Elliott Wave Guru Sees Dark Days Ahead

By TIERNAN RAY | MORE ARTICLES BY AUTHOR
One of America's most famous market forecasters thinks that investors should play it safe with their investments.

ROBERT PRECHTER, THE market forecaster who told investors to sell their stocks weeks before the October 1987 crash, is back in the news.

Prechter, head of market-forecasting firm Elliot Wave International and author of several books, including Conquer the Crash (available from Amazon.com), has been quoted recently as saying that the current recession could last for a long time and even force stock markets back down to levels seen at the market bottom reached in March of this year.

Barron's caught up with Prechter by phone this week to understand the technical trading signs he looks at to draw conclusions about investor sentiment.

Barrons.com: You've said that today's recession represents a very deep and prolonged decline, akin to the 1929-1932 depression. What's your reason for viewing things as so dire?

Robert Prechter: My model is that naturally occurring waves of optimism and pessimism, which result from unconscious herding, are the driver of financial and macroeconomic trends. Upon rare occasion, waves of very large degree come to an end. In the financial realm, when people get more pessimistic, they sell stocks and curtail credit. They also take fewer risks in the realm of production, which causes the economy to contract. Taken together, these changes -- at very large degree -- portended a downward revaluation of the stock market, a deflation in credit and a depression.

Q: By what measure are you judging this pessimism?

A: Aside from price patterns per se, we track waves of social mood by way of psychological indicators. At large degree, we use things such as price/dividend, price/book and bond yield/stock yield ratios, mutual fund cash percentages, the number of investors bullish vs. bearish, credit spreads, savings rates, consumer sentiment, duration of optimism, and so on. From 1998 to 2007, these measures set records. P/E is still setting records. Optimism occurs at tops, and the more extreme the optimism, the bigger the degree of the top.

Q: Some observers allege that steps taken by President Roosevelt during the early part of the Great Depression ended up prolonging the depression. Will policy decisions being enacted now ameliorate or exacerbate the current decline?

A: Governments' policy decisions hamper and ruin economies all the time, but their meddling does not affect waves of social mood. On the contrary, waves of social mood generally spur governments to act. The 1929-1932 collapse caused the government to get restrictive and separate commercial and investment banks in 1933; this was after the bust it was designed to prevent was over. The 1990s boom caused government to get frisky and repeal the act in 1999; this was just as the boom it was designed to foster was ending. These policy decisions did not cause any changes in social mood, but the social mood trends predicted the character of the policy changes. Government herds, just like everyone else, but it is at the tail end of the herd, because it takes time for a consensus to develop so extensively that government has the public support to act.

Q: While the Federal Reserve's FOMC Wednesday said the slump will be worse than originally expected in the next three years, others are convinced that the "less bad" data points could lead to a recovery in the second half of this year.

A: Social actions result from social mood change. When we recognized a temporary low in pessimism in late February/early March, we were able to predict changes that would result: stocks would rally, credit spreads would narrow, housing sales would pick up, and authorities would take bows for effective "liquidity" and "stimulus" programs. If it goes high enough, a consensus will probably develop that the bear market and recession are behind us. Then it will be time for the next wave down.

Q: You've been quoted as suggesting people invest in Treasuries, considering them "safe cash proxies," but you've also said skeptical things about Treasuries given massive borrowing and the threat of deflation. Which is it?

A: It's a matter of short rates versus long. The best investment stance for conservative investors has been simple: safety. My primary recommendation is safe-cash equivalents. This means Treasury bills, Swiss money-market claims, some New Zealand bonds, some gold and some cash. There has been no change there. Cash has been good. Today you can buy twice the house, twice the stock shares and twice the gasoline that you could a short while ago.

But long term, Treasuries are different. After 28 years of rising prices for T-bonds, the Fed announced in December that it would buy them. Part of the downturn in prices relates to an anticipated pick-up in the economy, which should in fact occur for part of this year; part is due to hyperinflation fears, which I think are misplaced; and part is due to early fears of eventual government default, which I think are not misplaced. If government rates go up, bond investors will lose money, while we bill investors will make money, at least until it's time to bail out of government debt entirely.

Q: Do you prefer dollars to other currencies?

A: My position is that the dollar is the most inflated currency in the world, so it has the furthest to deflate. In other words, because it is so sick, it is the currency most likely to rise during the deflationary period as dollar-denominated IOUs collapse. Regardless, my currency mix includes what I consider to be very safe foreign debt and some gold. You have to realize that almost everyone loses in a deflation. The key is to lose a lot less than everyone else. Market opinions are one thing; safety is another.

Q: Your remarks as quoted in the press seem to refer essentially to the U.S. economy. What is your view of the rest of the world's economic prospects?

A: It's a developing global depression. Economies and societies are so closely entwined in the modern world that social mood is much more pervasively shared than it was centuries ago. So the world had a boom together, and it's having a bust together. The canary in the coal mine was Japan, which reached impossible-to-maintain extremes of debt and investment values a decade earlier than other countries did.

Q: So in spite of this market run-up, there's more misery ahead?

A: If you stay safe, it's the opposite.