The Idiot Wave

By Tom Veale

The Idiot Wave name actually started as a play on words. In the 1980s, Robert Prechter popularized the Elliot Wave Theory. I guess it was just too good a fit. Since I’m gauging market risk, it seemed natural to say “Well, I wonder what the idiots are doing to the market today?”

Value Line Investment Survey has been one of my most reliable sources of information since the early 1980s. It’s available at most public libraries in their “1700 Stock” version. The Index section contains some very good screens. My favorites are “The Best/Worst Performing Stocks (Last 13 weeks)” on page 33. Here, at a glance, you can see 82 different stocks and how they’ve performed over the last quarter. I noted that market speculation seemed to be nicely displayed by these two charts. If the “Best” were soaring while the “Worst” weren’t too bad, it usually meant the market was getting to be over-bought. The opposite is true when the “Worst” are just awful and the “Best” aren’t doing much exciting. This became the first piece of the Idiot Wave.

Elaine Garzarelli gave a talk once about the correlation of interest rates and price/earnings ratios. She claimed there was a sort of “magic number” equal to 20. It was the long-term average value. If P/E plus the interest rate was greater than 20, by very much, then the market was over-bought and visa versa. She felt that + or – one point was the neutral range. When I tried this with the 52 week U.S. Treasury rate and Value Line’s P/E, I was amazed by how well it worked. That was the second piece.

One of my favorite books on the market is Norman Fosback’s “Stock Market Logic.” Almost every market statistic is explained and in many cases improved upon. One of my favorites is his “NYSE Hi/Low Logic Index.” It states that if everyone is in general agreement about market direction, then the number of new highs or lows will be very small. If the market is confused about its next move, there will be large numbers of new highs and lows simultaneously. This has proved to be a good way to confirm other high and low risk market events. I applied his formula to the NASDAQ Composite to see how it would do and have been pleased with the results. My only problem with the data is that there’s a seasonality factor near the end of the year – during “Tax Selling Season.” Then it seems that the “bad” get worse and the “good” get better. However it was good enough to add to the Idiot Wave, and component three was born.

Finally, a peculiar market condition in 1993 brought about the addition of the forth and final component – Zeal. The Idiot Wave had been very good right up to 1993. However, in that year we had a massive IPO surge. The NASDAQ Composite Index added about 800 issues to its usual count of 4200 in just one year! My “Speculation” index went flat, even though I knew there was lots of speculating going on. My Idiot Wave was not measuring it.

The solution was there, all I had to do was apply the data I already had. I started to measure the percentage of change in the number of issues on the NASDAQ and NYSE over about a 10 to 13 week period. If the number was increasing rapidly, this showed speculation in a way missed by my other measures. If it was decreasing, money was then concentrating in the remaining issues and showed low speculation.

Decreases were bullish and increases were bearish. The range is very small. A percentage less than 0.0 is bullish while an increase of more than 2.0% is bearish. In 1993 Zeal peaked at 8.6% and the following year was a consolidation DOG.

Thinking back, I find it hard to believe that I’ve collected so much data! When the four components are united as either being bullish or bearish, the Idiot Wave is a great device for confirming what AIM is doing.

When it’s a mixed bag and the Idiot Wave is in its own Average Risk range, there’s not as much to be learned from it. I scaled the grand total by weighting each component so that the Idiot Wave would correlate to what a rational Cash Reserve might be for the market conditions.