***AN INEFFICIENT MARKET HYPOTHESIS***
(Feel free to download this article for reading and distribution.)
***AN INEFFICIENT MARKET HYPOTHESIS***
By J. Adams
(http://www.primenet.com:80/~lion/j.html)
Revised Edition: 1/19/96
(Original: 2/25/95)
Recently the Dow Jones Industrial Average (DJIA) has been at all-
time highs above 5000. Based upon past stock market behavior, there is
significant reason to believe that a top is being reached which will be
followed by the worst crash in history. This crash involves a total
upset of irrational popular beliefs and expectations and, in
particularly, the worldview of economists.
According to mainstream economists, greed, in effect, is good.
Reigning theory holds that, if individuals and organizations seek to
maximize utility and profits, respectively, and there is "perfect"
competition, then, as if guided by an invisible hand, market prices and
the overall economy will tend toward general equilibrium and maximum
happiness for all in the long-run. The reality, however, is that greed
is not good, and, in the long-run, it is leading to the collapse of
civilization and maximum unhappiness for all. In this sense, reigning
economic theory constitutes a dangerous extraordinary popular delusion.
Stemming from pervasive greed and competition, market societies such
as our own historically suffer from general disequilibrium in the form
of persistent price instability and so-called business cycles. These
cycles involve swings between extreme optimism and pessimism in popular
mood which, in turn, lead to the formation of irrationally high and low
collective beliefs and expectations, respectively. On Wall Street,
irrational swings in prevailing expectations are readily observed as
general cycles in stock price movements commonly known as "bull" and
"bear" markets.
Experienced Wall Street professionals have learned that the general
ups and downs in stock prices can be predicted using technical analysis.
One effective approach is based upon a contrarian investment strategy
that involves "going against the crowd" (see David Dreman, 'The New
Contrarian Investment Strategy', 1982). By paying attention to
"psychological indicators" like the put-to-call ratio and polls of
investor sentiment, one can determine when extremes of optimism and
pessimism are being reached on Wall Street and time tops and bottoms
accordingly (see Martin Zweig's 'Winning on Wall Street', 1986).
Irrational extremes in consensus expectations are indirectly reflected
in generally overvalued and undervalued stock prices at major tops and
bottoms, respectively. Thus, a contrarian investment strategy is also
applied using indicators of relative historic valuation like price-to-
earnings ratios and dividend yields (see Dreman's book and/or Norman
Fosback's 'Stock Market Logic').
With the recent all-time highs above Dow 5000, collective beliefs
and expectations have reached an unprecedented irrational extreme.
In economics and finance this irrationality is reflected in the reigning
"Efficient Market" hypothesis of stock price behavior. According to
this hypothesis, in the aggregate, investors form "rational
expectations" of the future using all available information including
lessons learned from past mistakes. Assuming the stock market
efficiently discounts investors' rational expectations, stock prices
reflect an accurate assessment of intrinsic value based upon available,
relevant information. Consequently, only new, unexpected information
can lead to a price change (a movemement of market equilibrium). Thus,
stock market prices are expected to follow a random walk in which only
unpredictable, random shocks, i.e., unexpected news, moves prices up and
down.
According to the weakest form of the Efficient Market Hypothesis,
stock prices fully reflect the information implied by all prior price
movements. Price movements, in effect, are totally independent of
previous movements, implying the absence of any price patterns with
prophetic significance; investors should be unable to profit from
studying charts of past prices.
Unfortunately, the Efficient Market Hypothesis, like economic theory
in general, is, for the most part, wrong. While pervasive evidence of
irrational swings in investors' expectations mentioned above is
sufficient for undermining the key assumption of "rational expectations"
in efficient market theory, a straightforward way to falsify the
efficient market hypothesis is by making a prediction of the future
direction of stock prices based upon historical price patterns in the
Dow Jones Industrial Average.
-Psychological Barriers in the Stock Market-
When the DJIA reaches thousand marks, stock prices meet resistance
and usually head substantially lower. For example, between 1966 and
1982, the DJIA reached or slightly breached (by a few percent) the
"Magic 1000" barrier on five separate occassions: 1966, 1968, 1973, 1976
and 1981. Following each peak around 1000 on the Dow there was, on
average, a decline in stock prices of 34.4 percent over the course of
17.2 months. Then, in 1982, the DJIA blasted through the Magic 1000
barrier in a dramatic rally that marked the beginning of a bull market
that many consider still in force today. When the DJIA approached the
2000 mark in 1986, it ran into resistance for almost a year, and in
early 1987 the DJIA broke through 2000 in one of the most dynamic
rallies (in terms of market volume and breadth) ever observed on Wall
Street. In 1990, the DJIA climbed to the 3000 level for the first time.
In mid-July, the Dow closed two days in a row at what was then an all-
time high of 2999.75 and subsequently entered a sharp, three-month
correction of over twenty percent. The 3000 barrier was eventually
breached in 1991 with, again, a historically strong rally. The first
time the Dow reached the 4000 mark was in January of 1994.
Specifically, the DJIA reached an intraday high of 3985 and registered a
closing peak at 3978. Following this test of the 4000 barrier, stock
prices dropped by ten percent and then struggled with Dow 4000 for about
a year. In March of last year the DJIA broke above 4000 for the
first time in history. (See: "Dow Industrials' Failure to Break 4000
Barrier Stiffens Bears' Doubts" in the Wall Street Journal, 9/19/94 &
"Once Again, Industrials Close In on 4000 Barrier" in the Wall Street
Journal, 2/6/95.)
The most recent psychologically important thousand mark reached in
the DJIA is Dow 5000. In November of last year the stock market
broke above 5000 and has since climbed as much as four percent above the
mark. Likewise, the Nasdaq Composite index for over-the-counter stocks,
which is the second most widely watched stock average nowadays, broke
the 1000 mark for the first time in history last July and has since been
struggling. What seems to be takng place is a euphoric top similar to
the peak in the DJIA some five percent above 1000 in 1973; this peak was
followed by the worst bear market up to that time since the Great
Depression. All in all, based upon prior price declines following peaks
at or above thousand level psychological barriers in the DJIA, one
should expect at least a thirty percent drop in stock prices over the
next year or so.
-The Dow Theory of Stock Price Movements-
Based upon "Dow Theory", one can be relatively confident that the
DJIA is currently reaching a peak above the 5000 mark and will soon
enter a major correction. Dow Theory holds that, if the Dow Jones
Industrial Average reaches an all-time high when the Dow Jones
Transportation Average and the Dow Jones Utility Average do not make
all-time highs, then there is a "non-confirmation" and one should expect
a major price decline and sell their stock holdings (the actual buy- and
sell-signal is a little more involved then that, but "non-confirmations"
are the key prerequisite for such signals). (Notably, the reason charts
of the Dow Industrial, Transportation and Utility Averages are printed
together in the Wall Street Journal each day is to apply Dow Theory.)
If, between 1897 and 1981, an investor had bought and sold the stocks in
the DJIA with each Dow Theory buy signal and sell signal, respectively,
then they would have achieved a return almost nineteen times that
attained from simply buying and holding (see Martin Pring's 'Technical
Analysis Explained' (1985), p.21).
A textbook example of Dow Theory non-confirmations occurred when the
DJIA peaked at 3000 in July of 1990. The Utilities reached an all-time
high in 1988 and the Transports topped-out in August of 1989. With the
record closing peak in the Industrials at 2999.75 in 1990, the Utilities
and Transportation indexes were no where near new highs. Thus, soon
after that a sell signal was registered that correctly anticipated a
twenty percent decline in stock prices.
With the current all-time highs being reached in the DJIA above
5000, there are new non-confirmations suggesting a sell signal. The
Utilities last reached an all-time high in October of 1993. Meanwhile,
the Transportation index recently reached an all-time high well above
the 2000 mark, but since then the index has pulled back while the
Industrials remain at record heights above Dow 5000. Thus, non-
confirmations are taking place that suggest a Dow Theory sell signal is
near that historically has meant a major decline in stock prices
(actually, a sell-signal was registered the week before last, but one
last unconfirmed another high in the Industrials can not be discounted
at this time).
-The Elliott Wave Principle of Stock Price Movements-
The potential scale of a future decline in stock prices following a
peak above the DJIA 5000 mark and a new Dow Theory sell signal can be
predicted with the Elliott Wave Principle. The Elliott Wave Principle
holds that stock prices move in repeating, fractal-based wave patterns.
Based upon these patterns, Robert Prechter, the 'Elliott Wave Theorist',
predicted in the late-1970's and early-1980's that a major bull market
in stocks was due that would carry the DJIA to a "Grand Supercycle" top
which has been at least 200 years in the making. Following the final
peak, Prechter warned the 'worst crash in U.S. history' would occur.
Even though the bull market has lasted longer than Prechter expected
and the DJIA has gone higher than first projected, the indication is
that the final high is now being reached. One interpretation is that
the huge Grand Supercycle rising wave pattern is completing with a final
"fifth wave breakout" above a Supercycle upper channel line which has
been marking key Elliott Wave tops in stock prices since 1937. This
upper channel line, which was breached last spring when the Dow climbed
above 4200, can be seen on a logarithmic chart of the DJIA by drawing a
line through the 1937 peak at 194, the 1962 peak at 735, the 1987 top at
2722 and the 1994 closing high of 3978. As the Wave Principle predicts,
this Supercycle upper channel is parallel a lower trendline that can be
drawn through the 1942 low at 94, the 1974 bottom of 572 and the 1982
low at 777 on the Dow. One should note how the upper and lower
Supercycle channel lines are almost perfectly parallel, an important
pattern predicted by the Wave Principle.
One of the main reasons to believe the Grand Supercycle peak is now
being reached above the Supercycle upper channel line and Dow 5000 is
because the current high point in stock prices is coinciding with a
couple of major planetary alignments. Each of the Elliott Wave turning
points at the Supercycle upper and lower channel lines listed above
occurred around the time of rare planetary alignments. Similarly, when
the DJIA broke above 5000 last November, there was a tight alignment of
seven planets, and today the Dow closed near a record high going into
another tight seven-planet alignment this weekend. Thus,
"astroharmonics" indicate we are currently reaching the Grand Supercycle
peak with a significant alignment of the planets.
If, indeed, we are currently around the Grand Supercycle peak in
stock prices above the Supercycle upper channel line and Dow 5000, then
an historically unprecedented crash is near. Given the scale of the
relevant wave patterns, this crash would be the opening phase of a bear
market for stocks that could last upwards of a century and involve a 99%
decline in the DJIA (for more information, contact Elliott Wave
International in Georgia or the Foundation for the Study of Cycles in
Pennsylvania).
-An Inefficient Market Hypothesis Test-
All in all, the implication of historical price patterns in the
stock market is that the worst crash and bear market in history should
follow the peak currently being reached above DJIA 5000. Based upon
psychological barriers in the DJIA, Dow Theory non-confirmations, the
Elliott Wave Principle and astroharmonics, there is substantial reason
to believe that a major, unprecedented decline in stock prices is close-
at-hand.
If the expected decline occurs, then this will significantly falsify
the Efficient Market Hypothesis and undermine reigning economic theory.
Furthermore, this crash will demonstrate the inefficiency of markets and
how greed and competition result in the worst of all possible worlds in
the long-run. Thus, faith in an imaginal invisible hand is a dangerous
mistake.
While the anticipated crash will upset the worldview of economists,
it also implies an upset of prevailing popular opinions. Indeed, since
general swings in stock prices reflect swings in mass mood between
irrationally optimistic and pessimistic collective beliefs and
expectations, the current, unprecedented peak should involve the worst
popular delusions imaginable. Indeed, one such delusion is that a "New
World Order" of East/West peace, friendship and cooperation is at hand,
when, in fact, there is substantial reason to expect a new world
disorder and global war. While the approaching war will upset popular
expectations and surprise the modern "secular" world, it shall fulfill
biblical prophecy and thereby verify religious truth and the wisdom of
faith in God (see the articles on my web page).
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