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BEING STREET SMART
by Sy Harding
How Do Technical Indicators Know What They Seem To Know? (April, 2000)
In early March, the Nasdaq began to decline. Prior to the fact, analysts were all over the media predicting 6,000, even 7,000 on the Nasdaq before the tech stocks could possibly run into trouble (given the way they had the wind at their backs and such positive momentum).
After the fact, analysts were all over the media explaining why the decline had taken place. It was a statement by Henry Blodgett, internet analyst at Merrill Lynch, that 75% of Internet companies will never make any money. It was worries after hacker attacks had shut down several major websites. Or "Given the valuation levels, it was obvious something had to happen." Or any of dozens of other explanations (all given too late, as explanations of why it had happened).
By March 24, the Nasdaq had recovered back to its previous peak. After that fact, analysts were again all over the media euphorically claiming that the 10% pull-back had taken the excesses out of the Nasdaq, the correction was over, and it was the buying opportunity of the year.
But the Nasdaq plunged again, and within weeks was down 34%, a bear-market size decline to 3321 from its previous peak at 5048.
During and after that plunge, analysts again explained why it had happened. To some it was the breakdown of settlement talks in the Microsoft case. To others it was President Clinton's statement that cataloguing of genes should be free information for all scientists to use, and not be patentable. Still other had other explanations.
How then did technical indicators, unable to even realize after the fact that these supposed catalysts had taken place, manage to signal not after the fact, but in advance of the fact, that this time would be different, that these particular statements or judgments or events, no different or more serious than similar ones that take place every day, or at least every week, would create a Nasdaq decline that would be more significant. Or that subsequently the rally attempt in late March would fail, and that the downside would resume?
Or let's look at the Dow (next chart). How could technical indicators know that while the Nasdaq was soaring in the first few months of this year, that the Dow would go into a sharp correction? Or that, when the Nasdaq began its recent plunge that the Dow would begin to rally? After all that was an unusual situation. It was certainly not what fundamental analysts were calling for. In January, most were calling for substantially higher gains, to as high as 20,000 for the Dow.
When that proved to be wrong, at the Dow's low in March, the consensus became that there was considerably more downside to go, even that a bear market had begun. Even perennial bull Abby Joseph Cohen shocked the market by recommending that some money be taken off the table.
How did the technical indicators know different in both directions, predicting just the opposite of what the fundamental analysts were saying?
Let's take a look at the Transportation Average.
Fundamental analysts were caught totally off-guard by the gyrations in oil prices of the last two years, which in turn are so important to the prospects for the transportation industry. They were first surprised that crude oil prices could plunge to $11 a barrel, repeatedly predicting the bottom was in all the way down. They were then just as far off-base in oil's subsequent 300% surge to $34 a barrel, predicting all the way up that the top was in, at $16, at $20, at $24, at $30. First it was that OPEC would never reach an agreement to cut back production, then after OPEC did, all the way up (for oil prices) it was that OPEC countries wouldn't hold to the agreement.
How then did technical indicators so flawlessly predict the entire cycle so well for the transportation industry; that fuel costs would drop, allowing airline and trucking stocks to soar to new highs, then that fuel costs would soar, and cause the transportation stocks to plunge, and most recently, that the top was in for oil prices (and the bottom for the transportation stocks)?
The answer is that of course they don't know what OPEC countries are doing, and they certainly don't know what OPEC countries are going to do next.
What they do is detect momentum reversals in the market that will probably be significant, very quickly after they begin, while ignoring those momentum reversals that will probably be temporary. Are they foolproof? Of course not. But they certainly do beat the guessing that goes on as to what valuation levels, or the latest economic number, or the latest remark by Alan Greenspan might mean to market direction.
It does beg the question of how momentum can reverse even as fundamentalists, the media, and therefore the majority of investors, are still seeing a trend as destined to continue. Obviously, market or sector momentum only reverses at a top because enough selling comes in to overwhelm the optimistic buying that is still going on. Who are these people with the foresight to be selling at such times?
In the other direction, downside momentum only reverses back to the upside at a correction bottom because enough new buying comes in to overwhelm the pessimistic selling that is driving the market down at the time. Who are these people that know when to begin buying again?
We don't know for sure, but we can guess that it's the same Wall Street institutions that are sending their spokesmen out to the media to keep investors optimistic and buying at the tops, or to keep them pessimistic and selling at the lows, (so investors will be providing the opposite side of the trades the institutions have initiated).
The technical indicators sure don't know who they were, and don't even try to guess.
But, the technical indicators do detect their new activity (whoever they are), and thus the momentum reversal, much more quickly and accurately than can be achieved by guessing what OPEC or the Federal Reserve will do, and when, and how the markets might react.
One last point. Have you ever noticed how today's supposedly important event, or economic number, or merger announcement, or earnings report, or Greenspan remark, is discussed excitedly and endlessly, along with its implications for the markets, for only a day or two, and then its great importance is instantly forgotten a day or two later when the emphasis moves to the next event, or number, or remark by someone else? It sure keeps a lot of economists and analysts employed as they rush around to the various media outlets to give their interpretations. But does anyone even remember yesterday's, or last week's, or last month's 'overwhelming' number or event? What percentage of them ever mean anything? 1%? 1/10th%? Yet, with the excited chatter they keep millions of us wasting our time glued to every number, and their every word, as if we were learning something important.
Give me isolation, freedom from outside chatter and influences, and the technical indicators, any time.