16 Chapter 7

cy. 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 ques­
tions 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 Self-Fulfilling Prophecy

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 cer­
tainly 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 sec­

ond point actually cancels out the first. If chart patterns are "com­
pletely 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 caus­
ing the price pattern to be fulfilled), and then also criticize chart­
ing for being too subjective.
18 Chapter 1

aged money in the futures industry, and the proliferation of mul­

timillion-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 gen­
erally 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 compli­
ment. After all, for any forecasting technique to become so popu­
lar 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.
Can the Past Be Used to Predict the Future?

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 descrip­

tive 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 obser-
Philosophy of Technical Analysis 19

vations 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.
RANDOM WALK THEORY

The Random Walk Theory, developed and nurtured in the academ­

ic community, claims that price changes are "serially
indepen­dent" and that price history is not a reliable
indicator of future price direction. In a nutshell, price
movement is random and unpredictable. The theory is based
on the efficient market hypothe­sis, which holds that prices
fluctuate randomly about their intrin­sic value. It also holds
that the best market strategy to follow would be a simple
"buy and hold" strategy as opposed to any attempt to "beat
the market."

While there seems little doubt that a certain amount

of randomness or "noise" does exist in all markets, it's just
unrealis­tic to believe that all price movement is random. This
may be one of those areas where empirical observation and
practical experi­ence prove more useful than sophisticated
statistical techniques, which seem capable of proving anything
the user has in mind or incapable of disproving anything. It
might be useful to keep in mind that randomness can only be
defined in the negative sense of an inability to uncover
systematic patterns in price action. The fact that many
academics have not been able to discover the pres­ence of these
patterns does not prove that they do not exist.

The academic debate as to whether markets trend is of lit­

tle interest to the average market analyst or trader who is
forced
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mining shares are closely linked to the price of gold. What's more,
the related stock groups often tend to lead their respective futures
markets. As a result, utility stocks can be used as leading indica­
tors for Treasury Bonds. Gold mining shares can be used as lead­
ing indicators for gold prices. Another example of intermarket
influence is the impact of the trend of oil prices on energy and air­
line stocks. Rising oil prices help energy shares but hurt airlines.
Falling oil prices have the opposite effect.

THE DOLLAR AND LARGE CAPS

Another intermarket relationship involves how the dollar affects
large and small cap stocks. Large multinational stocks can be neg­
atively impacted by a very strong dollar, which may make their
products too expensive in foreign markets. By contrast, the more
domestically oriented small cap stocks are less affected by dollar
movements and may actually do better than larger stocks in a
strong dollar environment. As a result, a stronger dollar may favor
smaller stocks (like those in the Russell 2000), while a weaker dol­
lar may benefit the large multinationals (like those in the Dow
Industrial Average.)

INTERMARKET ANALYSIS AND

MUTUAL FUNDS
It should be obvious that some understanding of these intermar­
ket relationships can go a long way in mutual fund investing. The
direction of the U.S. dollar, for example, might influence your
commitment to small cap funds versus large cap funds. It may
also help determine how much money you might want to com­
mit to gold or natural resource funds. The availability of so many
sector-oriented mutual funds actually complicates the decision of
which ones to emphasize at any given time. That task is made a
good deal easier by comparing the relative performance of the
futures markets and the various stock market sectors and industry
groups. That is easily accomplished by a simple charting approach
called relative strength analysis.