Buy High and Sell Low? by Robert Gore

Review of The Socionomic Theory of Financeby Robert R. Prechter

Socionomic theory predicts it will be at its least popular when it’s most useful, implying that right now, few will read The Socionomic Theory of Finance (STF) or this review, although it’s an important book and most financial market participants would benefit immensely from learning why they consistently lose money.

The prevalence of herding throughout the animal kingdom suggests its evolutionary benefits. A gnu in a herd sees a stalking lion and before you know it, they’re all fleeing because they’re all fleeing. One may end up gnu tartare, but the rest are safe, and evolution cares about species, not individuals. On a less bloodthirsty note, when a gnu finds a spring in a parched savannah, before you know it, the herd has bellied up to the bar. In an uncertain world, herding allows for virtually instantaneous dispersal of knowledge and evolutionarily effective responses.

Socionomics (so-shee-o-nom’-ics or so-see-o-nom’-ics) is the study of social mood and its influence over social attitudes and actions. It provides a basis for explaining the genesis of past social events and for anticipating future ones, thereby offering a new science of history and social prediction.

STF, pg. 113

That humans, in contexts of uncertainly, herd, is the least controversial socionomic assertion. It’s all downhill from there, in terms of a first-blush reader’s willingness to accept further assertions. However, Robert Prechter, claiming that socionomics is a science, does what scientists do: views suppositions as hypotheses that must be tested, and if necessary, revised or discarded. So don’t quit reading after the next few paragraphs, even though it may seem, on first blush, absurd. Press on, reminding yourself that socionomics holds itself to scientifically rigorous standards.

In contexts of uncertainty, herding is what Prechter terms “pre-rational.” It is not governed by the same part of the brain and the same mental processes as solving a math problem or rational herding in contexts of certainty—queuing up early with your friends for what you all know will be a sold out concert. Pre-rational herding impulses take precedence over rational reflexion and are the fundamental psychological driver of inherently uncertain financial markets. So-called rational reflexion comes into play after the impulsive imperative, and is nothing more than rationalization for impulsive action or inaction performed either before or after the rationalization. Following the herd in financial markets brings participants to grief, because the herd always has and always will buy high and sell low.

Socionomic theory breaks revolutionary and controversial ground.

The main theoretical principles are that in human, complex systems:

• Shared unconscious impulses to herd in contexts of uncertainty lead to mass psychological dynamics manifested as social mood trends.

• These social mood trends conform to a hierarchal fractal called the Wave Principle (WP) and therefore are probabilistically predictable.

• These patterns of human aggregate behavior are form-determined due to endogenous processes, rather than mechanistically determined by exogenous causes.

•Social mood trends determine the character of social actions and are their underlying cause.

STF, pg. 313

The concept of individual free will is not negated, but social mood impels social action. The last bullet point often proves the bridge too far, and not just for those seeing it for the first time. Everybody “knows” that events are behind social mood and its swings. Rising stock markets and expanding economies make people optimistic and happy. Depressions and wars make people depressed, pessimistic, fearful, and belligerent. It’s the job of social scientists to figure out how to promote prosperity and rising markets and prevent depressions and wars.

If Prechter’s right, the social scientists are wasting their time. The socionomic theory requires a 180 degree reversal in most people’s thinking. Social mood trends, regulated by their own internal, or endogenous, dynamics and impervious to external influences, motivate social actions. Social mood is the cause; social actions are the effects. Stock markets rise and economies expand because of rising social mood. Depressions and wars are results of falling social mood.

Social mood itself is intangible, although its effects are not, but we have indicators of social mood, called sociometers, from fields of human endeavor that are collective exercises in contexts of uncertainty. The best sociometers are equity markets, which second by second register changes in the speculative herd’s mood. Studying stock market charts in the 1930s and 1940s, Ralph Nelson Elliott discerned the wave patterns that became the basis for the Elliott Wave Theory (EWT).

As established by R.N. Elliott empirically and Benoit Mandelbrot mathematically, financial prices fluctuate as a fractal, with a comparable style of movement on all time scales, from seconds to centuries.

STF, pg. 232

A fractal, according to the Merriam-Webster online dictionary, is: “[A]ny of various extremely irregular curves or shapes for which any suitably chosen part is similar in shape to a given larger or smaller part when magnified or reduced to the same size.”

While Elliott waves are irregular, they take shape according to certain guidelines and mathematical relationships, many incorporating the Fibonacci sequence (0,1,1,2,3,5,8,13,21….). For any given time period a stock market can go up or down, but the EWT yields probabilistic predictions about its likely direction and pattern, which means it can be empirically tested. Much of STF is devoted to demonstrating the EWT’s predictive efficacy in both an absolute sense and relative to other economic and financial theories.

In Part I, Prechter demolishes a slew of external, or exogenous, cause theories purporting to explain financial markets. Think interest rates, earnings, oil prices, trade deficits (or surpluses), the unemployment rate, GDP, war, peace, central bank policy, news shocks, or any other exogenous factor has a consistent relationship to stock averages? They don’t, and Prechter has the charts to prove it. Think the prices of precious metals reliably rise with inflation? More charts, and again, there’s no consistent relationship. Spicing up Part 1 are quotes confidently asserting various consistent relationships. The absolute certainty expressed, in light of subsequent events, makes some of them unintentionally hilarious.

Surely central bank control of short term interest rates is an exogenous factor affecting at least the bond market? Prechter at one point thought so, but had an epiphany, an insight that remains controversial to this day: central bankers are human. As such, they ride the same social mood waves as everyone else, but because they’re basically part of the government and governments are always the last to get the joke, they act with a lag. Turns out—and Prechter’s got the charts here, too—the Fed’s interest rate moves follow rather than lead short-term interest rate markets. If you want to know the Fed’s next move, watch short-term interest rates, which is how the analysts at Elliott Wave International (EWI), Prechter’s company, have accurately predicted such moves, including last December’s increase.

To win acceptance, a theory must be empirically testable and yield accurate predictions if specified test conditions are met. Prechter presents solid evidence that the socionomic theory yields testable predictions that flow logically from its postulates and are far more accurate than random guesses.

Socionomics deals with herding behavior in contexts of uncertainty, so its predictions are not confined to finance. Take the famous hemline indicator, the correlation between hemlines and the trend in the stock market. Fashion is herding: what’s everybody else wearing? Hemlines, socionomics posits, are driven by the same social mood as the stock market. Women get optimistic, frisky, and daring during periods of rising social mood and wear miniskirts; they wear more somber clothes with lower hemlines during periods of falling social mood. The socionomic theory throws off all sorts of these non-finance hypotheses, which the STF explores in detail.

Prechter’s bread and butter is finance. He’s had his whiffs—predictions can only be probabilistic, not certainties. However, he and EWI’s numerous home runs, including the last stock market crash and the subsequent rally, put them in the prognosticators’ hall of fame. Like most of their big calls, those two evoked widespread derision until they were borne out. Chapter 22, “Elliott Waves vs. Supply and Demand: The Oil Market,” makes a compelling contrary case to whatever everyone “knows”—that the price of oil is governed by supply and demand. EWI has an astounding track record in that market, compiled over a 22-year span by five different analysts.

Prechter does an outstanding job of making his theory accessible. He is a fine writer with a straightforward style, which makes most of the book an easy read. The numerous charts are well labeled and explained.

There are a couple of quibbles. Prechter differentiation of the socionomic theory from other economic and financial theories is at times repetitive and tedious. He makes compelling arguments that socionomics upends much of the conventional social sciences, and that socionomics deserves acceptance as a new social science. It’s not an overstatement to say he’s put the science in social science. However, Part VII consists of articles written by other writers that seem aimed towards establishing socionomics’ credentials among academics. The points established are important, but are mostly refinements and subsidiary to the basic theory, and the writing, unfortunately, is too often in dense academic prose. This section can and probably will be skipped by most general readers, and they won’t have missed the thrust of the book.

Socionomics predicts its own popularity. In periods of rising social mood, the herd listens to the chorus of exogenous cause rationalizations for rising markets and economic vigor, and believes straight-line projections of more of the same. It ignores endogenous mood waves and chart analysis—the heart of the socionomic theory of finance—and predictions the market will reverse course. So the STF’s publication at a time when stock market averages are making new highs almost daily may be an instance of poor timing.

Or perhaps not. Prechter’s prediction for equity markets and the economy is that we are within months of the end of a fractal series of rising mood trends that will mark the top not just of the bull market wave that began in 2009, but a larger wave that began in 1974, a still larger wave that began in 1932, and a still larger wave that began in the 1780s. After these up waves comes a series of huge down waves, a devastating financial crash, and a depression greater than the Great Depression. Then, presumably, Prechter will be more widely read.

The Socionomic Theory of Finance represents a seismic shift in social science, a breathtaking, monumental intellectual accomplishment. Prechter has exposed exogenous cause “theories” as nothing more than post hoc rationalizations with the predictive power of coin flips. It may take a century or two for socionomics to win general acceptance (anyone who understands the theory will understand why), and per its own analysis its popularity will rise and fall inversely with social mood. To his credit as a scientist, Prechter invites further study, refinements, and modifications. However, those who directly challenge socionomics cannot fall back on the comfortable and widely accepted formulations he’s discredited. They must propose a theory that yields testable hypotheses and has more predictive power. That’s how real science works. Until someone builds that better theoretical mousetrap, socionomics will reign intellectually supreme. Let’s leave Prechter with the last word.

To an uninitiated person, conventional economic thinking feels right even though it’s wrong, and socionomic causality feels wrong even though it’s right. To begin your journey out of that mindset, you must learn to accept and then embrace irony and paradox, at least as humans are unconsciously wired to interpret things. Once you recognize that social mood and patterned herding are independent, primary causes that have consequences in social action, once you get used to the world of socionomic causality, the irony and paradox will melt away, and everything the markets do will make sense. Rather than appearing unfathomable, market action will become completely normal, somewhat predictable and wonderfully entertaining.

STF, pg. 373

A BULL MARKET IN GREAT WRITING

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15 responses to “Buy High and Sell Low? by Robert Gore

  1. Great review. Covered all the right parts to touch on. I became aquainted years ago when I was learning how to follow the money in politics as a means of making sense of things. You are quite right that its very entertaining to watch and follow since I have no skin in it to lose or win. I’m an aesthetic monk type with no interest in making moolah. I have a big interest in all things financial political and historical because it all fits in with the spiritual realm us mere mortals are assigned to for now.
    This review fits in well with a question iv’e been meaning to ask because I think it fits well with P.R. Sakars theory of the 4 ages of a civilization or society whereas many of our friends in these forums see it as the 4th turning which I think is more of a lagging indicator even though all 3 seem to be happening. Sakar would most likely consider this to be the end of the short Laborer age and beginning of the warrior age. I know you are a free thinker unencumbered by a lot of establishment pablum so I would like to know what you think. Thanks.

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    • I think that there are many historical theories that amount to fitting a theory to historical data. As a former non-aesthetic monk type with an interest in making money as a trader, I was looking for a theory that could at least alert me to big turns in financial markets with reasonable accuracy. Prechter’s formulation fit the bill, with both predictive acument and a theoretical basis I understood. It also predicts, although not as accurately as direction of market moves, their timing and amplitude.

      The Elliott Wave model also fit the simple trading rule I had used with a fair amount of success: buy when everybody’s selling and sell when everybody’s buying. It sharpened my trading, and I made good money on some major market moves, like the 2007-2009 financial crisis. Conversely, the one time I ignored the model, after that crisis, it cost me a great deal. My brain said the financial crisis was coming to at least a temporary end, but emotionally I couldn’t accept that and regrettably, I traded on that emotion.

      As for P.R. Saker’s theory of the four ages, I’m not familiar with it. I have a general acquitance with Strauss and Howe, although I haven’t read their books. They have essentially reached the same conclusion about an apocalyptic outcome as Prechter, but the Elliott Wave model will be more valuable when it arrives for anyone who might be interested in trying to trade financial markets. Strauss and Howe predict an outcome, but have no scientific basis for further predictions about duration, magnitude, and timing of their Fourth Turning. The Elliott Wave model is essentially either-or; if you accept its hypothesis you necessarily reject others that are not consistent with it.

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  2. Thanks. wasn’t trying to deny you making gains, just wanted say I know the difference between interested observer and someone who has something real to lose like when you went against it. We will both have a lot of skin in the game soon and I prefer having a plan guided by input from others.
    This old Marine who looked like he had been in every war since 1776 told me if I don’t have a plan I’m gonna die because I can’t change something I don’t have.

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    • Here’s one plan I have that doesn’t come from Prechter, just common sense: guns, ammo, food, medicine, and other provisions, residence in Albuquerque, where Anglos, Hispanics and blacks have lived peacefully together for many years, and a go to cabin remotely situated in the mountains of NM where there is a fishing stream and the deer are so tame they come to your door. As for making money, I’ve got a feeling it may problematic for even those of us who are comfortable from the short side to do so, especially if the financial system crumbles. It’s hard to collect from counterparties who are bankrupt.

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      • “It’s hard to collect from counterparties who are bankrupt.” That is a perfect description of the 2007 crash in one sentence. Kudos.

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        • There’s an interesting personal story there. I was running a proprietary trading desk at a regional brokerage. We had initiated what was basically a short bet, with a variety of derivatives, including credit default swaps, for the crash. We set up a prime brokerage account with a large NY firm. We were doing well, but then rumors started circulating about the health of our counterparty. I couldn’t subject my firm to a big loss if our counterparty went broke, so I pulled the money from the prime brokerage account just as our bets were skyrocketing. The counterparty firm got bailed out by the government, or it would probably would have bankrupt. If I had left the money there we would have made a lot more than we did, but I couldn’t take that risk. That’s where that sentence comes from.

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  4. After reading your excellent review I just dusted off my 2nd edition of Conquer the Crash, which I bought after having donated the 1st edition as well as several other Prechter titles to the local library book sale when I concluded that (not unlike gold bars) there is great value but little utility in his writings. Reading them helps make sense of otherwise puzzling events and suggests a likely outcome, but then so does The Bible. Both authoritatively assure us the End is clearly imminent as confirmed by current events; both have been wrong for a long time.

    At the Crest of the Tidal Wave predicted the Supercycle peak during the dot com bubble twenty years ago, now your review states Prechter views the current mania as building that ultimate peak. I assume the 2007 peak in between provides a clear wave pattern pointing unmistakably to this conclusion.

    It looks like current society, politics, and markets couldn’t get any crazier, but it felt that way in 1999 and 2007. Neither of those proved to be the Top and we will only know if this is really It many years hence, at which time historical wave patterns will clearly confirm it. Elliott Wave theory shows us we are steaming through an ice field but cannot predict which iceberg will doom us.

    The reason I shelved him lies in Prechter’s continued reliance on financial markets as the principal gauge of social mood. Markets are no longer organic and are no longer accurate reflections of basic human behavior. While he would doubtless characterize the consequences of HFT and central bank intervention, for example, simply as socionomic phenomena, they and the plethora of other relatively recent market macro-manipulations have, I believe, distorted his data beyond utility for Elliott Wave analysis. Hence his inability accurately call The Top.

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    • Excellent observations and comments, especially the last paragraph. I have had similar thoughts over the last few years, and Prechter does say that markets can be distorted by government actions. However, he also says that governments cannot drive markets where they don’t want to go, that they are, as I noted in my review, the last to get the joke. Governments and central banks obviously intervening in equity and other financial markets, I believe, has an important socionomic message that you allude to but dismiss. They are doing so at the tail end of a supercycle stretching back over two centuries. How much they affect markets is open to debate, but the socionomic importance is clear. They would only be doing so at the tail end of this huge up wave, preceeding a huge down wave. They’re basically buying at the top.

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    • “At the Crest of the Tidal Wave predicted the Supercycle peak during the dot com bubble twenty years ago, …” No diss on you Kevin, however the dot com bubble was not a dot com bubble.

      That bubble of which people speak was the confluence of three events in real time of the period —
      1) The internet finding traction.
      2) The Y2K scare coming to fruition.
      3) Insurance companies reminding the fortune 5000 that they will not be covered under their self-insurance paradigm if due diligence was not applied on computational machinery.

      Had (2)&(3) not occurred at the same time as (1) then the business failures attendant for the dot bust would have quite honestly been viewed as ‘normal cycle new platform shakeout’ but they did not. The dot bust was in part caused by corporate exhaustion in capital expenditures for Y2K and part due to stupid business models. (Like selling dog food over the internet forgetting that shipping costs are the main driver.) But the dot bust label was a good cover for bad ideas and it stuck.

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  5. Some of this escapes me, but I know about the part when the herd decides, suddenly, and without any rationality, to thunder off to wherever. When I became a leader in the Army, it was an epiphany I had myself, and I never forgot the lesson, and how important it was. In the movies, you see the British officer smiling and encouraging the men with a “devil may care, but I don’t” attitude, even when all is obviously lost, (it ultimately was not). The herd CAN be turned, and disaster averted, IF the leadership stays calm, and keeps encouraging and staying on point and positive. Something happens in men’s minds when mortal fear enters, and most shut down, and go with their gut, fight, or flight if you will. Self preservation usually goes with flight, but that won’t do, if you actually want to preserve yourself. Most of the casualties in battle come not from the battle itself, but the pursuit of the defeated enemy, as they are interested in nothing but safety. The best colonels and generals wind up being the ones who know how to conduct an orderly and fighting retreat in the face of disaster. Witness the Battle of the Bulge, the Chosin Reservoir, and Washington preserving his army from annihilation and thereby America, by simply refusing to give battle to the British until he was ready to fight on his own terms. History is replete with the stories of victory snatched from the jaws of defeat. You don’t just stand on that burning bridge, because it’s noble, or brave, or honorable. You do it because it’s logical. Courage, after all, is simply the ability to think, under pressure.

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  7. Back around ’03 we were purchasing our house and a friend was big into Prechter and EWT. He feared we were buying right before a crash, but we needed housing and preferred not to rent. We barely got in early enough to avoid losing value below what we paid. Still, it was a decent prediction.

    A few other Prechter ‘predictions’ he shared back then that were pretty darn close: football would increase in popularity, and we’d get a woman president. That was well over a decade ago; doesn’t seem too shabby to me.

    Pragmatics begs the question: ok, so what? Are we really looking at a traumatic sort of return to the dark ages where advanced civilization collapses and hibernates for some time? And even if not so dramatic a situation, how best to survive and thrive? Hunkering down/bugging out seems perhaps a bit too temporary of a measure in light of everything.

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    • Prechter goes where the Elliott waves take him and now they take him where I indicated in my review. He believes the coming down wave will be a deflationary depression, with massive defaults on all sorts of debt, including sovereign debt and the debt banks owe to their depositors. He likes cash and to an extent gold, although he believes its dollar price will be caught, like everything else, in the deflationary undertow. EWI is headquartered in Gainesville, Georgia, about 90 minutes north of Atlanta. I’ve been there and it strikes me as a pretty good place to survive, if not necessarily thrive, in the event of apocalypse. Prechter sees the potential for violence and upheaval, but it’s not his main focus. But I’m sure in addition to what he recommends for financial survival (see the latest edition of Conquer the Crash) he would recommend common preparations readily available on the Internet and in various books. I don’t think he thinks civilization will collapse and hibernate, just regress, and a lot of what people now consider wealth will simply vanish. However, keep in mind his theory: when everyone is most depressed and desperate, it will be time to start acquiring assets at knock down prices, because up waves follow down waves.

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  8. Pingback: An Excerpt From The Socionomic Theory of Finance, by Robert Prechter | STRAIGHT LINE LOGIC

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