“The Stock Market Is Disconnected From Reality”. And this is not a problem at all!

The Stock Market Is disconnected from economic reality. And that is o.k. and not a problem at all! Why?

You don’t invest in the economy but in the stock market? The economy and the stock market are two different entities.

The stock market and the economy are not in alignment usually.

The only times that the economy and the stock market coincide and align are when the stock market is trending.

At turning points, investors who are waiting for confirmation from earnings and the economy will be lagging behind the stock market, as history has proven that the stock market turns well before the economy.

The stock market is a leading indicator for the economy.

The Efficient Market Hypothesis has proven to be an unworkable paradigm

In his seminal book “The Socionomic Theory of Finance,” Robert Prechter outlines why the economy and the stock market should be treated differently.

Whereas the law of “supply and demand operates among rational valuers to produce equilibrium in the marketplace for utilitarian goods and services . . . [i]n finance, uncertainty about valuations by other homogenous agents induces unconscious, non-rational herding, which follows endogenously regulated fluctuations in social mood, which in turn determine financial fluctuations. This dynamic produces non-mean reverting dynamism in financial markets, not equilibrium.”

Moreover, since the efficient market hypothesis (the basis for fundamental analysis in financial markets) is an outgrowth from the world of economics, it has become apparent to be an unworkable paradigm for financial markets.

Understanding that an underlying assumption within economics is that all investors act rationally and with the same knowledge, you can easily understand why it is unworkable in financial markets.

One cannot reasonably apply an economic model to the financial markets

Benoit Mandelbrot stated that one cannot reasonably apply an economic model to the financial markets:

“From the availability of the multifractal alternative, it follows that, today, economics and finance must be sharply distinguished . . .”

From an empirical standpoint, consider that, within economic theory, rising prices result in dropping demand, whereas rising prices in a financial market usually lead to rising demand.

Most investors continue to apply the same analysis paradigm to both environments incorrectly.

At the end of the (trading) day, there is no reality other than price. The stock market is a reality. And, if you are following anything that suggests that the stock market is disconnected from reality or wrong, you may be disconnected from reality.

“A prudent speculator never argues with the tape. Markets are never wrong. Opinions often are.”

Jesse Livermore noted: “A prudent speculator never argues with the tape. Markets are never wrong. Opinions often are.”

The Elliott Wave Principle

The Elliott Wave Principle is a form of technical analysis used to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors.

It was developed by Ralph Nelson Elliott in the 1930s, drawing on insights he gained while recovering from an illness. 

Here are its basic principles:

Wave Structure: Elliott proposed that market movements are not random but follow a natural rhythm or pattern of five waves in the direction of the main trend followed by three corrective waves (a "5-3" move). This pattern is repeated on various time scales, creating a fractal-like structure in market movements.

Impulse and Corrective Waves: In the Elliott Wave structure, the first five-wave pattern is called the "impulse waves," and the three-wave pattern is called the "corrective waves." The impulse waves are labeled as waves 1, 2, 3, 4, and 5. The corrective waves are labeled as A, B, and C.

Fractal Nature: Elliott's theory is fractal and thus infinitely scalable. This means the same patterns seen in long-term market data can also be identified in short-term market data.

Rules and Guidelines: Elliott Wave Theory has specific rules and guidelines. For example, Wave 2 never retraces more than 100% of Wave 1, and Wave 4 never enters the price territory of Wave 1.

Wave Degree: Elliott identified nine degrees of waves, from the Grand Supercycle, which may last several centuries, to the subminuette wave, which may last only a few minutes.

Fibonacci Relationships: Elliott discovered that Fibonacci ratios were integral to wave structures. For instance, Wave 3 is often 1.618 times the length of Wave 1.

Trader Psychology: The waves are said to reflect the overall mood of the market participants. The theory suggests that an investor's psychology is swinging from optimism to pessimism and back in a natural sequence, creating specific patterns in the price movements.

Predictive Value: Proponents of the theory claim that it can predict price movements by identifying the repeating patterns of waves.

Benoit Mandelbrot - Fractal Theory

Benoit Mandelbrot, a pioneering mathematician famous for developing fractal geometry, made significant contributions to the field of economics, particularly in understanding the stock market.

His work in this area focused on challenging traditional theories about market behavior and introducing new perspectives based on fractal geometry and complexity.

Challenging the Efficient Market Hypothesis: Traditional financial models, like the Efficient Market Hypothesis (EMH), assume that price movements in the stock market are random and follow a normal distribution. Mandelbrot questioned this notion, arguing that market prices do not follow a Gaussian distribution and are, in fact, far more volatile and unpredictable.

Fractal Market Hypothesis: Mandelbrot introduced the Fractal Market Hypothesis, which posits that financial markets exhibit self-similarity and scaling properties. This means market behavior can appear similar at different time scales – a characteristic of natural fractal patterns. His approach suggested that large market movements are more common than expected in a normal distribution.

Heavy Tails and Wild Randomness: He emphasized that stock market prices exhibit "heavy tails" – a statistical property where extreme values (like sudden and significant drops or spikes in stock prices) occur more frequently than would be predicted by a normal distribution. He referred to this concept as "wild randomness," which contrasts sharply with the "mild randomness" of standard financial theories.

Multifractal Time: Mandelbrot also introduced the concept of multifractal time in financial modeling. This approach accounts for varying degrees of market volatility over time, challenging the traditional assumption that time moves uniformly in financial models.

Mandelbrot's work in the stock market and economics was groundbreaking because it offered a new way to understand financial markets' complex and often chaotic behavior.

His theories have influenced modern financial analysis, leading to more sophisticated models that attempt to account for the irregular and fractal nature of market movements.

However, it's worth noting that while his ideas gained attention and sparked much discussion, they have not replaced traditional financial models but rather supplemented them, offering alternative perspectives on market behavior.

Jesse Livermore - boom and bust

Jesse Livermore, a legendary figure in the world of stock trading, is known for his groundbreaking work and strategies in the stock market during the early 20th century.

Unlike Benoit Mandelbrot, who approached the market from a theoretical and mathematical standpoint, Livermore's contributions were based on his practical experiences as a trader. His methods and philosophies are still studied and admired by traders today.

Price Action and Trend Following: Livermore was a pioneer in using price action and trends to guide his trading decisions. He believed in buying and selling stocks based on their price movements and trends rather than relying on fundamental analysis or a company's intrinsic value. This approach made him one of the early adopters of what we now call trend following.

Market Psychology: Livermore placed significant emphasis on understanding market psychology. He believed that the emotions of fear and greed were critical drivers of market movements and that successful traders needed to master these emotions, both in themselves and in understanding how they affected other market participants.

Money Management: He was known for his strict money management rules. Livermore advocated for the importance of preserving capital and cutting losses quickly. He famously said, “The real money made in speculating has been in commitments showing in profit right from the start.”

Market Patterns: Livermore studied and recognized specific market patterns and formations, which he used to predict future price movements. He was skilled in identifying market tops and bottoms and made some of his most profitable trades by correctly predicting these turning points.

Leverage and Speculation: Livermore often used leverage to maximize his gains, a risky strategy that sometimes led to spectacular successes but also contributed to his financial ruin on multiple occasions. His career was marked by dramatic ups and downs, primarily due to his aggressive trading style.

Livermore's Rules: He developed a set of trading rules and principles based on his experiences. These rules covered various aspects of trading, including when to buy and sell, how to manage risk, and the importance of studying the market.

Jesse Livermore's life and work have been immortalized in books like "Reminiscences of a Stock Operator," which is considered a classic in the field of trading.

His approach was less about mathematical models or systematic analysis and more about intuition, understanding market trends, and psychological discipline. His legacy lives on in the strategies and philosophies that many traders continue to use as a foundation for their approaches to the stock market.