Prechter speaks (langer Text)

verfasst von JüKü, 12.09.2000, 23:31

Technical vs. Conventional Approaches
The differences between fundamental and technical theories of market behavior are sometimes extreme. The following discussion, which originally
appeared in one of Robert Prechter’s most popular books, Prechter’s Perspective, examines these differences and provides a detailed explanation
of the technical approach and the reasoning behind it.

To the average person, the idea that stocks go up when companies make money makes perfect sense. Stocks are near all-time highs
and a lot of companies are more profitable than they’ve ever been.

Well, since 1932, corporate profits have been down in 19 years. The Dow rose in 14 of those years. In 1973-74, the Dow fell 46% while
earnings rose 47%. Twelve-month earnings peaked at the bear market low. Earnings do not drive stocks. As Arthur Merrill showed
years ago, earnings lag stocks. As many practitioners have pointed out, the economy lags stocks. It is therefore impossible for
earnings or the economy to drive stocks. Even most economists know this, since they use the stock market as a leading indicator. So
today’s high earnings are a confirmation that yes, stock prices have risen over the past five years. But it doesn’t say where they are
going next, and that is always the task at hand.

The old saying is that the market is a discounting mechanism — earnings lag stock prices because smart investors anticipate future
events correctly. Is that it?

While this position is a time honored and valiant attempt to explain why events lag stock prices, I believe it is false. In fact, because
markets are patterned, it must be false. The truth is that rising earnings are caused by the action of human beings spurred on by an
increasingly ebullient social mood, and the presence of such a mood is reflected by a bull market in stocks. This direction of causality
explains why aggregate earnings can almost always be predicted by the movement of aggregate stock prices.

When you put it that way, it sounds like something a believer could get downright radical about. You are undermining Wall Street’s
entire fundamentally driven research establishment. Why don’t we see and hear more insurrectionary statements from technicians?

In general, advocates of technical analysis have been content to defend it meekly as having an ancillary value, as providing a little extra
that might help some investors make some decisions. However, the truth is far more profound than that. Technical analysis is not just
one approach to determine value or a trend. It is based upon an overriding fact, the fact that collective human behavior is patterned.
Conventional analysis is not a hallowed sensible approach; it is nonsense. It is founded upon a false premise, which is that there are
no patterns, only unpredictable, random causes of behavior to which men respond like puppets. Conventional analysts can’t see their
own contradiction, that it is men who cause the causes. It is men who raise interest rates and create earnings and all the rest. But to
the conventional analyst, each is as detached a cause as a meteorite striking the earth. Because many technicians have not made
this distinction and contemplated and validated its meaning, they have been afraid to defend technical analysis as one would defend
any dearly held truth of human existence. They are afraid to say that the real fundamentals of market analysis are human beings and
their patterns of behavior. The result is that today, university professors, who have validated the spread between futures and cash
prices, relative IPO volume, and even trend following as being predictive of stock prices, are getting the credit for work we did decades
ago. Why? Because today too many technicians are talking about the economy, the Fed, interest rates and health care instead of
breadth, volume, point & figure, on-balance volume, rates of change, non-confirmation, divergence, trendlines, relative strength,
institutional cash levels, allocation percentages, derivative premiums, short selling ratios, public participation ratios, fear, hope, greed,
and the cycles and patterns of human behavior.

Can you suggest any changes that will move the burden from the shoulders of technical analysis?

My recommendation years ago was that we drop the term “technical,” which is used as if it is some subspecies in a universe of various
acceptable types of market analysis. The only craft is market analysis. At a larger scale, it is social analysis. And the approaches
technicians take are the only valid approaches to performing it. Conventional analysis is something else entirely, and technicians can
leave it up to its practitioners to define and defend it.

But what about when there are extreme extra-market events like interest rate spikes or world war? In 1974, for instance, one may have
been misled by earnings, but an insightful political or oil analyst could have been able to extrapolate Watergate or an energy crisis
into trouble for the stock market. Can a big enough event change the psychology?

I become a little more radical every year with my opinions on that. I believe that all external social events follow changes in the market.
They are not events that affect the market. Changes in mood show up later as fundamentals. If people become more optimistic after a
period of extreme pessimism, it is only natural that a few months later the economy picks up, because those changes toward
optimism result in decisions that expand economic activity, and that change shows up in the economic indicators a few months later.

What about something like the North American Free Trade Agreement? Isn’t that almost certainly going to have a positive effect on
business — if not here, then certainly in Mexico?

This may be difficult to accept if you have been steeped in financial “analysis” from newspapers, magazines and TV, but the passage
or non-passage of NAFTA or any other political resolution has no causal forecasting value whatsoever. NAFTA or a peace treaty or
whatever might coincide with a market turn, but not because the decision per se went pro or con. Even if the future of that treaty were
known to you before it went into effect, you wouldn’t know what to do about it. It’s mind boggling to see how much energy goes into
discussing such supposed indicators of market behavior. Yet no one has done one bit of study to see if there really is a correlation
between trade treaties and markets. They just barrel ahead confidently on unencumbered assumption.

Markets reflect social mood, and mood trends eventually produce social events. Since mood precedes events, you cannot forecast
mood using events. The only forecasting value that some events possess is that certain events can occasionally imply an extreme in
mood, further implying that that mood is more likely to reverse soon than to continue. However, this is not to say that the event itself is
causal. And analysis on this basis is a complex task that requires a good deal of sophistication about the relationship among markets,
mood and events.

Why do you say “supposed” in referring to the indicators used by conventional analysts?

They are truly not indicators at all. They are utilized because of a simple presumption that they are valid, not because of any rigorous
back-testing. Conventional analysts do not bother to study history. They merely assure us, for instance, that the passage of NAFTA
will guarantee another decade of rise in stock prices because it seems as if it should. Wouldn’t it be a delicious shock if a light bulb
suddenly lit up in some reporter’s head and he or she asked, “Pardon me, but have you by any chance checked the historical record to
see if trade agreements in fact are typically followed by stock market rallies?” Don’t hold your breath. The reason conventional analysts
get away with their suppositions is that they sound utterly reasonable to the average man on the street, who, as we all know, is
sophisticated in the ways of markets. Technicians, on the other hand, do study history. That’s what a chart is.

So, ultimately the technical evidence will manifest itself in some fundamental form. Does that mean you can forecast what most people
call fundamentals?

Absolutely. When gold was $850, we had the knowledge that it was likely to drop to more than half its value, and when stocks were at
900, we had the knowledge that the averages were likely to quintuple. Armed with that information, The Elliott Wave Theorist was able
to make a lot of forecasts regarding what the “fundamental” environment would be like in ensuing years. I said that disinflation was
likely, that there will be an improving economy and social mood, that the president in power would get re-elected, these kinds of things.
I think you can apply the same idea right now, which is what I did in At the Crest of the Tidal Wave. As long as you are pretty well on
top of your forecasting, you get a tremendous advantage over most methods of reading the market because you have something very
few people have: perspective. Then you can forecast a lot of fundamental events. Elliott and the markets have always been a greater
value in forecasting fundamental events than vice versa.

You look first to the market. And that’s as far as you really have to go, because in the market itself, you have everything you need to
make money. But as a secondary exercise, you’re saying you can actually extrapolate the kinds of fundamentals that normally
accompany the kind of market you’re predicting. Then how come anyone who reads the papers or listens to the news or knows the first
thing about supply and demand from Economics 101 knows that the game on Wall Street is played by scores of analysts and
economists who get paid big money to chase down the factors behind every little squiggle in interest rates and stock prices? They all
start with the fundamentals, which is the opposite point of view.

Quite so. One of the great paradoxes of forecasting is that so-called “fundamentals” (i.e., current events and conditions) have no value
in prediction, and yet that’s where people focus their attention when attempting a peek into the future. On the other hand, forecasting
based upon the tenets of social pattern allows one to predict “fundamentals” to some degree. In other words, when an analyst
understands some of the truly meaningful indicators of coming social trend change, he can then describe some of the types of events
and conditions likely to follow. The markets are the best forecasters of economic and social conditions. I think that economists should
use markets mainly for that purpose, and of course, they don’t.

Another example of this paradox in action was the barrels of ink that were used by the financial media to discuss what effect the
“Crisis in the Gulf” in late 1990 would have on the stock market. There is no way whatsoever to guess at such a thing, since its extent
could not be predicted at any point using only the knowledge of its current state. On the other hand, not a drop of ink was used in
discussing the fact that cycles of market prices, and thus social mood change, are valuable in predicting things such as international
conflicts and their extents. The fact that the stock market was at a four-year cycle bottom, and that by one count, it was ending
Primary wave 4, increased the probability of armed conflict. At the Crest of the Tidal Wave predicts an increase in warring on the heels
of the coming great bear market. Thus, understanding how wars have fit into such patterns in the past is valuable in predicting a
dramatic increase in the likelihood of war, whereas wars themselves have no value for predicting the course of stock prices except to
indicate that collective emotions are near an extreme.

Are you saying that if you were in the stock market for technical reasons and able to know ahead of time that the President would be
assassinated, you wouldn’t lighten up on your position?

I would buy some puts and sell them five minutes after the announcement. Otherwise, I would not change my position.

But if you knew ahead of time what the major events were going to be, how can you say that even that would not help you to know
what the markets would to do?

If the devil had come to you in early 1986 and said, “I’ve got some inside information. The Democrats will take over the Senate by a
wider margin than even they expected. We’ll have the biggest financial scandal on Wall Street in 60 years (the Milken/Boesky insider
trading debacle). And Ronald Reagan, the most beloved president in history, will be caught in the midst of a national scandal regarding
Iran.” If you shorted a bunch of stock, if you assumed the news would have an affect on future trends, you would have lost. Suppose
you knew in 1992 after 12 years of Republican reign that a Democrat would get elected, enact the largest tax increase in U.S. history
and attempt to socialize the entire medical industry of the U.S. Would you have sold? Fundamentals don’t work.

What about something that is known to everyone and has an obvious effect? Suppose you see interest rates begin to rise in February
1994, and despite your earlier case that the effect is not guaranteed, you have reason to believe that we are in a cycle in which rates
and stocks will go in opposite directions. Isn’t that a good solid fundamental reason for getting out of the market?

How do you know that interest rates didn’t stop rising today, in which case stocks are a buy?

Let’s suppose the latest economic report showed strength.

How do you know that the economy didn’t peak that month?

I’d wait for a change of some kind, a report of a slower economy or a lowering of rates by the Fed.

How do you know that that economic report won’t reflect the only economic down tick or that the Fed won’t lower rates once and then
start raising them again?

The Fed usually moves in multiple steps.

Aha! By forecasting the behavior of your supposed cause, you are engaging in technical analysis of your “fundamental” data. You’re
forecasting the behavior of an agency based on the history of its own behavior, in this case using the technical idea of trending. This
agency is then considered to affect a market (i.e., interest rates) that will affect the one you actually want to predict, i.e., stocks.

So you’re saying....

You cannot avoid employing technical analysis at some point. Since it must be employed, isn’t it far easier merely to perform technical
analysis directly on the market in question? Instead of saying, “The trend of Fed action is toward higher rates until that trend changes,”
you could simply have said, “The trend of stocks is down until that trend changes” and saved all the trouble and avoided the pitfall of
requiring a whole chain of causality to maintain itself, for which history shows numerous exceptions.

So all that interim reasoning is superfluous.

Exactly. I’m saying that the chain of predictions concerning each supposedly causal indicator in such exercises will be endless until
the conventional analyst finally provides a prediction based on technical analysis, so why not start with it?

Sometimes all these experts really say is that they see no evidence of a change in trend for their supposed cause. That’s a technical
statement, too?

Yes, trend following is the crudest form of technical analysis, and it is employed by nearly all conventional analysts and economists.
Unfortunately for them, they often make it far less useful than it already is by following the trends of lagging events. Some such
indicators, for instance, earnings, can time themselves exquisitely to produce maximum error in forecasting the stock market. So why
doesn’t he just start with the trend of the market and forget earnings?

Furthermore, a conventional analyst cannot adjust for error. If interest rates fall and stocks fall with them, or if earnings fall and stocks
are going up, he has no basis upon which to modify his stance. Technical analysis provides a built-in method of changing one’s mind.

All effective forecasting requires technical analysis. While technical analysis can be utilized perfectly well on its own, there is no such
thing as valid analysis apart from technical analysis.

I think we’ve uncovered the basic flaw in the conventional approach to markets. But I’m not sure exactly what that is.

Conventional analysts have to predict their own indicators. If the comment is made that the economy is going into a recession, and
thus stocks are going to go lower, an assumption has been made about what this fundamental indicator itself is going to do in the
future. For example, an analyst once said he was bearish on the stock market because long-term rates were high and rising. That
implied that rates were still rising. But in fact they had already peaked. He had to forecast a continued rise in order to explain why he
was bearish.

A technician is not reduced to predicting his own indicators. He can look at the evidence at hand without forecasting the indicators and
say the indicators right now are bullish or bearish. This is not to say that such indicators are always right, but at least the chain of
argument is direct and finite. The indicator speaks to the future, and that’s that.

Ultimately, however, isn’t it reasonable to say that the driving force behind long-term appreciation is always the same fundamental
force: earnings? No matter what 20th century success story you’re talking about, Coca Cola or IBM or Microsoft, the common element
was an ability to deliver on the bottom line. So if you can forecast profits, can’t you be expected to forecast rising stock prices?

How many people forecasting profits predicted the stock market one year ahead in mid-1929, mid-1930, mid-1931, and mid-1932? The
best forecaster of earnings is the stock price. Now, once you have established that a bull market is in force, which is a task requiring
technical analysis, then you can perform one type of useful fundamental analysis: you can set out to learn more about a company than
the otherwise best-informed people in the marketplace. A really dedicated fundamental analyst who gets inside a new company and
believes it has a huge advantage over the competition and believes that its stock price does not reflect that potential can make an
intelligent choice. He is, in effect, predicting profits and therefore the relative price of one stock.


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• Prechter speaks (langer Text) - JüKü, 12.09.2000, 23:31