The fortunes of the markets are in the charts

Anatole Kaletsky: Economic view

Why have stock markets around the world just enjoyed their best two-week run since 2003? A very clear explanation appeared at the weekend: analysts said that the market run was due to one simple statistical fact: the strength of US second-quarter earnings, which have taken almost everyone by surprise.

But if this was true, it was odd that Wall Street’s biggest gains came after disappointing results announcements from some of the most closely watched US bellwether companies: General Electric, Morgan Stanley and Microsoft. Maybe the market euphoria reflected a generalised conviction among investors that the recession was over? If so, it was odd that stock markets fell sharply in June, when most of the economic figures were rather stronger than they have been this month. Or maybe the bullish sentiment was a return of confidence in the global financial system? If so, it was odd that the shares of the four most vulnerable major banks — Citigroup, Bank of America, Lloyds and Royal Bank of Scotland — are all lower than they were two months ago.

The fact is that the so-called fundamentals that preoccupy media commentators, central bankers and politicians rarely determine market directions on a daily, weekly or even monthly basis. Usually, the absence of any close correspondence between market movements and economic events is of no great significance to anyone except financial traders. But, at a time when the fate of the world sometimes seems to depend on the short-term gyrations of financial prices, understanding the mood of the markets is crucial, which is why it is worth looking at some information that many professional financial traders rely on, which economists and central bankers ignore. This is the visual picture of the balance between demand and supply among investors, presented by charts and other technical studies of price movements taking place within the markets themselves.

Last week’s stock market movements provided a classic example. The really important event from a technical perspective was not some better than expected corporate profits or some worse than expected news on Britain’s GDP and US employment. It was the completion of an inverted head-and-shoulders formation illustrated in the attached graphic by the letters S5, H2 and S6.

https://martinskinner.files.wordpress.com/2009/07/the_head_and_should_594140a.pdf

The head and shoulders, whether inverted like the one this month, or right way up, as in the stock market peak of October 2007 (letters S3, S1, S2, H1, S2 and S4 in the attached chart) is considered by technical analysts to be the most important and reliable of all reversal patterns, indicating that the direction of the market has changed. More precisely, the investment trend tends to change when share prices break through the neckline created by an upright or inverted head and shoulders (indicated as NL1, NL2 and NL3 in the graphic). It is clear from the chart that the breakdown of share prices through lines NL1 and NL2 in 2007 and 2008 were followed by big falls on Wall Street.

Probably the main reason for the sudden outbreak of optimism in stock markets last week was the hope that the upside breakout through line NL3 would prove the prelude to some correspondingly big gains.

As noted by Brian Marber, a technical analyst whose work I have followed closely for ten years and who has proved uncannily precise in calling the gyrations of currencies and stock markets during the credit crisis, even without paying any attention to the dramatic changes in economic statistics or the astonishing financial and political events: line NL3 is all important. A 971.78 close would confirm an inverted head and shoulders with the inference of a no time limit advance to 1,323. When the S&P 500 closed at 976 on Thursday, this confirmation occurred and the objective of over 1,300, which would restore share prices to their levels before the Lehman crisis, suddenly appeared within reach.

But why should we pay any attention to such numerology? Most economists and policymakers regard technical analysis of market patterns with complete contempt, comparing its graphic terminology of head and shoulders, shooting stars and pennants with astrology or alchemy.

The obvious answer is that these techniques are widely used by professional investors and therefore have passed a market test. Indeed, according to a study by the New York Federal Reserve Bank, “nearly all” currency traders use technical models, which means that some, although not all, must produce consistently useful results.

This is particularly true of analysts such as Mr Marber, who name specific figures and focus rigorously on internal market information, rather than speculating about economic and political events, which may or may not occur and who also turn out to be right far more often than wrong. Such analysts provide an invaluable reality check for economic analysis, as well as a salutary reminder of the need to change one’s mind when the facts change. That the success of this approach, as described in the recently published book Marber on Markets, is not just an aberration is suggested by a growing body of statistical testing that has recently been done on technical analysis. The latest review of this academic work, published in 2007 in the Journal of Economic Surveys, found that 56 out of 90 recent academic studies demonstrated positive results from a variety of technical approaches.

A second reason for taking technical analysis seriously is that its main rationale makes sense. Markets usually move in uptrends or downtrends for extended periods because investors take a long time to recognise or notice changes in economic conditions and then acknowledge that reality has permanently changed. Technical analysis picks up this trending behaviour and tries to detect when trends reverse.

A third attractive feature of technical analysis is that its success refutes the efficient market hypothesis (EMH), which has led economists astray for the past 30 years in their efforts to understand financial markets. The EMH asserts that predictable patterns of market behaviour can never exist because if they did, they would be known to all investors, who would bid prices up (or down) instantly to make them disappear. In the words of Burton Malkiel, the Princeton economist whose book, A Random Walk Down Wall Street, is still an intellectual bible for most economists and central bankers: “The problem is that, once a regularity is known to market participants, people will act in such a way that prevents it from happening in the future.”

The problem with this argument, as with so much of modern economics, is that the EMH is a simplifying assumption masquerading as an empirical fact. In the real world, it is manifestly untrue that investors respond instantly to all publicly available information. Instead, markets spend months or even years adjusting to changes in economic conditions or company prospects. Moreover, it is far from clear what economists even mean by the information to which investors are supposed instantly to respond. For what one investor views as information — whether a corporate results announcement, or a government statistic or a technician’s chart pattern — may be an illusion or deception in the minds of other investors. If uncertainty is inherent, not only about the future but even about the present and the past, then academic economists’ assumptions about efficient markets can bear almost no relation to the real world. This is a lesson that we should surely have learnt in the past two years and it is a good reason for paying attention to the practical experience of technical analysts and traders, as well as to the theorising of economists and central bankers. (Anatole Kaletsky, The Times) http://www.timesonline.co.uk/tol/comment/columnists/article6728286.ece

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