This contributes to the herding behavior that finally causes the market to overreact to the new information. This is exactly what the insiders are hoping for, in order to extract the greatest amount of profit. Eventually a top is formed as the market runs out of buyers and/or money to invest. The activity subsides only to repeat again.
Figure 1.32 Markets Overreacting to New Information.
Price versus Value
One interesting question that many novices ask is whether the market is discounting price or value. In fact, a more fundamental question to ask would be whether price represents value. If it does, then how do we explain a stock valued at $10 rising to a price of $30 in the absence of any significant changes in its fundamentals?
In reality, market action is merely the collective expectations of all its participants. What we are really trading is expectation. It has not very much to do with absolute intrinsic value, but rather its expected value. In short, current price is the result of expectations about future price and value.
Market Behavior Repeats Itself
The second assumption or premise of technical analysis is that market behavior has a tendency to repeat itself. This means that past price and chart patterns will provide a reasonable basis for forecasting potential future behavior. The underlying explanation for the repeatability of price and market behavior lies in the fact that market behavior is driven by human psychology, which seldom changes over time. The uses of past patterns to predict futures moves are grounded in the reliability and consistency of human behavior.
Ironically, most equity valuation modeling and standard economic statistical indicators are based on past or historical information as well. How else are we able to make an intelligent assessment of future outcome without reference to past data? It is human nature to try to infer, extrapolate, generalize, and predict potentially probable future outcomes.
The reason for the popularity of classical price and chart patterns lies in the fact that they are essentially visual in nature. Human beings have an innate tendency for pattern recognition and as such there is a natural inclination to gravitate toward such forms of analysis. The reliability of pattern analysis tends to improve as more market participants start to employ such patterns in their day-to-day trading and forecasting.
Unfortunately, there are some challenges to the reliability of using past action as a forecasting tool, some of which are:
1. The preempting effect will slowly erode the reliability of historical patterns as traders start to outbid or outsell each other in anticipation of the approaching technical trigger levels. Preempting is a direct result of the self-fulfilling prophecy.
2. The effect of widespread program trading will affect the reliability of historical pattern trading as programs are able to trade in ways not easily replicated by manual or human trading.
3. The ever-changing influx of new participants into the markets will slowly affect the reliability of chart and price patterns unfolding in the expected manner. Although human psychology remains largely predictable over the longer-term horizon, short-term patterns are sometimes impacted by new participants who have a slightly different approach than the usual participants in that market.
The Market Tends to Move in Trends
Lastly, from the definitions given of technical analysis, it is generally accepted that the market has a tendency to move in trends. This explains the popularity of trend-based methodologies. Of course, it is not hard to understand the basis for the popularity of trend trading, since trend action affords market participants the greatest profit over the shortest possible duration in the markets.
But if we analyze this statement more closely, we understand that the term trend is inconclusive. What is actually is a trend? When is a trend a trend and when does it cease to be one? There have been many attempts to define what a trend is objectively. Successively higher or lower peaks and troughs is one widely accepted method, and is by far the preferred mode of identifying a trend. But then this begs the next question, which is: what constitutes a peak or a trough? Significant containment of price below or above a trendline or sloping moving average may also be deemed a valid way of defining a trend. We shall delve into the specifics of defining trends, consolidations, and other formations in Chapter 5.
Although trend following is popular, there are some challenges to using it, some of which are:
• Inefficient trade sizing in volatile markets
• Inefficient profit capture during trends
• Inefficient performance in ranging markets
• Inefficient adaptation to more volatile trend action
• Inability to identify trend changes efficiently
• Possibility of negative slippage in fast-moving markets
• Possibility of large drawdowns due to the low winning percentages
• Reduced performance caused by whipsaw action during consolidations
• Influx of trend-capturing systems produces inefficient fills
• Ineffective back and forward testing
Finally, it is important to note that a trend in one timeframe may be a sideways market in another.
1.7 FOUR BASIC ASSUMPTIONS IN THE APPLICATION OF TECHNICAL ANALYSIS
There are four underlying premises associated with the application of technical analysis, namely:
1. Price behavior is expected to persist until there is evidence to the contrary.
2. For every bullish indication or interpretation, there exists an equal and opposite bearish indication or interpretation for the same price behavior or phenomena.
3. Extreme bullishness is potentially bearish (and extreme bearishness is potentially bullish).
4. A technical tool or indicator has no real significance except for that attributed to it by market participants.
The first premise is about preserving the status quo. It should be noted that most technical analysis is based on a set of assumptions. Most assumptions derive from one grand underlying premise, that being the preservation the prevailing price behavior. For example, a trend is expected to persist until there is evidence to the contrary. Hence a state of persistence is assumed to be the status quo. If a cycle is identified, it is assumed to persist until cyclic failure is clear and obvious. If the market is in consolidation, it is expected to continue to range until a breakout is identified.
The second premise is also a fairly obvious, not only in relation to technical analysis but also with much of life. For example, an analyst may make a case for rising oil prices as the reason for a rise in the Dow Jones index since it is indicative of increasing demand, representing evidence of a recovering economy. The same analyst may also make a case for rising oil prices as the reason for a decline in the Dow Jones index due to the widely held perception of increasing cost, and hence bearish for the economy in general. Another example would be to find the stochastics at an oversold level and conclude that the current uptrend is strong since it is potentially or implicitly bullish. Alternatively, the stochastics could be at an overbought level, leading to the conclusion that the current uptrend is strong since an overbought level is regarded as explicitly bullish.
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