Less Reliance On Market Averages And Indicators

LESS RELIANCE ON MARKET AVERAGES AND INDICATORS

Stock market analysis is based heavily on the movement of broad market averages—such as the Dow Jones Industrial Average or the S&P 500. In addition, technical indicators that measure the strength or weakness of the broader market—like the NYSE advance-decline line or the new highs-new lows list—are heavily employed. While commodity markets can be tracked using mea­sures like the Commodity Research Bureau Futures Price Index, less emphasis is placed on the broader market approach. Commodity market analysis concentrates more on individual market action. That being the case, technical indicators that mea­sure broader commodity trends aren't used much. With only about 20 or so active commodity markets, there isn't much need.

Specific Technical Tools

While most of the technical tools originally developed in the stock market have some application in commodity markets, they are not used in the exact same way. For example, chart patterns in futures often tend not to form as fully as they do in stocks.

Futures traders rely more heavily on shorter term indica­tors that emphasize more precise trading signals. These points of difference and many others are discussed later in this book.

Finally, there is another area of major difference between stocks and futures. Technical analysis in stocks relies much more heavily on the use of sentiment indicators and flow of funds analy­sis. Sentiment indicators monitor the performance of different groups such as odd letters, mutual funds, and floor specialists. Enormous importance is placed on sentiment indicators that measure the overall market bullishness and bearishness on the theory that the majority opinion is usually wrong. Flow of funds analysis refers to the cash position of different groups, such as mutual funds or large institutional accounts. The thinking here is that the larger the cash position, the more funds that are available for stock purchases.

Technical analysis in the futures markets is a much purer form of price analysis. While contrary opinion theory is also used to some extent, much more emphasis is placed on basic trend analy­sis and the application of traditional technical indicators.

SOME CRITICISMS OF THE TECHNICAL APPROACH

A few questions generally crop up in any discussion of the tech­nical approach. One of these concerns is the self-fulfilling prophe­cy. Another is the question of whether or not past price data can really be used to forecast future price direction. The critic usually says something like: "Charts tell us where the market has been, but can't tell us where it is going." For the moment, we'll put aside the obvious answer that a chart won't tell you anything if you don't know how to read it. The Random Walk Theory ques­tions whether prices trend at all and doubts that any forecasting technique can beat a simple buy and hold strategy. These questions deserve a response.

The Self-Fulfilling Prophecy

The question of whether there is a self-fulfilling prophecy at work seems to bother most people because it is raised so often. It is cer­tainly a valid concern, but of much less importance than most people realize. Perhaps the best way to address this question is to quote from a text that discusses some of the disadvantages of using chart patterns:

1. The use of most chart patterns has been widely publicized in the last several years. Many traders are quite familiar with these patterns and often act on them in concert. This creates a "self-fulfilling prophecy," as waves of buying or selling are created in response to "bullish" or "bearish” patterns. . .
2. Chart patterns are almost completely subjective. No study has yet succeeded in mathematically quantifying any of them. They are literally in the mind of the beholder.... (Teweles et al.)

These two criticisms contradict one another and the sec­ond point actually cancels out the first. If chart patterns are "com­pletely subjective" and "in the mind of the beholder," then it is hard to imagine how everyone could see the same thing at the same time, which is the basis of the self-fulfilling prophecy. Critics of charting can't have it both ways. They can't, on the one hand, criticize charting for being so objective and obvious that everyone will act in the same way at the same time (thereby caus­ing the price pattern to be fulfilled), and then also criticize chart­ing for being too subjective.

The truth of the matter is that charting is very subjective. Chart reading is an art. (Possibly the word "skill" would be more to the point.) Chart patterns are seldom so clear that even experi­enced chartists always agree on their interpretation. There is always an element of doubt and disagreement. As this book demonstrates, there are many different approaches to technical analysis that often disagree with one another.

Even if most technicians did agree on a market forecast, they would not all necessarily enter the market at the same time and in the same way. Some would try to anticipate the chart sig­nal and enter the market early. Others would buy the "breakout" from a given pattern or indicator. Still others would wait for the pullback after the breakout before taking action. Some traders are aggressive; others are conservative. Some use stops to enter the market, while others like to use market orders or resting limit orders. Some are trading for the long pull, while others are day trading. Therefore, the possibility of all technicians acting at the same time and in the same way is actually quite remote.

Even if the self-fulfilling prophecy were of major concern, it would probably be "self-correcting" in nature. In other words, traders would rely heavily on charts until their concerted actions started to affect or distort the markets. Once traders realized this was happening, they would either stop using the charts or adjust their trading tactics. For example, they would either try to act before the crowd or wait longer for greater confirmation. So, even if the self-fulfilling prophecy did become a problem over the near term, it would tend to correct itself.

It must be kept in mind that bull and bear markets only occur and are maintained when they are justified by the law of supply and demand. Technicians could not possibly cause a major market move just by the sheer power of their buying and selling. If this were the case, technicians would all become wealthy very quickly.

Of much more concern than the chartists is the tremen­dous growth in the use of computerized technical trading systems in the futures market. These systems are mainly trend-following in nature, which means that they are all programmed to identify and trade major trends. With the growth in professionally man­aged money in the futures industry, and the proliferation of mul­timillion-dollar public and private funds, most of which are using these technical systems, tremendous concentrations of money are chasing only a handful of existing trends. Because the universe of futures markets is still quite small, the potential for these systems distorting short term price action is growing. However, even in cases where distortions do occur, they are gen­erally short term in nature and do not cause major moves.

Here again, even the problem of concentrated sums of money using technical systems is probably self-correcting. If all of the systems started doing the same thing at the same time, traders would make adjustments by making their systems either more or less sensitive.

The self-fulfilling prophecy is generally listed as a criticism of charting. It might be more appropriate to label it as a compli­ment. After all, for any forecasting technique to become so popu­lar that it begins to influence events, it would have to be pretty good. We can only speculate as to why this concern is seldom raised regarding the use of fundamental analysis.

Can the Past Be Used to Predict the Future?

Another question often raised concerns the validity of using past price data to predict the future. It is surprising how often critics of the technical approach bring up this point because every known method of forecasting, from weather predicting to fundamental analysis, is based completely on the study of past data. What other kind of data is there to work with?

The field of statistics makes a distinction between descrip­tive statistics and inductive statistics. Descriptive statistics refers to the graphical presentation of data, such as the price data on a standard bar chart. Inductive statistics refers to generalizations, pre­dictions, or extrapolations that are inferred from that data. Therefore, the price chart itself comes under the heading of the descriptive, while the analysis technicians perform on that price data falls into the realm of the inductive.

As one statistical text puts it, "The first step in forecasting the business or economic future consists, thus, of gathering obser­vations from the past." (Freund and Williams) Chart analysis is just another form of time series analysis, based on a study of the past, which is exactly what is done in all forms of time series analysis. The only type of data anyone has to go on is past data. We can only estimate the future by projecting past experiences into that future.

So it seems that the use of past price data to predict the future in technical analysis is grounded in sound statistical con­cepts. If anyone were to seriously question this aspect of techni­cal forecasting, he or she would have to also question the validi­ty of every other form of forecasting based on historical data, which includes all economic and fundamental analysis.

RANDOM WALK THEORY

The Random Walk Theory, developed and nurtured in the academ­ic community, claims that price changes are "serially indepen­dent" and that price history is not a reliable indicator of future price direction. In a nutshell, price movement is random and unpredictable. The theory is based on the efficient market hypothe­sis, which holds that prices fluctuate randomly about their intrin­sic value. It also holds that the best market strategy to follow would be a simple "buy and hold" strategy as opposed to any attempt to "beat the market."

While there seems little doubt that a certain amount of randomness or "noise" does exist in all markets, it's just unrealis­tic to believe that all price movement is random. This may be one of those areas where empirical observation and practical experi­ence prove more useful than sophisticated statistical techniques, which seem capable of proving anything the user has in mind or incapable of disproving anything. It might be useful to keep in mind that randomness can only be defined in the negative sense of an inability to uncover systematic patterns in price action. The fact that many academics have not been able to discover the pres­ence of these patterns does not prove that they do not exist.

The academic debate as to whether markets trend is of lit­tle interest to the average market analyst or trader who is forced to deal in the real world where market trends are clearly visible. If the reader has any doubts on this point, a casual glance through any chart book (randomly selected) will demonstrate the presence of trends in a very graphic way. How do the "random walkers" explain the persistence of these trends if prices are serially inde­pendent, meaning that what happened yesterday, or last week, has no bearing on what may happen today or tomorrow? How do they explain the profitable "real life" track records of many trend ­following systems?

How, for example, would a buy and hold strategy fare in the commodity futures markets where timing is so crucial? Would those long positions be held during bear markets? How would traders even know the difference between bull and bear markets if prices are unpredictable and don't trend? In fact, how could a bear market even exist in the first place because that would imply a trend? (See Figure 1.3.)

Figure 1.3 A “random walker” would have a tough time convincing a holder of gold bullion that there’s no real trend on this chart.

It seems doubtful that statistical evidence will ever totally prove or disprove the Random Walk Theory. However, the idea that markets are random is totally rejected by the technical com­munity. If the markets were truly random, no forecasting technique would work. Far from disproving the validity of the techni­cal approach, the efficient market hypothesis is very close to the technical premise that markets discount everything. The academics, however, feel that because markets quickly discount all informa­tion, there's no way to take advantage of that information. The basis of technical forecasting, already touched upon, is that important market information is discounted in the market price long before it becomes known. Without meaning to, the acade­mics have very eloquently stated the need for closely monitoring price action and the futility of trying to profit from fundamental information, at least over the short term.

Finally, it seems only fair to observe that any process appears random and unpredictable to those who do not under­stand the rules under which that process operates. An electrocar­diogram printout, for example, might appear like a lot of random noise to a layperson. But to a trained medical person, all those lit­tle blips make a lot of sense and are certainly not random. The working of the markets may appear random to those who have not taken the time to study the rules of market behavior. The illu­sion of randomness gradually disappears as the skill in chart reading improves. Hopefully, that is exactly what will happen as the read­er progresses through the various sections of this book.

There may even be hope for the academic world. A num­ber of leading American universities have begun to explore Behavioral Finance which maintains that human psychology and securities pricing are intertwined. That, of course, is the primary basis of technical analysis.

UNIVERSAL PRINCIPLES

When an earlier version of this book was published twelve years ago, many of the technical timing tools that were explained were used mainly in the futures markets. Over the past decade, howev­er, these tools have been widely employed in analyzing stock mar­ket trends. The technical principles that are discussed in this book can be applied universally to all markets—even mutual funds. One additional feature of stock market trading that has gained wide popularity in the past decade has been sector investing, pri­marily through index options and mutual funds. Later in the book we'll show how to determine which sectors are hot and which are not by applying technical timing tools.