Elliott Wave Prediction: Is the Dow Heading for Another Plunge?

Think the market's bad enough now? If you believe the Elliott Wave Principle, a market-analysis theory that predicted the 2008 fall, you can expect it to get much worse.

Stock analyst Robert Prechter, who uses the principle in his financial forecasts at Elliott Wave International, predicts the market will suffer a cataclysmic collapse in the next six years. The firm's monthly Elliott Wave Theorist newsletter forecasts that the Dow Jones Industrial Average ($DJI) will lose more than 90% of its value in that time, MarketWatch reported last week.

For some investors, such pessimism is doubtless difficult to understand. Despite fears of a double-dip recession and frequently disappointing macroeconomic data, an actual decimation of the market seems unfathomable. Even during the Great Recession, the Dow didn't fall below 6,000. Imagine what a full 5,000 points below that would be like.

Explaining the Elliott Wave

Essentially, the Elliott Wave Principle uses a form of crowd psychology to understand and predict investor behavior. Because stock prices are driven by human decisions, the principle uses patterns in human behavior to analyze financial markets.

While the theory is complex, the basic idea is that financial markets cycle through alternating waves of optimism and pessimism, with the length and intensity of the waves depending on their stage in the cycle. The cycles themselves last for different amounts of time, ranging from minutes to centuries, and display unique features.

According to the Elliott Wave Theorist, the market is currently in the longest type of cycle, called a "supercycle," which takes decades -- or even centuries -- to manifest. Typically, when such an oscillation reaches a top or bottom, it's either extraordinarily profitable or tremendously destructive. Elliott Wave expects the latter to occur by 2016.

Can Elliott Wave Forecast the Future?

But the theory hasn't yet proven it can flawlessly predict the market. While Elliott Wave has accurately anticipated some of the major swings that stocks have experienced, it hasn't been perfect. For every move that it called correctly, like the 2008 dip, it has made an error, like its failure to foresee the rally in the last year or so.

In the end, Elliot Wave is only one form of technical analysis, the merits of which are hotly debated. Technical analysis uses statistics, rather than market news or companies' intrinsic value, to predict market activity.

Different analysts have many different ways of assessing the market, and asking them how the market will behave will yield an incredible range of answers, both positive and negative.

So while there is always a possibility that the financial markets collapse, it's far from a certainty. Only in 2016 will the world find out whether the famous theory is right.