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The Wave Principle is, first and foremost, a detailed description of how markets behave. Now,
theres probably more that is not in that sentence than is in that sentence. For instance, a
detailed description of how markets behave does not refer to what outside events are
occurring, such as in the fields of economics, politics, or social trends. Its strictly a study of
how human beings behave collectively in the trading arena.

What specifically did Elliott discover?

Elliotts most important discovery was that the patterns that develop in the stock market occur
at all degrees of trend. The larger patterns are made up of components that are themselves
composed of smaller ones. The same patterns on a smaller scale combine to create any one
of those patterns on a larger scale. The larger pattern will combine with several others of the
same degree to create an even larger pattern and so on. He described in detail exactly what
those patterns look like. He identified 13 of them. Only recently has data been available for
general stock prices back to the late 1700s, and the patterns are there as well.

How did he label the degrees of trend?

Elliott began by naming a particular structure with an arbitrary label, Primary degree, a term
borrowed from Dow Theory. The next larger degree he called Cycle, and the next larger
Supercycle. The lower degrees he named Intermediate, Minor, and so on. We therefore have
a way to refer to the degrees of trend that we are talking about.

What was the biggest degree trend he talked about?

Grand Supercycle, which he guessed dated back to the founding of the United States. Since
then, more detailed stock market data has confirmed that he was right. Thats not the biggest
degree, though, as all waves are components of larger ones.

You once referred to the Wave Principle as the purest form of technical analysis. Why?

For a hundred years, investors have noticed that events external to the market often seem to
have no effect on the markets progress. With the knowledge that the market continuously
unfolds in waves that are related to each other through form and ratio, we can see why there
is little connection. The market has a life of its own. It is mass psychology that is registering.
Changes in feelings show up directly as price changes in the barometer known as the DJIA,
or the S&P 500, or any other index. The Wave Principle is a catalog of the ways that the

crowd goes from the extreme point of pessimism at the bottom to the extreme point of
optimism at the top. It is a description of the steps human beings go through when they are
part of the investment crowd, to change their psychological orientation from bullish to bearish
and back again. That description fits the movement of any market, as long as human beings
are involved, rather than Martians, who may have a differently operating unconscious mind.
Since people dont change much, the path they follow in moving from extreme pessimism to
extreme optimism and back again tends to be the same over and over and over, regardless of
news and extraneous events.

What is the basic path?

Very simply, Elliott recognized that movement in the direction of the one larger trend
subdivides into five waves. Movement against the trend subdivides into a three-wave pattern
or some variation involving several three-wave patterns. In rising markets, true bull markets,
the subdivisions occur in five waves up, an up-down-up-down-up sequence. Bear markets
tend to occur in three wave sequences, down-up-down. Each one of those movements has a
shape and a personality. As long as you can recognize the shapes that are occurring, you
have a handle on what might happen next.

But the five-wave form does occur on the downside.

Yes, but only as a component of a larger three-wave pattern. The essence of the Wave
Principle is that the moves in the direction of the one larger trend are five-wave structures,
while moves against the one larger trend are three-wave structures. From that, you can tell
what the underlying trend is and invest accordingly.

You just go on Elliotts description alone. Does that mean you must act without knowing whats
causing the pattern?

On the contrary, I know what is causing the patterns: human nature as it relates to a person
interacting with his fellows. When you ask what outside force is causing the patterns, you are
asking the wrong question, so you are already on the wrong path. Elliotts description of how
markets behave forces you to a conclusion about cause and effect in social events. All of the
causes most people assume to be operative are not, such as the latest political speeches or
the latest numbers on the economy. They are simply results of the patterns of mass human
psychology.

Is Elliotts a mechanical system?

Not really. What were dealing with here is the behavior of people. If the tools you work with
measure something other than the behavior of people, youll be removed from the reality of
whats going on. One of the biggest failures, in terms of approaching the stock market, is to
assume that the market is mechanical in the sense that outside action causes market
reaction, such as the idea that the market responds to Fed policy or the trade balance or
political decisions. Others have tried to reduce it to a sum of periodic sine waves, but always
find that it cannot be done, because the market is not a time-repetitive machine in its
essence.
From the standpoint of theory, market behavior is tied to a mathematical law, but it is just not
the same type of law found in the physical sciences. From the standpoint of practical
application, the Wave Principle is tracking a living system, which is allowed variation in its
forms, in fact, infinite variation, but limited by an essential form. Whereas a rigid system with
numbers, strict mechanical numbers, never works.

Doesnt infinite variation imply that anything goes?

Not at all. Trees vary infinitely, but they all look like trees, dont they? And you can tell them
apart from clouds, which also vary infinitely, and buildings as well. In fact, despite infinite
variability, they are amazingly similar. The same is true of market patterns.

Does knowing Elliott guarantee profits?

Only the most trained and experienced market participants can act contrarily to their natural
tendencies. I have yet to meet a man who invested or traded with a completely rational
program based on reasonable probabilities without allowing his greed, his fear, his extraneous
opinions or his irrelevant judgments to interfere. It is mans emotional side, particularly his
social dependency, that makes him think the way his fellows do, and when he does that, he
loses money in the markets. At least using Elliott, you have a basis that makes winning
possible.

Continue to Part II