The Four-Letter Word of Investing

By Elliott Wave International's Robert Prechter, Prechter's Market Perspective
Aug 24, 2005

Off-color language crops up in TV shows and movies more frequently nowadays than it did 10 or even five years ago. And four-letter words you would never have heard uttered publicly in the 1950s and '60s have become more common in everyday language. Yet a word that doesn't sound filthy or disgusting to the ear is still the one word that shouldn't be uttered by traders or investors. Read this question-and-answer excerpt from Prechter's Perspective to find out what it is. Along the way, you'll also learn how Bob Prechter got started with technical analysis.

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You have said that you came into the markets as a tabula rasa, a blank slate. What do you mean by that?

Bob Prechter: Just that. I didn't learn a lot of theories before going head-to-head with the real thing. I didn't major in economics or finance. A lot of theories of market behavior that I think are fallacious were started by someone who dreamed up a concept and then tried to force stock market movements into it. If you come to the markets with that kind of bias, you have to unlearn a lot of stuff. My discovery of what R.N. Elliott had postulated came after my initial interest in technical analysis, which was generated from an interest in what made markets tick and ultimately how one went about making money in the market.

You found the methods to which you were predisposed, but you didn't make a beeline for Wall Street. You took a few years off to be a drummer in a rock and roll band. What was it that finally pulled you into the markets?

Bob Prechter: Quintupling my money in 16 months in South African gold stocks in the early 1970s on my father's advice. In 1972, I purchased shares of West Rand and Orange Free State and sold out with a 400% gain. Even after that, the long-term gold rise still had more than five years left in it. So despite a limited experience with investments, I figured one thing out early: that was a bull market. Needless to say, to this day, I haven't bettered that rate of gain in unleveraged investments. But at the time, it got my attention.

You had the bug from that point forward?

Bob Prechter: Yes. Then I started doing a little bit of trading for myself, and I think anybody who wants to do market timing is forced to turn to studying market behavior, because otherwise, you'll go bankrupt. You might go bankrupt anyway, but at least it will not be assured. Once I started studying technical methods, I investigated every one out there.

Along the way, there was naturally some exposure to the other side of stock market study, fundamental analysis. What do you see as the essential difference between technical and fundamental approaches?

Bob Prechter: Fundamental analysts use data generated outside the market to come to their conclusions. Fundamentalists assess events and situations apart from market behavior, considering them the cause of market movements. They forecast where markets are likely to go in response to those background events or conditions that they feel are significant. For example, they will study the managers of a corporation and the trend of its earnings to decide on such bases whether the company's stock is worth buying. In a macro sense, they will study the political environment, interest rates, the trade deficit and all kinds of outside factors and then will try to predict – I would use the word 'guess' – where the market is going.

Since you chose to base your market analysis almost entirely on technical considerations, you've obviously become very comfortable with them. What was it about being a technician that drew you in?

Bob Prechter: The technician looks at the data generated by the market itself, the construction of patterns within the market, the psychology of the players in the market, the speed and breadth of price change, and so on. The technician studies behavior and decides from that data which way the market is likely to go next.

You mentioned psychology. How do you measure psychology?

Bob Prechter: We can determine, for example, how many people are short and how many shares are held short. We can calculate the volume of put buying vs. call buying, which are bets on a decline versus an advance. We poll money managers and ask, 'Do you think the market is going up or down?' to determine aggregate sentiment. We study reports of the long and short commitments of various types of speculators, both the typically sophisticated and the typically unsophisticated. The latter more easily succumb to fear and hope.

Hope is a bad thing?

Bob Prechter: Hope is a four-letter word in the world of investment. Only a cold reading of the pertinent factors can keep you on track for more time than you're off.

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