Classical Technical Analysis Indistinguishable From Astrology
The bulk of classical technical analysis charting is based on confirmation bias: chartists look for patterns that confirm expectations tied to future economic conditions. But biased analysis is wrong more often than it is right. A recent example is included.
There are high expectations of rising interest rates. Actually the Fed has provided forward guidance about rates. This means bonds yields may probably rise. I say maybe, because I have been in this business for 25+ years and I have seen wide divergences between expectations and reality. One example no one should ever forget is the economist consensus in 2011–2012 period that quantitative easing will cause a surge in inflation and high bond yields. Pundits appeared on financial TV daily predicting a bond market crash. Some believed them and paid the price.
Classical technical analysts were trying hard during that time to identify a pattern in bonds that would confirm the economist bias of a market plunge. They finally found one, a complex head and shoulders top in bond prices. They were excited in financial and social media when making references of this pattern. I included this one in my book Fooled By Technical Analysis for TLT ETF as it is shown below:
For some hedge fund managers this seemed like an opportunity of a lifetime because as it has been shown the bulk of CTA profits have been generated in the bond markets. After a brief confirmation of the complex top prices reversed, causing heavy damage to bond shorts.
The recent confirmation bias has taken the form of a head and shoulders pattern is the S&P 500 /10-Year Note yield ratio chart, as shown below:
The story sold to public goes as follows: If there is confirmation of this pattern, then stocks will fall or if the pattern fails, stocks will rise.
Is there anyone who does not understand that stocks will rise or fall?
Save the fact that if the pattern is confirmed, it means that stocks fell already provided that yields stayed constant or rose.
There is of course the possibility that the pattern is confirmed but stocks and yields go higher. How? Stocks gain little but yields surge. This is a low probability scenario but possible.
Why are people still involved in this type of technical analysis that is indistinguishable from astrology?
The answer is because it is simple and there is the availability heuristic bias: simple explanations to complex problems are popular within a network of people because other people have accepted them.
This chart analysis leads nowhere. Waiting for patterns to form over a three year period and insisting that they are not random but carry useful information is a big leap of faith. But the TA-astrologers find audience because showing patterns is easier than showing math formulas.
But trading nowadays is math and computers. Below is a picture of a group of modern traders:
As long as there are people who look for simple patterns on charts, HFT traders and other professionals will be making profits. There is no incentive to educate anyone, actually the opposite pays, i.e., financing those who promote random market decisions.
More information about classical technical analysis, how it emerged and why it failed, can be found in my interview with Forbes.
If you have any questions or comments, happy to connect on Twitter:@mikeharrisNY
This article was originally published in Price Action Lab Blog
About the author: Michael Harris is a trader and best selling author. He is also the developer of the first commercial software for identifying parameter-less patterns in price action 17 years ago. In the last seven years he has worked on the development of DLPAL, a software program that can be used to identify short-term anomalies in market data for use with fixed and machine learning models. Click here for more.
