November 18th, 2011
Markets like such as we’ve been suffering through since June tests the loyalty and dedication of most believers in charting as a trading tool. Nothing that’s happen in the market since the European crisis fully bloomed at summer’s beginning has been actionable for trend followers with any degree of confidence or certainty.
Chart patterns actually represent the convergence in time and space (i.e., prices for stocks and levels for indexes) of a condition of balance between supply and demand that is bounded by one sort of trend line or another (ascending, horizontal or declining). If chart patterns depict equilibrium conditions then it’s futile to use them to predict the direction in which that equilibrium will be broken. We can state with some degree of confidence, however, that over the long run patterns will tend to break to the upside between 60-70% of the time because that’s the percentage of time that markets are in bull mode.
Take the symmetrical triangle we’ve watched forming over the past several weeks and finally broke down dramatically yesterday. As fellow blogger Springheel Jack on Tim Knight’s typically bearish blog Slope of Hope points out, “these triangles are poor performers on downwards breakouts, with only a 48% chance of reaching the target in a break down.” He goes on to quote the “bible” of chart patterns, Bulkowski’s The Pattern Site, “symmetrical triangles have a tendency to double bust — the final breakout direction is the same as the original one.”
The fact that most commentators see patterns busting is that they fail to take the phenomena of fractals into consideration; in other words, these commentators look at charts in only one time horizon without taking into consideration that all patterns are actually the actualization of a stream of continual changing market emotions and psychology. It’s when a general consensus begins to take hold (either a positive or negative one) that a breakout occurs and a new trend is established. Until that happens, the stalemate continues and one pattern morphs into another and another and another.
Rather than looking at two or three week’s worth of trades through a magnifying glass and seeing (creating) a “pattern”, it’s better to take a longer-term view and see where all the potential boundaries of this congestion of equilibrium might be:
To proclaim that the symmetrical triangle had been broken and a major move down had therefore begun is ludicrous. It ignores the following realities:
- trendlines aren’t concrete structures. They are only a visual representation of the chartist’s belief as to where one a boundary might be
- rather than being lines, boundaries are actually zones, a range of prices where the struggle for control changes
- there can always be tail-end moves, crosses of trendlines that are nothing more than an atypical expression of momentary extreme optimism or pessimism. Until proven that the psychology of the majority or market participants has changed, the stalemate continues (and the symmetrical triangle pattern morphs into another pattern … perhaps a horizontal trading range channel?)
- it’s understandable that since it’s jammed between two earlier larger patterns (the head-and-should reveral and the summer’s horizontal trading channel), those equilibrium situations have to be resolved before a new extended trend can start.
True the lower boundary of the symmetrical triangle was violated but there are still several other trendlines that act as resistance against a major downside move. Most of the bad news coming from Washington and Europe has already been reflected in the market and there isn’t sufficient consensus for the launching of a new bear market. If anything, the surprise could be from a new positive development from some unexpected source.