An Inefficient Market Hypothesis

***AN INEFFICIENT MARKET HYPOTHESIS***

By J. Adams
Revised Edition: 7/21/97
(Original: 2/25/95)

Recently the Dow Jones Industrial Average (DJIA) reached an all- time high just above the psychologically important 8000 mark and has since started a significant reversal. Based upon past stock market behavior, there is reason to believe that a "Grand Supercycle" top has been reached and the worst crash in history is now at hand. 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 high above Dow 8000, collective beliefs and expectations 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. (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.) In November of 1995, the DJIA ran up to the 5000 mark for the first time and then briefly retreated by five percent. Next, after soaring through 6000 last year, the DJIA reached above the 7000 mark for the first time in February of this year. The Dow then retreated to 6300 into April, the first ten percent correction since the index tested the 4000 mark in 1994.

The most recent psychologically important thousand mark reached in the DJIA is Dow 8000. Last week the DJIA broke above 8000 for the first time in history and then reversed sharply. What seems to have occurred is a euphoric top at 8000 similar to the peak in the DJIA at 3000 in 1990. Indeed, it was on July 16th and 17th of 1990 when the Dow closed at a then record peak of 2999.75, and it was on July 16th and 17th of last week that the Dow closed above the 8000 mark for the first time in history and then fell back below 8000. 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 a little more confident that the DJIA is currently entering a major bear market in the wake of the Dow's peak above the psychologically important 8000 mark. Dow Theory holds that, if the Dow Jones Industrial Average reaches an all-time high when other major market averages 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). 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 recent all-time high reached in the DJIA above 8000, there was another non-confirmation indicating a future sell-signal. The Utilities last reached an all-time high in October of 1993. Thus, when the Industrials reached an all-time high last week above 8000, the record peak was not confirmed by a record high in the Utilities meaning that a Dow Theory sell-signal could occur which historically has been followed by a major decline in stock prices. (Notably, the peak in the Industrials WAS confirmed by a record high in the Transportation average, suggesting the final peak may still not have occurred.)

-The Elliott Wave Principle of Stock Price Movements-

The potential scale of a future decline in stock prices following the recent reveral from Dow 8000 and a Dow Theory non-confirmation 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 has now been 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 when the S&P climbed above 700 last year, can be seen on a logarithmic chart of the S&P by drawing a line through the key 1937 peak, the 1966 peak and current highs in the S&P. As the Wave Principle predicts, this Supercycle upper channel is parallel a lower trendline that can be drawn through the 1942 low, the 1974 bottom and the 1982 low.

One of the main reasons to believe the Grand Supercycle peak has been reached above the Supercycle upper channel line and Dow 8000 is because the current high point in stock prices is coinciding with a major planetary alignment. Each of the Elliott Wave turning points at the Supercycle upper and lower channel lines listed above, i.e., 1937, 1942, 1966, 1974 and 1982, occurred around the time of rare planetary alignments. This pattern is repeating now as the current top is coinciding with another major planetary alignment.

If, indeed, we are currently around the Grand Supercycle peak in stock prices above the Supercycle upper channel line and Dow 8000, 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.

-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 is getting underway following the peak recently reached above Dow 8000. Based upon psychological barriers in the DJIA, a Dow Theory non-confirmation, the Elliott Wave Principle and astroharmonics, there is substantial reason to believe that a major, unprecedented decline in stock prices has just begun.

If the expected decline occurs, then this will significantly falsify the Efficient Market Hypothesis and undermine reigning economic theory. Furthermore, the collapse 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 recent unprecedented peak likely involves 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 .