Social Moods Move the Markets

11/02/2012 10:00 am EST

Focus: MARKETS

Robert Prechter

Founder and President, Elliott Wave International

Elliott Wave International's Bob Prechter explains how his research has shown that the moods of society cause changes in the markets, and not the other way around.

What makes Elliott Wave Theory different than other investing theories? I'm here with Robert Prechter, who's going to answer that question for me. Robert, what is it that you've discovered that makes your system different than most systems out there?

It's fundamentally different. Virtually everyone approaches the market as if it's a mechanical system where outside events are coming in impacting the markets, and changing valuations such as economic announcements will come out and the market reacts. Or political announcements come out and the market reacts.

So they see sentiment in the market. In other words, the mood of the market as a result of these events. If there's a war going on, it's going to make people feel a certain way.

There's a perfectly emotional way...

Or the economy is expanding and people will feel a certain way. My theory is completely different because I think that those types of events are not causes, they're results.

How do we get there? I think the market moves naturally in waves of social mood, so that social mood is not the result of these events, it's endogenously regulated. That means that when people are together in a social system, their mood will fluctuate in a natural way.

Benoit Mandelbrot already proved mathematically that all markets are fractals. That means that the fluctuations of very small degree, intermediate degree, and large degree are basically all the same. They're just different sizes.

Right, derivations of the smaller fractals.

Yes, the essential pattern. Well, R.N. Elliott was the first person who recognized this back in the 1930s. He said, "I've discovered something: the market's a fractal."

He didn't use that word, because it's the modern word, but he says the patterns in small degree, intermediate, and large degree are all the same. The small ones are the building blocks of the larger.

I believe if that's the case, and specifically if Elliott's theory that waves take a certain shape is correct, then the only logical explanation is that the markets are an endogenous process. They're not hit randomly from the outside, or you wouldn't have any patterns at all.

So I think this kind of psychology I think derives from the herding impulse. People are herding when they buy and sell, and my speech today was all about when people herd, how they herd, how often they herd, which is all the time-short term, intermediate, and long. They're chasing trends during the day, and they're chasing trends that may last years. It's all the same.

So I think that what we have here is a natural process among human beings. Social mood is regulating where the stock market is going. When social mood is more positive, people buy more stocks, they get more productive so the economy expands, they listen to happier music, and they wear jazzier clothes. All that stuff.

When the trend is toward negative social mood, they do the opposite. They sell stocks, they get less productive, they start fighting with each other. Politics begin to polarize as people start getting a worse mood, and they want to fight. And that's the kind of thing we're seeing today, so that creates the events that everybody else thinks are causes. So it will make the economy expand when mood is more positive, and make it contract and we go into a recession if it's negative.

And guess what: it follows the stock market, because stocks can react quickly to mood, whereas economic changes when a business person decides to expand or contract a business, it's going to take three or four months to arrange a loan with the bank or buy new space or rent new space, hire new people, have the meetings. So that's why the economy lags.

And it's a completely different way of looking at market fluctuations than anyone else uses. I think it's useful because it's true and valid, and the way other people are looking at it doesn't work.

I spent 45 minutes today showing that none of the outside relationships that people take for granted work. The economy is not pushing the stock market. Oil prices don't mean anything for stocks. Wars and times of peace don't mean anything for stocks. The stock market has done everything you can imagine under all those conditions.

Right. Right.

But waves in social mood have had the same results going back in history, and now for 12 years that we've been using the forecast. If the market goes down, you're going to see all these things happen. They keep happening. And the market goes up, you're going to see all these things happening, and they've kept happening.

So, I think our theory is valid. It's called the Theory of Socionomics, and if anybody wants to know more about it, we've had a paper published in the Journal of Behavioral Finance in 2007 talking about the difference between finance as a socionomic process and the economy as an economic process, because they're very different. And we're having a paper published this year, in fact any week now, under Sage Open, and it's about how to predict elections based on waves and social mood of the stock market.

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