Wednesday, December 16, 2009

Technical analysis and the repeatability of history, some incoherent ramblings

According to John Murphy (Technical Analysis of the Financial Markets, 1999, and included in the online knowledge base of the Market Technicians Association) technical analysis is based on three premises: (1) market action discounts everything, (2) prices move in trends, and (3) history repeats itself. The first premise is grounded in economics, the second in both mathematics and physics, and the third in psychology.

Today I want to take a very brief, subjective look at the third premise, that history repeats itself. The premise was famously stated by Jesse Livermore: “There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion that always gets in the way of human intelligence. Of this I am sure.” (Richard Smitten, Trade Like Jesse Livermore, p. 167)

There is no question that markets exhibit broad cyclical patterns, some of which follow business cycles and many of which result from the fear and greed of traders and investors. For the longer-term trader these trending patterns are vitally important. But no events ever repeat exactly; this time always is different. As chaos theorists would say, markets exhibit aperiodic behavior. (By the way, I have a visceral reaction every time I hear someone repeat Mark Twain’s vapid statement that history rhymes, but that’s a rant for another day.) The question is whether history repeats itself closely enough for technical analysis to be a useful tool or whether, as Bill Williams argued in Trading Chaos (Wiley, 1995), “Not only is technical analysis based on the false assumption that the future will be like the past, but it uses inappropriate linear techniques for analysis.” (p. 43)

Williams adopts a fractal view of the markets, citing Mandelbrot’s study of cotton prices. “Each particular price change was random and unpredictable. But the sequence of changes was independent of scale: curves for the daily and monthly price changes matched perfectly. Incredibly, analyzed Mandelbrot’s way, the degree of variation had remained constant over a tumultuous sixty-year period that saw two World Wars and a depression.” (p. 36, quoting James Gleick, Chaos, 1987) By the way, those interested in Mandelbrot’s work should read The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin & Reward, co-authored with the journalist Richard L. Hudson (Basic Books, 2004). I myself haven’t read it, so I’m going to leave fractals behind and move on.

Instead of confronting the question of the repeatability of history head on (or the more interesting question of the extent to which each of us shapes the history we purport to know) I’m just going to interject a personal bias for which I offer no defense. And note that this is not a wholesale rejection of technical analysis as a tool. I personally take absolutely no solace in knowing that over a certain period of time in 62 percent of the cases the market closed up the day after scenario XYZ occurred. I keep thinking that the scenario has been framed too simplistically, so I have no confidence in this alleged historical probability. I also don’t know whether, even if over time this same statistical scenario continues to play out, I would be in the markets long enough to make the statistical strategy profitable. You could say that in my case the subjectivist theory of probability (that is, that probability is a measure of confidence or degree of belief) has swamped the objectivist theory of probability. Now that shouldn’t be the case for anyone with a scientific bent of mind, but unfortunately I can’t overcome it.

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I’ve just reread the draft of this post and would consign it to the dustbin save for the fact that, however embarrassingly illogically it meanders through some difficult and important concepts, there are a few ideas that I will try to develop more rationally at a later time. My defense is that I wrote it in the netherworld between being awake and dosing off. The heat went out in the house around 7 p.m. and instead of just sucking it up and waiting until the next morning I made the mistake of calling the heating oil company for service (I’m on a contract so they are obligated to come 24/7 at no per/call charge). The technician arrived in the wee small hours of the morning when, despite being on a caffeine high, I was still struggling to stay awake. Of course, when he finally left and I went to bed I was too juiced up to drop off instantaneously as is my wont. So another day was trashed. There’s merit in stoicism.

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