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)
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