The Elliot Wave Theorist (July 9, 2002)

July 2002 issue © July 9, 2002

THREE STUDIES A SOCIONOMIC VIEW OF CENTRAL-BANK CAUSALITY

Both supporters and critics of the Federal Reserve System agree that the first cause of paper money inflation and credit expansion in the U.S. over the past 89 years is the Fed. How does a socionomist respond to this assertion? Conventional statements about social causality always treat the purported cause as an isolated force, as if it appeared from nowhere, with no antecedent causes of its own. Likewise, the Fed is taken as akin to the Law of Gravity, and all consequences flow therefrom. Certainly the Fed is the primary engine of inflation via money creation and the fostering of easy credit throughout the banking system. But an engine and causation are different. The motor of an automobile is the engine of locomotion but it is not the cause of it. Somebody built the motor in order that locomotion could occur. Likewise, people built the Fed in order that credit could be made easy. The socionomic insight provides a principle of causation that requires an inversion of conventional statements of causality. Thus, to reverse the presumed direction of causality expressed in the first paragraph of this report, we may conclude that the proper reformulation is as follows: The Fed is not the root cause of money and credit inflation; the desire for money and credit inflation is the first cause of the Fed. If this re-statement is true, then a socionomist should be able to find evidence of it in the record of the formal structure of social-mood fluctuation, which is best manifest in the fluctuations of aggregate stock prices. A review of that record suggests that the Fed did not appear out of nowhere at a random time but in fact was a product of social-mood forces desiring an engine of credit inflation. We come to this conclusion because in three of these four instances, central-bank formation occurred at almost exactly the same place in wave structure, i.e., in the progression of social psychology. Credit Engines as Products of Fourth and Fifth-Wave Psychology Figure 1 shows the stock-price record from its beginning in 1695 in England. I would be remiss as a socionomist if I neglected to mention that the very appearance of reported stock prices was itself a symptom of fourth and fifth-wave social psychology, just as the appearance of all-financial network television was in the early 1980s. In other words, minds were turning to finance, and these outcomes were simply manifestations of that orientation. In Figure 1, the points of three central-bank formations are marked with arrows, and the ensuing period that encompassed a fourth and fifth wave are traced with a bold line. By the way, the labels on the graph are not retrofitted to this discussion. For over twenty years, publications of Elliott Wave International have labeled the wave structure consistently as shown. Observe that there is a remarkable correlation between the wave position and central bank creation. With one exception in our sample, we find that central banks have come into being during fourth waves of large degree: — The first modern central bank was the Bank of England, constituted in 1694. It appeared during wave 4 of III, just prior to wave IV of (V). — The second American experiment with central banking was the second Bank of the United States, chartered in 1816. It appeared during wave 4 of III, just prior to wave IV of (I). — The latest incarnation of central banking in the U.S. is the Federal Reserve System, which was signed into law in 1913. It appeared during wave IV of (III). You can always get The Elliott Wave Theorist instantly upon release; for information, visit www.elliottwave.com.

The Elliott Wave Theorist — July 9, 2002

CENTRAL BANK FORMATIONS: A WAVE-FOUR PHENOMENON

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In each of these three cases, the central bank was constituted in time to provide credit for the excesses of a fourth wave and the ensuing major fifth wave. The Bank of England financed the ongoing Nine Years’ War (also known as King Williams’ War and the War of the Grand Alliance) with France during wave IV and then the South Sea Bubble, wave V. The second Bank of the United States created the credit to finance the War of 1812’s debt legacy and then wave V, the Era of Good Feeling. The Federal Reserve System created credit to finance World War I during wave IV and then the Roaring Twenties, wave V. Probably because the next major correction was itself a fourth wave, wave (IV), the Fed remained in operation to finance the New Deal of wave (IV) in constant-dollar terms and the major expansion of wave (V), which culminated in wave V of (V), the Great Asset Mania of the 1980s and 1990s. The second Bank of the United States was an object of political controversy. The presidential campaign of 1832 between Jackson and Clay was fought largely over the issue of re-chartering the Second Bank. Clay, who supported the bank, lost the election. The bank operated just long enough to finance waves IV and V of (I). In 1836, the first down year after the top, its 20-year charter was allowed to expire. There is little question that the Fed was a product of a certain necessary social psychology as well, because it came into being only after decades of political opposition to the idea of a central bank. In the 77 years following the expiration of the second Bank, promoters of central banking in the United States lost all of their political battles. In 1913, during a major fourth wave, resistance melted away, and proponents got their central bank.

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The Elliott Wave Theorist — July 9, 2002

An Exception For the record, the first Bank of the United States, which Alexander Hamilton guided to formation in 1791, did not appear in the same wave position as the other three examples. It was formed in the midst of an economic depression substantially to finance Revolutionary War debts that had already been incurred. Thus, while we may postulate that the social psychology of fourth and fifth waves is conducive to facilitating the formation of a credit-expansion engine, such engines may come into being and operate at other times as well. It is probably pertinent that after the debts were paid, Congress closed the bank in 1811. Until we get evidence to the contrary, we might suggest that central banks formed in fourth waves will continue to operate through the ensuing fifth wave. Those formed at other times, such as the first Bank of the United States, will be discontinued fairly quickly because they have no fourth and fifth-wave social imperative to keep them going. First Cause The chronology we have explored suggests that psychology is the first cause of the credit excesses of fifth waves. I conclude, then, that governments have formed central banks to facilitate credit in response to the psychological demands of major fourth and fifth waves. Fourth waves first engender credit expansion, and fifth waves are then propelled by it. Because the Wave Principle is the first cause of the tenor of social events, we should properly conclude that had the government not authorized the Federal Reserve System, then during the terminal waves V of (III) and (V), banks and other financial institutions would have exploited credit anyway, through their own ingenious methods and with much of the public happily participating throughout the process. Major fourth and fifth waves, we may safely postulate, encourage and thrive on easy credit no matter what the mechanism. A Moral Question If this thesis is true, then is there any reason to object to central banking monopolies? Yes, because a free market in money and banking would allow prudent banks to operate independently from the majority. They would advertise their safety services, and prudent people would have the opportunity to protect themselves with sound banks. Then only those choosing to take risk would get hurt. Under central banking, the innocent suffer the most. Future Prospects Regarding this topic, what can we say about the fact that at Grand Supercycle degree, the stock market is in wave (, with wave ) due thereafter? Clearly, if a credit engine generally appears during major fourth waves to finance their attendant social profligacies and conflicts and then to stimulate the speculation typical of fifth waves, and if fourth and fifth waves of immense degree are due, then we might postulate the emergence of an unprecedented credit engine for waves ( and ) over the next 2 or 3 centuries. Some economists, such as Charles Kindleberger in the appendix to his book, Manias, Panics, and Crashes, advocate a “lender of last resort” to stave off deflation, in other words, a global super-Fed. This is like advocating crack to save a cocaine addict, but sense has no force against the formological imperative. Such a proposal would forestall the next deflation only by generating an even greater credit expansion than has been accomplished by any previous monetary experiment. Given the imperative of Grand Supercycle waves ( and ), I suggest that authorities will embrace the “lender of last resort” proposal, or something like it, some time in the next hundred years as wave ( progresses. Wave ) will be the most spectacular credit inflation in the history of man and lead to the greatest credit bust in the history of man. After that experience, the wave position suggests that fiat-money central banking will go out of style for a millennium or so.

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The Elliott Wave Theorist — July 9, 2002

ANOTHER EXAMPLE OF A LINK BETWEEN NATURE’S TREES AND WAVES Chapter 3 of The Wave Principle of Human Social Behavior (1999) proposed the following hypothesis: Are nature’s developing waves, branching arbora [i.e., trees] and expanding spirals all the same thing? Figures 3-15, 3-16 and 3-2 express the Fibonacci sequence in three different ways: as a tree, a spiral and a wave…. Natural processes express this cross-representational property as well. For example, evolution is a process that makes waves, spirals and arbora…. This transformation property may cover other types of fractals as well. For example…a topographic fractal (mountains, hills, hillocks, etc.) [is] also an arborum…when water, snow or flowers fill the cracks. See Figure 3-20…. It is also true that price trends can be graphed in such a way as to reveal not a line but a spiral…. All these pictures resemble many natural expressions of growth and expansion [or recession and decay], from life forms to galaxies. In terms of their essence, then, there may be little difference among nature’s progressing forms. The only difference may be the template upon which nature projects them.”1

Source: Mandelbrot Gaussian Self-Affinity and Fractals (2002)

The work of a scientist in the field of fractal geometry has allowed us to view another example of this idea. Benoit Mandelbrot’s latest book, Gaussian Self-Affinity and Fractals (2002) presents an illustration of a highly stylized tree, “a Peano motion in the plane.” The illustration may be conceived of as “rivers that flow into the black ‘sea’” or as trees with “new layer[s] of shorter branches,” which you can see in Figure 1. This is a simple stylized branching fractal. The more interesting depiction is Figure 2, which displays “the graph of the limit curve,” i.e., “the X(t) coordinate function of the Peano motion in Figure 1.”2 The fact that the tree in Figure 1 can be shown as a wave in Figure 2 supports the observation quoted above, from The Wave Principle of Human Social Behavior.

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The Elliott Wave Theorist — July 9, 2002

Source: Mandelbrot Gaussian Self-Affinity and Fractals (2002)

The Arborum in Figure 1, Plotted as a Wave

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Nearly an Elliott Wave

The details of the result are even more fascinating to a trained eye because as detailed in Figure 3, the self-affine fractal in Figure 2 reflects the 5-3 form of net progress described by R.N. Elliott’s Wave Principle. It follows Elliott’s observations of market behavior even to the point of including alternation (see text, pp.6163) between waves two and four. This stylized tree, then, does not reflect an indiscriminate line fractal but something extremely close to an ideal Elliott wave. The pattern’s detail is interesting. Corrections bottom at the level of the preceding wave four, as under the Wave Principle. With respect to alternation, it sports a short-long declining pattern in the “wave 2” position and a long-short pattern in the “wave 4” position. There are two main variations from the rules of Elliott wave construction. The first is that wave four in this pattern continually falls to the level of the peak of wave one, which never happens in financial markets. Secondly, what should be wave C under the Wave Principle alternately subdivides into three waves instead of five. (I have labeled this construction “N” in Figure 3.) There are other variations in terms of guidelines. In Figure 3, all advancing subwaves are the same length, which does not typically occur in financial markets or in Elliott’s model, which reflects reality. The Arborum in Figure 1, Labeled in Elliott Fashion (5)

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The Elliott Wave Theorist — July 9, 2002

The Expanded Hypothesis Since plotting an aspect of a stylized tree produces a stylized Elliott wave, we may reiterate the suspicion that plotting aspects of robust fractals in the form of arbora in nature is likely to produce robust fractals called Elliott waves, with all the natural order and variation that we have come to know from their expressions in financial markets. They should have this property because arbora and Elliott waves both depict natural growth patterns. Indeed, as shown in The Wave Principle of Human Social Behavior, they can depict the same natural growth patterns, such as the number of families of fauna produced through evolution. Both the stylized tree in Figure 1 and the stylized advancing wave in Figure 2 may be circumscribed with spirals, as shown below in Figures 4 and 5. (See also Figures 2-29 and 3-14 in The Wave Principle of Human Social Behavior.) Thus, once again, we have expressions of all three of nature’s primary growth forms in a single process.

© July 2002 Elliott Wave International

The Spiral Implied by the Arborum in Figure 1

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The Elliott Wave Theorist — July 9, 2002

The Spiral Implied by the Wave in Figure 2

© July 2002 Elliott Wave International

Figure 5

Getting Closer Every Year In a 1999 paper, I related this experience: In 1993, a correspondent wrote to my firm in response to an article about physicists pursuing chaos in financial markets and said, “Like Alexander King’s story of the man in the isolated village in Switzerland who unknowingly reinvented the typewriter, it looks like these people are about to rediscover the Elliott wave.” Some of them have now gotten so close to the Wave Principle that they are within smelling distance of it. An educated nose would prove a useful resource.3 ENDNOTES 1

Prechter, Robert. (1999). The Wave Principle of Human Social Behavior and the New Science of Socionomics, pp.75-82.

2

Mandelbrot, Benoit B. (2002). Gaussian Self-Affinity and Fractals. New York: Springer. Note: As the author explains, the illustration in Figure 1 exaggerates one-dimensional branches into two-dimensional ones for effective visual illustration.

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R.N. Elliott originated the idea of fractals in finance. Apparently miffed over this fact, Mandelbrot has ungraciously dismissed Elliott while simultaneously attempting to claim much of his territory (see The Elliott Wave Theorist Special Report, “Credit Where It Is Due,” February 1999). Ironically, his aloofness with respect to Elliott’s model has provided an opportunity for a wave practitioner to make an observation that otherwise he could have made.

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The Elliott Wave Theorist — July 9, 2002

A VALUABLE TARGETING METHOD FOR BEAR-MARKET RALLIES Before the market’s opening on Friday, May 31, 2002, I commented to several colleagues that the Dow’s upside target for the day was in the very close vicinity of 10,046.8. At 12:56 p.m., I sent the following email to Steve Hochberg: The Dow stopped 4 points from the target with a big intraday non-confirmation vs. the NDQ. The 4th of the 3rd is the most powerful targeting method I know. It’s a subtle point on the chart, and few pay attention to it, which is even better.

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That was 53 minutes after the Dow had peaked at 10,042.3 and 34 minutes after it double-topped at 10,041.5. The S&P was above 1080, and the NDQ had just topped at 1250. On Saturday, I finished the June issue of The Elliott Wave Theorist, ending with this comment: On Friday, the Dow rallied to within four points of a perfect intraday target at 10,046 based on wave form. I would not be surprised if that were the last time we will see a five-digit Dow. I could be wrong on that idea, but this pattern is sufficient reason for speculators to move to 200% short. Place a stop at Dow 10,100 on only this additional portion of our short postition. If the stop is hit, we will add this portion later. 10300

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The Elliott Wave Theorist — July 9, 2002

The Dow has been plummeting ever since. What is this targeting method, and how can you use it to your advantage? The Fourth Wave of the Third Wave Within most five-wave declines, there is one point that repeatedly provides, in the ensuing upward correction, both a magnet for rising prices and a ceiling of resistance for further advance. That point is the (usually small) fourth-wave rally within the third wave down. Figure 1 shows the picture for the Dow prior to the rally. Study the wave labeling of the decline and observe that within wave (iii), wave iv topped at 10,046.8. At that very time, I marked that level as being the most likely point at which the next upward correction would stop. From there, the market fell to complete waves (iii), (iv) and (v). Then an (a)-(b)-(c) rally ensued, topping at 10,042.3, as you can see in Figure 2. As mentioned in the above-quoted email, the fact that the NDQ index at the time had failed to join the Dow to a new rally high was a subtle technical sign of topping action. Figure 3 shows the outcome. This is not an isolated incident. I have seen it happen many times, at all degrees of trend. Figure 4 shows that the same target had been fulfilled just days earlier, within the same larger wave structure. (This time, the rally exceeded the target by 27 Dow points, which is about 3 points in the S&P.) It happens over and over.

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An Example at Cycle Degree The 1929-1932 decline was an a-b-c zigzag of Supercycle degree. Wave b took (5) place from November 1929 to April 1930. 3 200 Where would you guess it stopped? 5 Figure 5 shows the daily bar chart of a © July 2002 Elliott Wave International the DJIA for that period. Observe that after the five-wave decline of SeptemberMay-30 Mar-30 Sep-29 Nov-29 Jan-30 November 1929 (the famous Crash of ’29), Figure 5 the market underwent a major rally. Market analyst Robert Rhea reported that volume surged to higher levels than in the previous bull market and investors became aggressively bullish. In the excitement, he covered his own short sales at a considerable loss. You can see on the graph where the rally topped out: within the fourth wave of the third wave down, wave (4) of 3. The peak of that small bounce occurred at 298.97 (close) and 303.60 (intraday). The April 16-17, 1930 peak came at 294.07 (close) and 297.25 (intraday). There was also a gap in prices on the opening 9

The Elliott Wave Theorist — July 9, 2002

where wave (5) of 3 began, at 295.18-298.97. Gaps are among the greatest targeting tools available. This target had both. The market turned down and did not stop until it reached a closing low of 41.22, 2 years and 3 months later. When This Targeting Method Is Applicable The level of the “fourth of the third” wave is a reliable target for a rally when wave four peaks lower than wave four of three and when the third wave is fairly long relative to the first wave. This is actually the most common development, so the target is often applicable. This target is less often valid when wave five is extended, in which case the ensuing rally generally tops between the peak levels of wave two of five and wave four. This target is almost never valid when the first wave is extended because, by the rules of wave construction, wave three is then shorter than wave one, and wave five is even shorter than wave three. In these cases, the ensuing rally typically carries to around the peak of the preceding wave two or even wave four of one. This retracement is not common to reactions in bull markets. It seems to come into play after a short fifth wave. Normally, though, the area of the preceding fourth wave is the most common target for bull market corrections. This tendency may simply be symptomatic of advancing waves during periods of monetary inflation, which we have had for most of the past century. We should not generalize these observations as traits of Elliott waves per se. The Next Big Opportunity Over the next couple of years, we should observe the culmination of a declining wave a of Cycle degree. Then wave b will take place on the upside. If the wave structure is compatible with the prerequisites for this targeting method, we should watch for a peak in that rally around the top of wave (4) of 3 of wave a down. As noted above, if wave 5 is short, then other guidelines will be applicable. Market Strategies Speculators have been riding this bear market “200% short.” Given the possible bottom in a 40-week cycle, lighten up to only 100% short. We will return to the more aggressive position if stocks have a summer rally. Investors should stay in cash. Wealth Preservation Seminar For most people, Conquer the Crash provides all you need for instructions on how to protect your investment capital. Those with substantial net worth may wish to attend a big-ticket wealth preservation seminar being offered by the SafeWealth Group. Their week-long seminar, to be held in Switzerland from September 29 through October 6, will include personal introductions to safe banks, previous metals storage facilities and other financial institutions. For those few subscribers who may be interested, we will forward information in coming weeks. THE ELLIOTT WAVE THEORIST is published by Elliott Wave International, Inc. Mailing address: P.O. Box 1618, Gainesville, Georgia 30503, USA. Phone: 770-536-0309. All contents copyright © Elliott Wave International, Inc. 2002. Reproduction, retransmission or redistribution in any form is illegal and strictly forbidden, as is continuous and regular dissemination of specific forecasts or strategies. Otherwise, feel free to quote, cite or review if full credit is given. EWT is published irregularly, one or more times per month. All contents are written by Robert Prechter. Correspondence is welcome, but volume of mail often precludes a reply. For best results, send concise e-mail to one of the addresses listed on the bulletin board of our web site (www.elliottwave.com). SUBSCRIPTION RATES: $20 per month (add $1.50 per month for overseas airmail). Subscriptions paid via credit card automatically renew each month. Visa, Mastercard, Discover and American Express accepted; call our office for other payment options. Delivery available via internet download, email, first class mail and fax, (Call for fax pricing.) Telephone 770-536-0309 or 800-336-1618, or send credit card number and expiration date with your order. Georgia residents must add sales tax. The Elliott Wave Principle is a detailed description of how markets behave. The description reveals that mass investor psychology swings from pessimism to optimism and back in a natural sequence, creating specific patterns in price movement. Each pattern has implications regarding the position of the market within its overall progression, past, present and future. The purpose of this publication and its associated services is to outline the progress of markets in terms of the Elliott Wave Principle and to educate interested parties in the successful application of the Elliott Wave Principle. While a reasonable course of conduct regarding investments may be formulated from such application, at no time will specific security recommendations or customized actionable advice be given, and at no time may a reader or caller be justified in inferring that any such advice is intended. Readers must be advised that while the information herein is expressed in good faith, it is not guaranteed. Be advised that the market service that never makes mistakes does not exist. Long term success in the market demands a recognition of the fact that error and uncertainty are part of any effort to assess future probabilities.

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