Wednesday, February 26, 2014

The Market Tends to Repeat Itself — Should We Care?

By Dr Van Tharp Trading Education & Workshops Institute

“History does not repeat itself, but it does rhyme.” — Generally attributed to Mark Twain, though unconfirmed

An interesting chart is still making its way around the markets and financial press. Commonly known as an analog chart, its function is to compare today’s market action to a past period in hopes that history can provide some guidance as to what we might expect going forward from today.

Are such charts useful? Let’s look at the current chart du jour and then we’ll dig a little deeper:

Market Year Analogs — Like Almost All Market Tools- Useful in the Right Context

Let me jump to my conclusion first, and then we’ll dig into some supporting evidence. I have been watching market analogs for decades and have tried really hard to dismiss them. But I can’t. Mostly, however, I have seen them broadly misused as a technical tool (but then again, so are stochastics, VIX lows, etc.).

Because they are not created or used properly most of the time, analogs can be very misleading. There was a time back in 2003 when a very good analyst went down an analog rabbit hole that had him looking for another scorching drop. While he was looking for that drop to happen, he missed the start of a 5 year bull market.

The current popular analog above comparing today’s market to 1929 is an example of a grossly misleading analog, though it does have some merit, as we shall see.

It’s All About the Scale

The biggest problem with market analogs is that you can use any price scale and any starting point to make two curves seem fit each other. Put a couple of clever people in a room for a day, and they can come up with dozens.

What’s the biggest problem with the current analog? The creator used two independent Y axis scales which misleadingly makes it look like we could be facing a 1929-style crash.

If we look at the same data and put all of it on a consistent scale (indexing both time frames to a starting point of 100), we see a very different picture:

The 1929 time period was MUCH more volatile. On an equal basis this analog is much less compelling.

This doesn’t mean, however, that we have to throw the market analog tool out the window. It means we should use it responsibly and with proper context – just as we should use all technical tools.

Is There a Good Use of Market Analogs?

One of the reasons that I can’t throw out market analogs all together is that some really excellent traders have used them and continue to use them.

In fact the current 1929/2014 chart has been credited back to Tom DeMark, who certainly has plenty of high-powered funds following his work.

Paul Tudor Jones has widely credited market analog studies as a source of inspiration for his famous 1987 crash call (though he certainly also used other tools).

A friend of mine and an extraordinary trader, Peter Brandt made a great call at the beginning of 2012 using recent market analog to call the bull market run in the first four months of the year.

If you think about technical analysis in general, it is based on the premise that market patterns repeat themselves. Those patterns arise because buyers and sellers are subject to human emotions and the psychological biases of auction markets. It is easy to verify that some patterns happen again and again. Are market analog charts really so different?

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