Charting the Market: The Past 25 Years

by | Jul 7, 2001

Ever since I started trading and investing in the 1970s I have looked at stock charts every day. I am entirely aware of — and respectful of — the empirical and theoretical arguments against the predictive value of charting. And yet, at the same time, I remain to this day a dedicated user of these […]

Ever since I started trading and investing in the 1970s I have looked at stock charts every day. I am entirely aware of — and respectful of — the empirical and theoretical arguments against the predictive value of charting. And yet, at the same time, I remain to this day a dedicated user of these tools. I mention all this now because, after last week’s sharp declines in all the market indices, my first instinct is still to go to the charts for guidance. And indeed, they are telling very interesting stories right now.

Twenty-five years ago I took charting very seriously and very literally. I thought of charting as an electrocardiogram of the market — a way of objectively and scientifically identifying meaningful patterns that derived from objective realities, and had predictive value. But as I’ve acquired more experience in the markets over a quarter century, I’ve come to think of charting as a much less scientific and less precise predictive tool.

Or to put it more precisely, perhaps I should say I’ve lost some of my respect for predictive tools in general — including electrocardiograms. It’s easy to think of electrocardiograms as objective and predictive when you are in your twenties and the risk of heart disease is unimportant to you anyway. When you get closer to your fifties the stakes are life and death, and suddenly the same tool doesn’t seem quite so reliable. And so it is with charting, as you acquire more experience and sophistication in the market.

If the electrocardiogram is the most flattering metaphor for charting, then the least flattering is astrology. In astrology, an objective reality — the positions of the planets at the time of your birth — is linked as an input to a highly subjective analytic output: a characterization of your personality and a prediction of your fate. To begin with there’s no demonstrable link between the input and the output. And what’s worse, even if there were, it’s not clear how you would ever prove that that astrology’s descriptions of your personality and your fate are right or wrong, or to what use you could really put them.

Charting takes an objective reality as its input, too: the past prices of stocks and indices. And like astrology, its subjective output is a characterization of personality: the stock’s or index’s “trend” — and a prediction of fate: the stock’s or index’s future price. But as with astrology, there’s no demonstrable linkage between input and output — there’s no strong evidence that the path of price changes over time is anything more than a random walk. And the predictions of charting are too subjective and poorly formed to be testable. Even if one takes as the ultimate test the investment performance of the chartist, it’s impossible to be assured that the results — good or bad — were truly the consequence of charting, and not of other influences on investment decision-making. And even if the influence of charting could be separated, it would not be clear that a tool as subjective and idiosyncratic as charting would be as valuable in the hands of any other practitioner.

I think the comparison with astrology is too harsh, although I would agree that it is useful in correctly refuting the too-strong claims that are sometimes made for charting. It is not an objective science, and its predictions are not well formed. But in a challenge as subjective as investing and trading, highly subjective tools can still have a use. Over twenty-five years I’ve observed over and over that charting does seem to capture the state of the market in a uniquely concise way, and that prices often seem to mysteriously conform to trends visible on the charts. What could explain this?

Perhaps charting is not like astrology — perhaps it is more like voodoo. In voodoo, a practice with no basis in reality at all nonetheless works because people believe it will work — it becomes a self-fulfilling prophecy. If I stick a pin in the arm of a doll shaped like you, your arm will really feel pain if you believe enough in voodoo — even though there is no connection in objective reality between the doll’s arm and your arm. In the case of charting, a particular price level in a stock or index might become well known among chartists as a “support level,” and when that level is approached in a falling market, the chartists rush in to buy. As a result, the decline is indeed arrested at the forecast support level, and charting is therefore judged to have made a correct prediction. This is an attractive metaphor, especially for those who believe that charting does make correct predictions, and therefore that some behavioral explanation is required for them in the absence of a good theoretical explanation.

The voodoo explanation almost has to be true, at least to some extent. There are people who believe in charting and act on it, so it should be no surprise that there is support at support levels and resistance at resistance levels. But there are obvious flaws in this explanation. For one thing, not everyone’s a chartist. And for another, if everyone were, then there would emerge complex games-within-games based on everyone knowing what everyone else was likely to do — that would quickly introduce distortions into simple “buy support” and “sell resistance” expectations.

For me the best metaphor for charting is psychoanalysis. The principles of charting ARE as subjective and symbolic as Sigmund Freud’s theories of the human mind. And the predictive value of charting is as ambiguous as the curative value of five years on the couch. But just as Freud’s vocabulary, framework, and clinical procedures seem to give flight to the insights of talented healers, so it is with charting. For the investor or trader who is looking for a vehicle to bring out the insights he already has, charting can be just the thing to unlock his inner voice.

Charts invoke the principle of “a picture is worth a thousand words,” condensing multiple abstract and complexly related insights into a single conceptual unit. With the power of that distillation, a gifted interpreter can use charts to test his insights against the holistic and fully contextualized backdrop of history, and extend his insights into the future with a disciplined vocabulary. The trick is not to take the charts literally, or for their own sake. They are stimulants to the insight that your own mind is capable of already — they are not themselves insight.

Here is my chartist’s interpretation of the history of the NASDAQ Composite since the mid-1980s. There have been five great trends, and each symbolizes an important macroeconomic influence on the market.

  • The first is the gentle uptrend that began after the crash of October, 1987 (shown on the chart as a thin orange line). This symbolizes the Reagan legacy, the painful restructuring of US business that took place throughout the 1980s.
  • The second is the steeper uptrend that began in October, 1990, when America began to mobilize for Operation Desert Storm (shown on the chart as a thin light green line). This symbolizes the age of the Pax Americana, the emergence of the United States as the world’s sole superpower, and the conversion of the US economy to a post-cold war footing.
  • The third is the even steeper uptrend that began in December, 1994, when the Congress was taken by the Republican party (shown on the chart as a thin red line). This symbolizes the age of political gridlock in which global market forces centered in the US superseded global political forces.
  • The fourth is a gentler uptrend — the first in the sequence to have a less steep slope than it’s predecessor — which was begun in October, 1998 (shown on the chart as a thin gray line). This symbolizes the great boom and bust of the Internet/telecommunications revolution.
  • The fifth is a downtrend — the first downtrend in the sequence — which was begun in March, 2000 (shown on the chart as a thin pink line). It symbolizes the investment recession that was deliberately induced by Alan Greenspan to puncture “irrational exuberance.”

I believe there are two important levels on the chart as well, which give rise to lateral lines rather than trendlines.

  • The first is the 2028 level of the top in July, 1998 (shown on the chart as a thin light blue line). This symbolizes the market’s first questioning of the Greenspan standard. This was when Alan Greenspan abandoned his implicit policy of targeting the gold price at around 350, and global deflation began to ravage the Asian economies.
  • The second is the 1357 level of the bottom in October, 1998 (shown on the chart as a thin dark blue line). This symbolizes the market’s renewed confidence in the Greenspan standard following the Fed’s brokering of the rescue of Long Term Capital Management.

The NASDAQ was violated the light blue lateral line in March, and the red trendline in April, symbolizing loss of confidence in Alan Greenspan, and loss of confidence in the political process. Both were reinstated by the end of April. And on Friday, the light blue lateral line was tested again. All of this is being carried out in the middle of an indecision pattern, with the forces of optimism in the Internet/telecommunications revolution symbolized by the support of the light gray trendline (presently at 1648), and the forces of pessimism about the recession symbolized by the pink trend line (presently at 2961).

Understood in these symbolic terms, this chart only has the power to signal the market’s valuation of these symbolic forces. Coupled with an understanding of the importance and implications of these forces, the chart can help us understand where the market is going as these forces evolve. The chart is telling us now that we are mired in fundamental indecision. The chart can contain no intrinsic information about which way the indecision will be resolved.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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