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A few questions generally crop up in any discussion of the technical approach. One of these concerns is the self-fulfilling prophecy. Another is the question of whether or not past price data can really be used to forecast future price direction. The critic usually says something like:“Charts tell us where the market has been, but can't tell us where it is going.”For the moment, we'll put aside the obvious answer that a chart won't tell you anything if you don't know how to read it. The Random Walk Theory questions whether prices trend at all and doubts that any forecasting technique can beat a simple buy and hold strategy. These questions deserve a response.
The question of whether there is a self-fulfilling prophecy at work seems to bother most people because it is raised so often. It is certainly a valid concern, but of much less importance than most people realize. Perhaps the best way to address this question is to quote from a text that discusses some of the disadvantages of using chart patterns:
a. The use of most chart patterns has been widely publicized in the last several years. Many traders are quite familiar with these patterns and often act on them in concert. This creates a“self-fulfilling prophecy,”as waves of buying or selling are created in response to“bullish”or“bearish”patterns…
b. Chart patterns are almost completely subjective. No study has yet succeeded in mathematically quantifying any of them. They are literally in the mind of the beholder…. (Teweles et al.)
These two criticisms contradict one another and the second point actually cancels out the first. If chart patterns are“completely subjective”and“in the mind of the beholder,”then it is hard to imagine how everyone could see the same thing at the same time, which is the basis of the self-fulfilling prophecy. Critics of charting can't have it both ways. They can't, on the one hand, criticize charting for being so objective and obvious that everyone will act in the same way at the same time (thereby causing the price pattern to be fulfilled), and then also criticize charting for being too subjective.
The truth of the matter is that charting is very subjective. Chart reading is an art. (Possibly the word“skill”would be more to the point.) Chart patterns are seldom so clear that even experienced chartists always agree on their interpretation. There is always an element of doubt and disagreement. As this book demonstrates, there are many different approaches to technical analysis that often disagree with one another.
Even if most technicians did agree on a market forecast, they would not all necessarily enter the market at the same time and in the same way. Some would try to anticipate the chart signal and enter the market early. Others would buy the“breakout”from a given pattern or indicator. Still others would wait for the pullback after the breakout before taking action. Some traders are aggressive; others are conservative. Some use stops to enter the market, while others like to use market orders or resting limit orders. Some are trading for the long pull, while others are day trading. Therefore, the possibility of all technicians acting at the same time and in the same way is actually quite remote.
Even if the self-fulfilling prophecy were of major concern, it would probably be“self-correcting”in nature. In other words, traders would rely heavily on charts until their concerted actions started to affect or distort the markets. Once traders realized this was happening, they would either stop using the charts or adjust their trading tactics. For example, they would either try to act before the crowd or wait longer for greater confirmation. So, even if the self-fulfilling prophecy did become a problem over the near term, it would tend to correct itself.
It must be kept in mind that bull and bear markets only occur and are maintained when they are justified by the law of supply and demand. Technicians could not possibly cause a major market move just by the sheer power of their buying and selling. If this were the case, technicians would all become wealthy very quickly.
Of much more concern than the chartists is the tremendous growth in the use of computerized technical trading systems in the futures market. These systems are mainly trend-following in nature, which means that they are all programmed to identify and trade major trends. With the growth in professionally managed money in the futures industry, and the proliferation of multimillion-dollar public and private funds, most of which are using these technical systems, tremendous concentrations of money are chasing only a handful of existing trends. Because the universe of futures markets is still quite small, the potential for these systems distorting short term price action is growing. However, even in cases where distortions do occur, they are generally short term in nature and do not cause major moves.
Here again, even the problem of concentrated sums of money using technical systems is probably self-correcting. If all of the systems started doing the same thing at the same time, traders would make adjustments by making their systems either more or less sensitive.
The self-fulfilling prophecy is generally listed as a criticism of charting. It might be more appropriate to label it as a compliment. After all, for any forecasting technique to become so popular that it begins to influence events, it would have to be pretty good. We can only speculate as to why this concern is seldom raised regarding the use of fundamental analysis.
Another question often raised concerns the validity of using past price data to predict the future. It is surprising how often critics of the technical approach bring up this point because every known method of forecasting, from weather predicting to fundamental analysis, is based completely on the study of past data. What other kind of data is there to work with?
The field of statistics makes a distinction between descriptive statistics and inductive statistics. Descriptive statistics refers to the graphical presentation of data, such as the price data on a standard bar chart. Inductive statistics refers to generalizations, predictions, or extrapolations that are inferred from that data. Therefore, the price chart itself comes under the heading of the descriptive, while the analysis technicians perform on that price data falls into the realm of the inductive.
As one statistical text puts it,“The first step in forecasting the business or economic future consists, thus, of gathering observations from the past.”(Freund and Williams) Chart analysis is just another form of time series analysis , based on a study of the past, which is exactly what is done in all forms of time series analysis. The only type of data anyone has to go on is past data. We can only estimate the future by projecting past experiences into that future.
So it seems that the use of past price data to predict the future in technical analysis is grounded in sound statistical concepts. If anyone were to seriously question this aspect of technical forecasting, he or she would have to also question the validity of every other form of forecasting based on historical data, which includes all economic and fundamental analysis.