An Excerpt From The Socionomic Theory of Finance, by Robert Prechter

Several weeks ago, SLL posted “Buy High and Sell Low?” a review of Robert Prechter’s groundbreaking The Socionomic Theory of Finance. Mr. Prechter and his team at Elliott Wave International have now made available to SLL an excerpt from Chapter 1, for any SLL reader who wants to sample the book. For those who don’t need a sample and want to go straight to the book, here is the Amazon link. The book has eight out of eight 5-Star reviews on Amazon, as it should. From Robert Prechter at elliottwave.com:

The Myth of Shocks

An Excerpt from Chapter 1 of The Socionomic Theory of Finance, by Robert Prechter

Few people find a new theory accessible until they first see errors in the old way of thinking. Part I of this book challenges the universally accepted paradigm under which humans’ rational reactions to exogenous (external, or externally generated) causes purportedly account for financial market behavior. The current chapter explores whether dramatic news events affect financial markets.

Testing Financial-Market Reaction under Perfect Conditions

In the physical world of mechanics, action is followed by reaction. When a bat strikes a ball, the ball changes course.

Most financial analysts, economists, historians, sociologists and futurists believe that society works the same way. They typically say, “Because so-and-so has happened, it will cause such-and-such reaction.” This mechanics paradigm is ubiquitous in financial commentary. The news headlines in Figure 1 reflect what economists tell reporters: Good economic news makes the stock market go up; bad economic news makes it go down. But is it true?

In the second half of the 1990s, a popular book made a case for buying and holding stocks forever. In March 2004, after several terrorist attacks had occurred, the author told a reporter, “Clearly, the risk of terror is the major reason why the markets have come down. We can’t quantify these risks; it’s not like flipping a coin and knowing your odds are 50-50 that an attack won’t occur.”1

In other words, he accepts the mechanics paradigm of exogenous cause and effect with respect to the stock market but says he cannot predict a major cause part of the equation. The first question is, if one cannot predict causes, then how can one write a book predicting effects? A second question is far more important: Is there any evidence that dramatic news events that make headlines, including terrorist attacks, political events, wars, natural disasters and other crises, are causal to stock market movement?

Suppose the devil were to offer you historic news a day in advance, no strings attached. “What’s more,” he says, “you can hold a position in the stock market for as little as a single trading day after the event or as long as you like.” It sounds foolproof, so you accept.

His first offer: “The president will be assassinated tomorrow.” You can’t believe it. You are the only person in the world who knows it’s going to happen.

The devil transports you back to November 22, 1963. You quickly take a short position in the stock market in order to profit when prices fall on the bad news you know is coming. Do you make money?

To continue reading: An Excerpt From The Socionomic Theory of Finance

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