The Indifference Zone

The graph shows the weekly averages for the S&P 500 since October of last year.  The index has been stuck in a trading range between 1990 and 2110 for the past six months. A move to 2200 as the forecast in last week’s post suggested would require breaking out above that range into new territory.

Bulls and bears playing tug-o-war created that range because of their diverging expectations. Bears can become bulls when the market hits a support level near the bottom, and bulls will morph into bears near the top. The great Austrian economist Ludwig Lachmann explained the dynamics of trading ranges in his essay “A Note on the Elasticity of Expectations.”¹

Pundits Practice Post Hoc

The mainstream media rounds up the usual suspects when trying to explain the latest stumble from the stock market. One expert had this to say:

Many factors have conspired to increase market volatility and push stocks lower over the last several weeks. Chief among them have been nervousness over the timing of Federal Reserve (Fed) interest rate increases, worries over the outlook for the Chinese and eurozone economies, the escalating Ebola epidemic in Africa, and rising geopolitical instability—particularly in the Middle East.

Others add the collapse in oil prices or commodities in general, global warming or just plain irrational fear. Technical analysts will cite the S&P 500 falling below the 200 day moving average or another favorite indicator, but that doesn’t explain why it fell through the glass barrier. Most of these are merely examples of the post hoc fallacy in which people notice that one event followed another and concluded that the earlier event must be the cause of the later one. An obvious example is attributing the rising of the sun to the crowing of a rooster.

Great Expectations part II

The previous post introduced the concept of elasticity of expectations as developed by Ludwig M. Lachmann and applies it to the stock market. Lachmann added that the velocity of price change is important as well as the practical range and break outs from the range: 

“‘Explosive’ price change is seen to be the main cause of elastic expectations, both in the sense of violent change, and in that it destroys the existing basis of expectations, the sense of normality, which provided a criterion of distinction between the more probable, the less probable, and the highly improbable. It does so by demonstrating that the highly improbable, which had been excluded from our range, is possible after all. Now, as we saw, a price will pass the limits of the range with difficulty. As it approaches them it encounters increasing pressure from inelastic expectations resulting in sales at the upper and purchases at the lower limit. To overcome the pressure of these stabilizing market forces the price movement will most probably have to be carried by a strong ‘exogenous’ force, i.e. one originating outside the market, unknown to it and therefore not taken into account when expectations were formed.”[1]

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.