God is a Capitalist

Sunday, October 6, 2013

Great Expectations – an Austrian economist lends support to technical analysis (part 1)

Does technical analysis of the stock and commodity markets have any validity, or is it the financial equivalent of reading tea leaves? Technical analysis encompasses a wide variety of methods, so a workable definition might be any method that uses historical prices and volume to predict future ones. Of course, the efficient market hypothesis denies that is possible. The alternative to technical analysis is fundamental analysis, which looks at earnings, dividends, management, sales growth, etc. to predict prices. 

 Technical analysts search charts for patterns such as head-and-shoulders, hammers, shooting stars, flags, pennants, double tops or bottoms, cups-and-handles, and many others. They employ multiple moving averages, relative strength indices, Bollinger Bands, Dow Theory and many other methods of analyzing price pattern and volume of trading. 

A few financial economists have tried to assess the validity of technical analysis methods with mixed results. Economists typically ridicule technical analysis, but a late great Austrian economist, Ludwig Lachmann, who championed the importance of the stock market more than any economist, provided support for technical analysis in his concept of the “elasticity of expectations.” He applied the concept to all kinds of prices, not just to the stock market, but it fits the stock market exceptionally well.

Here’s the main point: people don’t expect one price; they expect a range of prices, which Lachmann called the practical range. Applied to the stock market, an investor will not expect a future price for XYZ stock of exactly $115. Instead, he will expect a range of say $80 to $150. In his mind the probabilities of the stock falling below $80 or rising above $150 are too small to take seriously.  Assuming that the starting price for his analysis is $100, the investor will ignore price movements that stay within his practical range of $80 - $150. Lachmann summarizes:
“A range extending from $80 to $150 means that people think they know enough of the nature and strength of the forces operative in their situation to allow them to predict that the price will be neither above $150 nor below $80. The width of the range expresses the degree of our uncertainty about the exhaustiveness of the information at our disposal. If we thought we knew everything relevant to the expected event about the forces, major and minor, which shape the situation, we could predict one price with certainty. An increasing range expresses an increasing uncertainty about the completeness of our knowledge.
“The next point to grasp is that any price movement taking place between ‘now’ and 1, i.e. between the date at which the prognosis is made and the date to which it refers, can be regarded as a test of the diagnosis which forms the basis of our prognosis, throwing additional light on the nature and strength of the forces surveyed, and thus as adding to our information. As long as the price movement is confined to within the range, it does not provide relevant new information, but merely confirms the soundness of the diagnosis which found its expression in our range. That is why we said above that as long as the price moves within the middle reaches of the range, people’s expectational reactions will not be affected by the actual movement and expectations will therefore be indifferent. But as soon as the price moves beyond the limits of the range, the inadequacy of the diagnosis on which the range was based becomes patent. A new situation has arisen which requires a new diagnosis.[1]
But, as the price approaches the upper or lower limits, say falling to $90 or rising to $140, 

“…expectations will tend to become inelastic.  People will think that the price movement ‘cannot go much farther’, and anticipate a movement in the opposite direction, perhaps after a temporary stagnation; the narrower the uncertainty range the sooner expectations will become inelastic. On the other hand, as long as the market price moves between, say, $95 and $135, people’s expectational reaction will not be affected by the actual movement and expectations will therefore be indifferent; the wider the range the larger is this ‘indifference zone’. “[2]
In other words, the indifference zone is narrower than the practical range and as the actual price of the stock approaches the boundaries of the indifference zone many investors will expect a reversal of the price movement that will bring the price back into the middle of the range. 

What are the limits of the practical range if not the technical analyst’s levels of support and resistance? As prices rise and approach a resistance level, possibly the upper range of a channel, technical analysts will expect the price to fall back toward the middle of the channel, or not change much until the channel moves upward and leaves the price in its middle. Or as a price falls and approaches a support level, technical analysts would expect the price to reverse direction. Support and resistance levels act like walls off which prices “ricochet.” Lachmann continued:

“But as soon as the market price passes either the upper or the lower limit, a new situation arises. People, shocked out of their sense of normality, will have to readjust the basis of their predictions, and in the interval before forming a new, and probably wider, uncertainty range their expectations are likely to become elastic. “[3]
In the terms of technical analysis, a price movement above the resistance level or below the support level is a break out; instead of “ricocheting,” the price penetrates the barrier. The investor will now create in his mind a new range that absorbs the new information. The breaching of the barriers indicates a new trend that the investor can follow until prices approach the new support or resistance levels created by his new practical range. Many technical analysts wait for prices to break out of the barriers and buy or sell in order to get in on the early days of the new trend.
(Continued in the next post)

[1] Ludwig M. Lachmann, “A Note on the Elasticity of Expectations [1945],” Expectations and the Meaning of Institutions, Don Lavoie, ed., London: Routledge, 1994,  124.
[2] Expectations, 121.
[3] Expectations, 120-121.

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