflation, general euphoria, heightened consumption and investment activity, risky speculation, excessive debt accumulation and other such financial excesses. The bubble eventually bursts, however, and the social mania is broken, usually starting with a sharp panic. A dramatic breakdown in sentiment and financial conditions hits society and a ten- to twenty-year period of general malaise and economic stagnation takes hold that is known as the "secondary depression". (9)

In American history, there have been three complete Kondratieff Waves and we are currently in the midst of the fourth. As can be seen in figure 13, the first wave started in 1789 and peaked in 1814 along with a price spike stemming from the War of 1812. Following a primary, post-war recession, an "Era of Good Feelings" took hold that was eventually broken by a secondary depression that lasted until 1843.

Following the low of 1843, the second long-wave began and brought prosperity up until an inflationary spike in 1864 associated with the Civil War. The price spiral was broken by a primary recession, and a disinflationary boom got underway in conjunction with the "Reconstruction" and "Railroad Prosperity" following the Civil War. In 1873, there was a severe financial panic and the economy sunk into a lengthy secondary depression that lasted until 1896.

After 1896, the third Kondratieff upswing got underway. It peaked in 1920 along with a sharp spike in prices following World War I. As interest rates shot up to historic highs, a sharp primary recession hit between 1920 and 1921 and the spike in inflation was broken. Thus began the epic disinflationary boom of the "Roaring Twenties". The pervasive euphoria, reckless speculation, and careless overindebtedness of the 1920's ended rather abruptly in 1929 with the Great Crash on Wall Street and the beginning of the Great Depression.

After the long-wave bottomed in 1937, another Kondratieff wave upswing got underway. Between the late 1930's and the 1970's there was a broad upswing in economic activity and prices. This topped-off with a severe inflationary spiral during the late-1970's and early-1980's. Surging prices were halted by a severe primary recession between 1981 and 1982 during which the discount rate peaked at a historic extreme of 14 percent and unemployment rose to its highest level since the Great Depression. With the spiral of inflation broken, a disinflationary plateau phase got underway along with a classic speculative blow-off which continues to this day.

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An important implication of the wave patterns in stock prices and economic activity overviewed above is that society is currently at a historic cyclical turning point.

First off, a large-scale Elliott Wave uptrend in stock prices that started in 1932 appears to be near or possibly just past completion. This implies that a bear market may be approaching that will be at least as severe as what occurred after the 1929 stock market peak, i.e., one should expect an approaching drop in stock prices of ninety percent or more.

That an important turning point in the stock market might be close-at-hand is made more clear by Dow Theory and the psychological barrier phenomenon. At the present time divergences are visible between the various indexes which suggest a major trend reversal is near. First off, while the Dow Jones Industrial Average has been making all-time highs over the past several months, the Utilities average has not made an all-time high since October of 1993. Furthermore, while the Transports have confirmed recent highs in the DJIA, this has happened belatedly. The Transports had peaked back in January of 1994, and, while the DJIA was making new highs between March and July of this year, the Transports were still not in record territory. Thus, divergences between the Industrial, Transportation and Utility averages have developed that often forewarn of important stock market turning points.

Another warning sign that stock prices might be near a critical top is that the Nasdaq Composite index of over-the-counter (OTC) stocks is around the psychologically important 1000 mark (see figure 14). The Nasdaq Composite, which now receives a good deal of attention since trading in OTC stocks is today *heavier* than trading on the New York Stock Exchange, recently breached the 1000 mark. After the first day the Nasdaq Composite closed above the 1000 mark, there was a dramatic reversal and the index fell over five percent in less than two days. OTC stock prices have come back, however, and Nasdaq 1000 was substantially penetrated in recent weeks. Possibly the situation is similar to the euphoric 1973 top in the stock market when the DJIA climbed some five percent above the Magic 1000 mark. Following that high-point in investor expectations, the worst bear market since the Great Depression took place that carried stock prices down over forty percent.

While the Nasdaq Composite index has apparently cleared the 1000 mark in a significant way, the Dow Jones Transportation average may not be so lucky. This week the Transports reached the psychologically important 2000 mark and have since sharply reversed course. As can be seen in figure 15, the Dow Jones Transportation index reached the 2000 mark for the first time in history this week. Similar to the peak in the industrials at 2999.75 in July of 1990, the Transports closed at an all-time high of 2000.39 on Monday (9/18/95) and have since dropped over 50 points. Thus, one possibility is that the overall stock market is currently topping-out with a reversal from the 2000 mark in the Dow Jones Transportation Average. (Click here for updated graphs.)

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Clearly any reversal in stock prices here must be closely watched since it might involve a panic and signal the beginning of the Kondratieff Wave "secondary depression" that is now due. The excesses from the speculative blow-off that has been underway since the early-1980's may soon be paid for in a painful way. A turning point in stock prices at this point could be as important as the top which was reached in early-September of 1929. As is mentioned above, following that peak the Great Crash occurred and the American economy collapsed into the worst depression in history. Thus, as suggested by large-scale wave patterns in market prices, another severe breakdown in collective mood could be near-at-hand.

If another major collapse in investor expectations and social mood is coming, then we are currently in the season when it is most likely to begin. Historically, the spring and fall are the seasons when financial panics occur that typically mark the beginning of major bear markets and Kondratieff Wave depressions. In fact, there are only three months that stock prices fall on average: May, September and October (see figure 16). Furthermore, the worst stock market crashes in history have almost all occurred during the spring and fall. For instance, the historic '29 and '87 crashes both occurred during September/October as well as the less noted autumn crashes of 1873, 1947 and 1989. As for the spring, the most famous example was the Panic of '62. That the spring and fall are bad seasons for stocks seems particularly evident during the last decade. Of the five major drops in stock prices over the last ten years, all occurred into the spring or fall. The stock market declines in 1987, 1989, 1990 and 1992 all bottomed around October whereas the most recent decline in 1994 bottomed in April and then again in November.

Notably, the seasonality of stock price movements and the associated swings in the mass mood of investors is the same as the seasonality of mood swings in "manic-depressive" (bipolar) mental patients. (see the diagram below the table of monthly stock price changes in figure 16). The spring and fall are the periods when major depression typically hit (the suicide rate peaks in May and October), summer is most likely to be when patients suffer mania and the winter could go either way. Likewise, while the spring and fall are when the stock market is most likely to decline, there is usually a "summer rally" and rising stock prices associated with the "January Effect" each year. Thus, instead of rationality, efficiency and price stability on Wall Street, what prevails is more like a form of social insanity.

All in all, following a huge run-up in investor expectations and stock prices over the past several months, years and decades, a critical cyclical top may be near that will be followed by a collapse in mass mood and social depression. This breakdown, the likes of which the world has not experienced at least since the 1930's, could begin this fall in the wake of stock prices peaking above the psychologically important 1000 mark on the Nasdaq Composite index of OTC stocks and the 2000 mark on the Dow Jones Transportation Average.

UPDATE (4/18/96): The stock market continued to reach record highs through the seasonally dangerous September/October period and climbed well above the 5000 mark to above 5600 this year (click HERE for an updated graph of the DJIA). Likewise, the Transportation average breached the 2000 mark by some ten percent, climbing to all-time highs above 2200 in recent months. Most recently, the DJIA reached a record intraday high above 5700 with a Spring Equinox/new moon/five-planet alignment on March 19th/20th. The Dow then reversed a little and rebounded to an all-time closing high with a Passover/full moon/lunar eclipse on April 3rd that was of great Spiral Calendar significance (see my 1996 Peak Alert). Notably, both the planetary alignment and lunar eclipse highs in the DJIA were not confirmed by all-time highs in the other major indexes like the Transports, Utilities and S&P 500. Thus, the final Grand Supercycle peak may have finally been reached and a historic collapse is now getting underway that might involve some sort of Spring crash (keep in mind the suicide rate peaks in May).

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1. For the academic view, see:

Sheffrin, Steven. Rational Expectations. Cambridge, UK: Cambridge University Press, 1983.

For the truth, see the work of David Dreman:

2. This is particularly the conclusion of Robert Prechter, the Elliott Wave Theorist. At the end of his newsletter, the following explanation of the Elliott Wave Principle appears:

3. Major reversals in stock prices are one of the best leading indicators of turning points in the economy.

4. Pring, Martin. Technical Analysis Explained; 1985.

5. Ibid.

6. Prechter, Robert and A.J. Frost. Elliott Wave Principle: Key To Stock Market Profits. Gainesville, GA: New Classic Library, 1985.

7. New Classics Library; Gainesville, GA.

8. See: Kansas, Dave. "Dow Industrials' failure to break 4000 barrier stiffens bears' doubts", 9/19/94; p.C1 & "Once again, Industrials close in on 4000 barrier", 2/6/95, p.C1 in the Wall Street Journal.

9. Berry, Brian. Long-Wave Rhythms in Economic Development and Political Behavior. Baltimore, MD: Johns Hopkins University Press, 1991.

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1. (a) & (b) Tables & graphs from Martin Zweig's Winning On Wall Street, 1990.

2. The price-to-earnings table is from David Dreman's New Contrarian Investment Strategy., 1982. The dividend yield table is from Norman Fosback's Stock Market Logic, 1984.

The PE ratio graph is from a recent issue of Martin Zweig's newsletter.

3. Prechter, Robert and A.J. Frost. Elliott Wave Principle: Key To Stock Market Profits. Gainesville, GA: New Classics Library, 1985, p.22.

4. Ibid.; p.63 (slightly revised).

5. Ibid.; p.28.

6. Ibid.; p.54.

7. From the March, 1994 issue of Robert Prechter's Elliott Wave Theorist investment letter (graph is revised and currently not consistent with the "wave count" being used by Prechter).

8. From a May, 1993 Elliott Wave Theorist special report.

9. From Prechter & Frost, 1985; p.122.

(The price index was compiled by Professor E.H. Phelps Brown and Sheila Hopkins and further enlarged by David Warsh. It is taken from "The Great Hamburger Paradox," which appeared in Forbes magazine, 9/15/77.)

10. From the Wall Street Journal.

11. Ibid.

12. See, for instance: Duijn, Jacob. The Long Wave in Economic Life. Boston, MA: Allen & Unwin, 1983.

13. Prechter, 1978; p.148 (slightly revised version).

14. Chart from a recent issue of Investor's Business Daily.

15. Ibid.

16. The top table of stock market seasonality is from Martin Zweig's Winning On Wall Street (1990), p.168.

The bottom diagram of annual swings in the mood of bipolar mental patients is from Frederick Goodwin's Manic-Depressive Illness, 1990.