Why Prechterian Theory is Wrong on Gold

Under the rules of Elliott Wave analysis, a bullish trend is determined by the fact that the price being charted forms 5 waves in an upward direction. The price movement is comprised of three "impulse" waves and two "correction" waves, alternating in a sequence of Wave 1 up, Wave 2 down, Wave 3 up, Wave 4 down, and Wave 5 up. Once completed, these five waves are then termed a major impulse wave.

This sequence is imperative in order to establish a bullish trend. If the pattern does not unfold in three waves up alternating with two waves down, then it is not an impulsive wave pattern, and a bullish trend has not been established.

For example, if the wave sequence unfolds in a 3-wave pattern up, it is defined as a "corrective" wave, which means that the primary trend down previously in progress is merely correcting, and soon to be resumed. Corrective waves can assume numerous different patterns, and are often quite messy and difficult to identify. Their defining characteristic, however, is that their major legs always form three waves rather than five. I realize this is a very rough explanation of Elliott Wave price movement theory, but all Elliott Wavers will know what I'm talking about.

The important point for gold in all this is whether Elliott Wave theory shows the 20 year bear market from 1980 to 2000 to be ended, or is gold's bear market merely correcting, and doomed to be resumed eventually finishing at a lower price down the road? If the last two years of price action has formed a solid impulsive wave up, then the bear market is over. If, however, the price action is forming a corrective wave up, then the bear market is to be resumed.

The foremost practitioner of Elliott Wave theory, Robert Prechter, has stated for the past two years now that gold is merely correcting. The wave pattern up throughout 2001 and 2002, he maintains, is not impulsive. It is a corrective wave only, and the 20 year bear market will continue on in the deflationary Kondratieff winter, with gold eventually selling for under $200.

I am not a card carrying expert in Elliott Wave theory, but I do understand its basics, having read most of Prechter's books and having charted countless wave patterns of the Dow, the S&P, the Dollar, Gold, and Silver, etc. in the markets for the past seven years. I have the utmost respect for Robert Prechter. His work over the past 25 years in formulating a cogent exposition of Elliott's theory of price movement is a masterpiece of clarity and understanding. He has integrated it all into the Kondratieff Cycle theory, and has added a vast array of prescient insights to further the body of knowledge that Elliott began. This has enlightened us all in many ways.

But that being said, the primary question is whether gold's bear market is over. The question is whether the wave pattern for 2001 and 2002 is impulsive or corrective. Is Mr. Prechter right, or has he perhaps succumbed to a flawed analysis of what is taking place today? I believe it is the latter, that he has made a wrong call on gold, and that the price action of the past two years is indeed impulsive.

To get a better grip on this, we need to view the chart pattern of gold on a monthly basis. Below is a clear depiction of it that appeared in John Murphy's January 27th article here on Gold-Eagle entitled, "Gold Bull Market is Based on More than Iraq." It shows prices forming a double bottom in August of 1999 and April 2001, and then an upward 5-wave pattern that is bullish, i.e., impulsive beginning from there.

Price waves, of course, can be interpreted in numerous ways depending upon who is doing the interpreting. But I think we can find an impulsive technical pattern here that, when combined with the fundamental picture for gold, becomes pretty much irrefutable.

If we consider the above price pattern as a double bottom, then impulse Wave (1) up begins in April of 2001 at $255 and takes us to about $290 during the month of May 2001. Correction Wave (2) then commences and takes prices down to $265 by July of 2001. From there, a subdivided impulse Wave (3) begins and takes prices to $330 in June of 2002. From there, correction Wave (4) commences and takes prices back to $298 in August of 2002. From there, impulse Wave (5) begins and takes prices to the $360-$370 range that we are now in.

This is as clear a 5-wave pattern as any chart technician could ever ask for. It is a perfect 5-minor waves up, which will form major Wave 1. The entirety of major Wave 1 is either ending now (and due for a correction), or it is still unfolding with its fifth segment perhaps due for some more upside movement, maybe even as high as the $400-$410 area before correcting down, and then heading up again for major waves 3, 4 and 5. This is James Sinclair's reading on it, and it makes for a powerfully bullish case in a technical sense.

The importance of this is that the price action is IMPULSIVE! It is comprised of five clear waves rather than three. We have the beginning of a bull market price pattern that adheres to the rules of Elliott theory. It confirms technically the clear bullish fundamentals that have been unfolding for the past several years.

The only technical foothold that Prechterians have to cling to for their bearish case is if the entire price movement from August 1999 to January 2003 can be construed as an A-B-C correction. This, I am assuming, is how they read the price action of the past three years. If one looks at only a chart and its configurations, then this is one possible interpretation. But why use only a chart and various technical indicators for one's guidance? Are there not other tools to incorporate into one's analysis that will clarify whether gold's price action is corrective or impulsive? When the waves indicate that either scenario could be unfolding, is there a way to determine which one has greater probability? Yes, there most indubitably is. We must examine the fundamentals. What they are indicating will confirm the wave pattern as either bullish or bearish, which will give us much more certainty.

Fundamentals Versus the Technical Charts

This brings us to one of the most important issues in market forecasting -- the question of whether we should place more importance on the fundamentals of the market, or whether we should concern ourselves more with the technical chart patterns. Which methodology is the better tool with which to get a handle on future price action? And do we dare rely solely on one or the other? This debate has been waged over the past century by many colorful and profound intellects, and it no doubt will continue to be debated well into the future.

Many technical advocates (e.g., hedge funds) actually pride themselves on being totally unconcerned with "fundamentals." They churn out prodigious amounts of numbers from their computers, which guide them in their decisions. They don't care what the fundamentals are, because they feel the fundamentals are far too convoluted a mess for any human to interpret effectively and incorporate into a workable strategy. Mathematics, being clean and simple, is their chosen tool; and their little computer boxes automatically make their decisions for them. This eliminates the subjective element of the human mind and makes for a much more workable forecasting tool.

Many fundamental advocates think just the opposite, and maintain that all the fuss over technical charts is either pure subjectivist hooey if humans have to interpret it, or such information is just too late in coming to the investor to be of any meaningful use in fast changing markets. Such advocates prefer to concentrate on getting a grasp of the major fundamentals of the market in which any particular investment operates (e.g., supply and demand, corporate earnings, Fed policy, geopolitical concerns, etc.), and then to buy or sell according to what the sum of those fundamentals indicate. Only in this way, they maintain, can one make adequate decisions as to future price movements.

I myself am basically a traditionalist, and believe that fundamentals are the more important tool. They must always be taken into account first, and then if one wishes, he can supplement his strategy with chart analysis. Technical chart analysis is a marvelous way to get an overall picture of where one is in any price movement scenario, and there are numerous chart theories complete with dazzling indicators to pick from, Elliott Wave being one of the best. But technical wave analysis ALONE is like trying to sail the oceans with a map indicating islands and reefs, but without a radar system to be forewarned of impending storms and icebergs. (We will come back to this map vs. radar example later, so remember it.)

Both methodologies are necessary if we are to really achieve high accuracy. But fundamentals always come first. Know the supply and demand configurations, get a grasp of what the Fed and the monetary authorities are doing, stay abreast of the relevant geopolitical events, etc. and one can quite often pull off profitable trades and investments.

Gold's Bullish Fundamentals

This is why gold has such powerful potential at this juncture in history. Its fundamentals are incredibly bullish: 1) There is a deficit every year in production, so the supply and demand ratio is favorable. 2) The Fed has indicated that it will print up paper dollars and drop them out of airplanes if necessary to avoid deflation. 3) Our nation is running the largest trade deficit in history. 4) Congress has embarked upon massive deficit spending. 5) American citizens are in debt up to their eyebrows. 6) Many major banks are involved in highly dangerous derivative trades that could come unwound. 7) Terrorism grows with every year to wreak havoc in the minds of investors and create a world rife with insecurity. 8) Third-world countries are honoring their debts like Hollywood stars honor their marriages. 9) We are no longer a producer nation, but a mass of pampered consumers with a gang of counterfeiters leading us from Washington. 10) The dollar has entered a bear market that should extend for several years. The chain of bullish fundamentals acquires new ominous links with each passing month. It points to $500-$600 gold near-term, and quite possibly much higher long-term.

But still, there has always remained in the back of many investors minds who follow Elliott Wave analysis, a fear of the bearish scenario that deflation portends. With Prechterian newsletters shouting every week for the past two years that "Gold is topping," and maintaining that the upward waves of 2001 and 2002 are "clearly corrective," these investors have remained pulverized on the sidelines, and some of them even short in the market.

In my opinion, this is clearly wrong. The chart above (when combined with all the fundamentals of gold) strongly indicates that the upward waves of 2001 and 2002 are NOT corrective; they are impulsive. The bottom for gold is in. We have a bull market. It will be volatile and messy. It will involve corrections that drive us to despair. And it will climb an endless wall of worry. But we have the beginnings of a classic bull market.

Only if we combine the fundamentals and the technical chart data, however, can we arrive at this much certainty. Since Prechterians do not believe in the importance of fundamentals, they cannot see this certainty. Thus, they interpret the price action over the past three years as corrective with the bear market to be resumed. This kind of sole reliance upon wave patterns and technical indicators is like going into a fight with one hand tied behind one's back.

Is there anything that could possibly sabotage the bullish case for gold? Yes, if the dollar somehow rallies because of severe deflation in the upcoming years. This is a possibility, of course. But it is difficult, in face of the Fed's announced intentions recently, to envision any kind of sustainable rally for the dollar. Unless the Euro and the Yen somehow start depreciating faster than the greenback, it looks like 70-75 on the charts for Greenspan's "US Peso." The rest of the world's nations will probably embark upon a rash of competitive devaluations in the upcoming years so as to try and achieve an advantage over their neighbors in the export business to the US. But will they be able to outpace the dollar in depreciation, thus creating a sustained dollar rally? Highly doubtful. America's trade deficit will force the Fed to compete in the depreciation game. This will put all major currencies into the toilet, and it will push gold upwards to $500-$600, and then who knows how much higher?

Understanding the Primary Causes

To the Elliott Wave purist, such fundamental events are superfluous and irrelevant. The waves are all that are important. They indicate the future and are brought about by the psychological mood of investors. This latter point is certainly true. Investor mood moves the market and determines the wave patterns that prices take. But what is it that causes the psychological mood of the investing public? It is not a given. It doesn't exist as a primary. Investor mood is caused by something. In my opinion (and in the opinion of a whole bevy of highly astute analytical minds going back many decades), investor mood is brought about by a myriad of fundamentals acting upon the human minds that comprise the marketplace. It is the summation of all these various fundamentals in the millions of investor minds every day (supply and demand, corporate earnings, monetary growth, Fed policy, wars, tragic events, corruption, debt overload, etc.) that determines the mood of the investing public. This psychological mood does indeed form waves, and therefore it can be charted. But it is not primary! It is derivative. That is to say it is derived from the fundamentals that comprise everyday life.

According to Prechterian theory, though, it is just the other way around. As Prechter sees it, fundamentals are brought about by the "psychological mood" of the public. Thus, Elliott practitioners' insistence on charting this mood via wave analysis. They maintain that they are tapping into the primary force of the market with their wave counts, and that this will lead one to the best possible forecast for future price movements.

But if this is so, then they still have to answer the question, what causes this psychological mood? And once that cause is identified, would it not then be the real "primary" force to tap into? All phenomena of the universe are caused by something. They do not exist axiomatically. They are brought about by preceding causes. This is basic science -- cause and effect. It extends to all phenomena of the universe. Therefore, Prechterian theory is flawed in that it appears to consider "psychological mood" as a given and does not try to explain it's origin.

Traditional fundamental analysis, on the other hand, does explain the origin of the investing public's psychological mood. It does not consider it to be a given. Investor mood is brought about by the vast coalescence of fundamentals in the minds of millions of investors that make up the marketplace. Investors then bid prices up or down depending upon the mood that results from their interpretation of these fundamentals.

Are the fundamentals then primary? No. They are caused by human action guided by all the various drives of human nature -- ambition, love, power lust, greed, security, etc. Investor mood moves the market, but it is fourth in the cause and effect chain. For example:

Human nature [creates] human action [which creates] fundamentals [which create] investor mood [which creates] price direction.

Even human nature is not primary, though, because it comes from something. But to go beyond this basic cause and effect chain is to enter into fields such as sociology, physiology and metaphysics, which serves no useful purpose for our analysis here. So for investing theory, we can safely make good old human nature our primary.

To sum all this up then, both fundamentals and technical chart data are important. But fundamentals are more important than the charts and technical indicators because they cause the mood that is reflected in the charts. And that is why we must always be concerned with as sophisticated a grasp of the fundamentals as our minds can encompass. This is most difficult to do, but it is the requisite for any successful venture in investing, and for that matter in life itself.

The Power of Fundamentals

It should be stated here that Elliott Wave theoreticians do concede that certain fundamentals (such as tragic events, interest rate changes, etc.) can at times alter investor mood, but they maintain that such causation is only of very minor, short-run importance. It is of no consequence for the long-term unfolding of price movements. And therefore, they insist that concern with fundamentals is not necessary.

If one accepts this premise, however, it means that when the Fed signals it is going to become very accomodative with its printing press, as Bernanke recently did, such a fundamental event (in both its announcement and in its implementation) will have no long run effect on the mood of investors for the dollar and precious metals. In other words, telling all investors around the world that the Fed will trash the dollar to avoid deflation, and actually implementing that trashing, are merely "mundane affairs" in the routine of modern day living that we need not concern ourselves with. These affairs will not change the mood of the public for more than a few days or weeks at best.

It should be obvious that this is totally untrue. This fundamental (Bernanke's signal), and its implementation via monetization, when combined with other fundamentals such as 12 rate cuts, massive trade deficits, etc., have in fact set the mood for the currency and precious metal markets for many months, and probably years, into the future. These fundamentals are the primary causes of the dramatic mood swing that has taken place in the minds of the big money investors throughout the world, and which are causing them to now shift assets into the gold market. These fundamentals are massive straws that have broken the back of world confidence in the dollar. These fundamentals are the salient dominos that will set off scores of other fundamentals to swell the investing public's bullish mood for gold in the upcoming years. To claim otherwise is mystifying indeed.

Recall now the above analogy I used about a map and radar at sea. In 1993 the Prechterian wave map showed its true believers that the Dow was topping. But because Prechterians eschew fundamentals, they were at sea without any radar system. This caused them to miss the raging "fundamental" storm of inflation hidden behind the Clinton-Rubin dollar policy, which signaled a coming bull market for equities for the rest of the decade. The Prechterian wave map with its technical indicators showed them only a partial picture. If it had been combined, however, with the radar of fundamental analysis, the two methodologies together would have shown them what was actually happening. Are Prechterians making the same mistake again in the gold market? I believe they are.

To further demonstrate the power of fundamentals, we need only to consider the Kondratieff Cycle. Is it not brought about by a fundamental policy? Is not its linchpin the practice of fractional reserve banking and the inflation that such banking policy subjects an economy to? Without inflation, we would not have a Kondratieff Cycle. Does this not then make fundamentals of prime importance that are causitive agents that drive the mood of the market? Yes, I believe it does. Fundamentals matter! We can change them via human action, and therefore we can alter the mood that forms the Kondratieff Cycle itself, and thereby change its alleged "inevitability." (See my previous article, "How the Kondratieff Cycle Might Play Out.")

Herein lies a lesson that humans have been learning and relearning for centuries. Truth does not come easily packaged with all the t's crossed and i's dotted. It is a Herculean task to decipher the markets. It takes more than charts and technical indicators. There is no one simple tool or array of tools that will ever absolve us of the necessity to encompass as many of the fundamentals as we can into our minds, and then combine the knowledge of such fundamentals with all our experience and all our intuitive skills to anticipate the path that prices will take. Fundamentals are paramount. Any analysis devoid of their guidance will ultimately prove to be flawed.

(This article is for general information purposes and not intended as specific investment advice. I am not a registered investment advisor. Investing in equities, precious metals, and futures entails risk. Do your own due diligence.)