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Finance & economics | Buttonwood

Why investors are reaching for the astrology of finance

That technical analysis is in vogue indicates a certain uneasiness

[20220903_F]
Sep 1st 2022
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Why did the markets move? Most investors, analysts and even financial
journalists will look, first and foremost, for news. Perhaps the jobs
data were published, a firm announced it was being acquired or a
central banker gave a sombre speech. Yet a small, dedicated cult of
"chartists" or "technical analysts" believes that the movement of
stocks, bonds and currencies can be divined by the making and
interpreting of charts.

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Their methods are many, varied and wackily named. A "death cross" is
when a short-term moving average of an asset's price falls below a
long-term moving average. "Fibonacci retracement levels" rely on the
idea that an asset climbing in price will fall back before rising
again. Such backsliding is supposed to stop at levels based on
Fibonacci numbers, like a 61.8% drop. The "ichimoku cloud", loved by
Japanese traders, sees the construction of a cloud by--bear with
this--shading the area between two averages of high and low prices
over the past week, month or two months. A price above the cloud is
auspicious; one below it is ominous. A true chartist needs only such
information and "does not even care to know what business or industry
a company is in, as long as he or she can study its chart", as Burton
Malkiel, an economist at Princeton and author of "A Random Walk Down
Wall Street", has noted.

These methods, though patently mad, have attracted attention lately
because of how the s&p 500, the leading index of American stocks, has
wiggled around. After slumping to a low of 3,637 on June 17th the
index began to climb. On August 16th it peaked at an intraday high of
around 4,325, a whisker away from its 200-day moving average of
4,326--a supposedly critical technical level. An asset that has fallen
in price but is rising is supposed to meet "resistance" at such
levels. To chartists it is concerning when an asset fails to "break
through" a resistance barrier--it is an indication of a bear-market
rally, rather than a true bull market. And so, this time, it appears
to have been: stocks have slumped by around 8% since August 16th.

Plenty of mainstream investors use some version of trend-following.
Factor investing, invented by Eugene Fama, the Nobel prize-winning
economist, and Kenneth French, is used by successful quantitative
funds, like aqr Capital Management. It breaks down returns into
component factors like "size" (small companies earn better returns
than bigger ones) or "quality" (low-debt, stable businesses earn
better returns than riskier ones). Another such factor is momentum:
stocks that are rising tend to keep rising. Still, their approach is
a little more sophisticated than looking at a price chart. aqr's
algorithms tend to combine factors like momentum with others. They
might buy, say, a small or high-quality firm whose share price has
recently risen.

It is nevertheless possible to understand the chartists' obsession
with levels and trends. There is no real difference between a euro
being worth $1.0001 or $0.9999, but these "big figures" in
foreign-exchange markets assume importance. This is in part symbolic
and in part practical: clients tend to place orders near round
numbers and derivatives tend to be sold with round "strike prices".
That means it will take a lot more activity for the euro to fall from
$1.0001 to $0.9999 than for it to fall from $1.0487 to $1.0485. When
placing orders, investors try to figure out where others are placing
theirs. That can help them place a stop-loss order, to close a trade
that moves against them, at a sensible level. If enough investors
look at technical levels to inform their behaviour, then they begin
to matter.

Perhaps the real value of technical analysis is what its use tells
you about market conditions. No one bothers with the chartists'
pretty drawings when the economy is good, profits are high and stocks
are moving smoothly higher--nor, indeed, in the depths of a frantic
bear market, when prices will plunge through any and all levels
technical analysts are wont to draw. Much as people who are feeling
restless about the direction of their lives are more prone to become
interested in astrology, investors who are uneasy about the direction
of the markets will reach for the easy reassurance of an eye-catching
diagram.

That some are laying the blame for the end of the summer rally on a
technical tripwire suggests they have little idea what is really
going on. Perhaps Buttonwood should derive a technical indicator of
her own: the more regularly chartist analysis lands in her inbox, the
clearer it is that no one has any clue as to why the markets are
moving.

Correction (September 2nd 2022): An earlier version of this article
said Eugene Fama and Kenneth French won the Nobel prize for their
work on factor investing. They did not. Mr Fama won a Nobel prize for
his work on the efficient-markets hypothesis. Mr French is yet to win
a Nobel. Sorry.

Read more from Buttonwood, our columnist on financial markets:
Investors are optimistic about equities. They have no alternative
(Aug 18th)
Reminiscences of a financial columnist (Jul 30th)
The Fed put morphs into a Fed call (Jul 23rd)

For more expert analysis of the biggest stories in economics,
business and markets, sign up to Money Talks, our weekly newsletter.

This article appeared in the Finance & economics section of the print
edition under the headline "Head in the ichimoku cloud"

Finance & economics September 3rd 2022

  * Europe is heading for recession. How bad will it be?
  * Europe scrambles to protect consumers against dizzying energy
    prices
  * Vast corporate profits are delaying an American recession
  * China and America's long-awaited audit deal may yet fail
  * Distressed-debt investors are preparing to pounce
  * The missing pandemic innovation boom
  * Why investors are reaching for the astrology of finance
  * Central bankers worry that a new era of high inflation is
    beginning

The disunited states of AmericaThe disunited states of America

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