The Only Reliable "Cycle" in the Market

The Only Reliable "Cycle" in the Market
By Brian Hunt
December 7, 2009

Many years ago, I came across a stock market phenomenon that looked like the "Holy Grail" of trading.

I came across the Elliot Wave Principle. And at some point in your trading career, you will too.

The basic idea behind the Elliot Wave Principle (EWP) is the market moves in cycles. An accountant named Ralph Nelson Elliot developed it back in the 1930s. According to Elliot's theory, upward market moves occur in a series of five small stairstep-like "waves" inside a larger cycle. Down moves occur in three small waves.

Traders swing between greed (buying) and fear (selling) like a pendulum, creating these cycles. And as theory goes, you can spot them and use them to time market moves for big money.

Elliot is long gone these days. But an analyst named Robert Prechter keeps the EWP torch burning. That's where most hear about these cycles. And when you read the marketing material from folks selling EWP information, it sounds like they've unlocked the mysteries of the stock, bond, and commodity markets.

Should you go after this "Holy Grail" of trading?

Well, Robert Prechter is an excellent analyst. He's written some of the most insightful stuff on crowd behavior I've ever read. And he's used EWP to make some great financial predictions, like the 1987 market crash and last year's crash. The billionaire supertrader Paul Tudor Jones is also known for using EWP to time trades. The "principle" has produced some major wins.

But years ago, I spent time studying this wave theory. I read the books. I read the newsletters. Most importantly, I asked a lot of smart, wealthy investors their opinion. I came to the same conclusion most of them did: Trying to pick out "waves" in a price chart – and trade on them – is too subjective to be of great use to most traders. Here's why...

It's just too easy for the average trader to fool himself when trying to pinpoint cycles in a chart. It's like checking the mirror a week after starting a diet. Your mind is going to play tricks on you. One day you see a wave, one day you don't.

So despite Prechter and Jones' success, my advice to the part-time trader is this: Don't spend much time studying predictive theories - like Elliot waves or lunar cycles. Some huge crazy event comes along and makes hash out of all predictive models. Life is just too random for them to work.

Sure, some market "predictor" will grab headlines for calling a few moves correctly. But his track record will probably reveal his accuracy is the same as a coin flip.

What you should do is spend a lot of time learning how to be a connoisseur of extremes. Learn that the only reliable "cycles" in the markets are periods of extreme pessimism toward an asset (when that asset gets dirt cheap)... and periods of extreme optimism (when the asset gets outrageously expensive).

This is the only kind of cycle that regularly occurs in the market over years and years. This is the only kind of cycle that investment greats like Warren Buffett and Richard Russell will tell you to rely on. These extremes regularly happen... and they're easier for most folks to spot, prepare for, and trade on than a series of waves on a chart.

Take money manager John Paulson's "Trade of the Century." Paulson made himself and his clients around $15 billion by spotting extreme optimism and overvaluation in the real estate market back in 2006. Or take Rick Rule, who made himself and his clients incredible returns by spotting excessive pessimism and huge value in the mining sector in 2001. And John Templeton made millions of dollars betting against Nasdaq tech stocks in 2000 by spotting extreme optimism and overvaluation there.

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Unfortunately, while these sentiment "cycles" regularly occur in the market, they do not occur in an orderly, predictable fashion. You simply have to watch the market all the time and hunt for them. You have to be a "connoisseur of extremes."

That's the market's only reliable magic key.

Good trading,

Brian Hunt

P.S. Don't forget... several traders made a fortune using this sort of stuff. But I think brilliant position sizing and a commitment to playing great defense is the real factor behind their success.

You can learn about defensive techniques – and read lots of examples of how extremes have made trading fortunes – in the trader's bible, Market Wizards.

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•	Gold retreats 4.5%... low job-loss numbers send the yellow metal below $1,200.
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	Last	Change	52-Wk
S&P 500	1109.30	+1.45%	+27.03%
Oil (USO)	40.29	+2.99%	-12.75%
Gold (GLD)	111.63	+1.72%	+52.29%
Silver (SLV)	18.01	+5.01%	+92.41%
U.S. Dollar	75.37	+0.68%	-13.15%
Euro	1.49	-0.70%	+17.54%
VIX	22.89	-2.01%	-65.48%
HUI	475.53	+3.26%	+155.07%
10-Year Yield	3.33%	-0.10	-0.37

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