Buy High and Sell Low? A Review of Robert Prechter’s The Socionomic Theory of Finance

Review of The Socionomic Theory of Finance, by 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.