Technical Analysis and Cognitive Bias

One may find scores of recent articles in the blogoshpere calling for a continuation of the gold downtrend after a pause and an extension of the stock rally to … you pick the future date, all are there. In reality, these analysts are conveying their cognitive biases to the public because unless one experiences precognition and knows the future the only reasonable assessment of the situation can be a subjective probability much less than 1. Current situations in GLD and SPY are discussed.

It must be the case that a high percentage of market analysts experiences precognition, a clairvoyant power of prophecy that allows one knowing the future by just looking at charts. How could otherwise one explain statements like “the market will rise to 20,000 in the next five years” or that “gold is going to $1,000 an ounce”?  Do all those people posses psychic powers? That is highly unlikely and the simplest explanation is that their conception of reality is highly distorted by their cognitive biases. Here is an example: Mary is thinking of a person, the phone rings and on the other side of the line that is the person who is calling her. Does she have psychic powers? If she only considers this specific event as proof of her powers, then she imposes selection bias, a serious cognitive bias from which suffer many technical analysts, trading system developers and investors. If one does that very often, then it may not be just bias but a serious psychological disorder and should be treated by a qualified professional. A correct assessment of precognition ability in this particular example should include a careful count of all cases when one thought of a person and that particular person did not immediately call. If that is done, one will find out that the event is way outside any statistical significance bounds, i.e. it is a random event. If technical analysts do the same and count all times they have been wrong about all those extraordinary moves in the markets, then they will see that in the best case their success rate is 50%.

Let me be clear at this point and not confuse profitability from technical calls with indirect claims of precognition. These are two different things and the former depends on many factors like risk management, purchasing power, luck, etc. This post deals only with the latter claim. Profiting from such technical calls requires a well-defined and proved method of assigning probabilities to them so that in the long-term trading carries a positive expectation of a reasonable size to cover friction and expenses, as well as, opportunity cost. Trading and investing are not as trivial as claiming that the DJIA is going to 20,000 or that gold is going to $1,000. One may be right on any of those calls but end up broke after 10 years because of other bad calls. This is the key flaw in calling the directions of the markets while lacking a methodology for trading them.

Gold

GLD_20130516

After finding support above the $130 level, GLD rebounded to close the gap and now it is about to retest support at $130.50. Maybe a double bottom will be formed here or the market will go through the support to lower levels. There is another support level near $127.80. Those who expect an easy ride down towards $100 may not get what they want or actually may get what they deserve. The key here to realize is that nobody knows the future and economic euphoria manufactured by purchases of paper around the world may be replaced by reality soon. On the other hand, gold sales may continue for raising money for investing in stocks, if stocks continue to rise. These are just possible scenarios but nobody knows the future.

SPY

Those who bought at the top of 2007 are still making less that 10% in absolute total return. With dividend reinvestment my estimate is that the total return since the top of May 2007 is about 20% but if inflation is taken into account that drops to less than 10% again. That is inflation ate away the dividend gain (no free lunch). The important thing to notice is that according to my analysis, the first round of sales from those who invested in stocks between 2005 and before that 2007 top, mainly retail investors, occurred in May of 2011 and some thought it was a “sell in May and go away event”. Actually, most of those who sold then did so because they were making a decent return after 4 years of net losses.

SPY_20130516

The SPY chart above shows a 6-year (6 x 252) rolling arithmetic percent return plotted on the bottom pane. A second round of selling may be approaching by those who bought at the top of 2007, again mainly retail investors who were counting on those funds for their retirement. As already mentioned, the inflation adjusted total return of S&P 500 since the top of 2007 is less than 10% at this point assuming dividend reinvestment. Those who did not reinvest the dividends are probably making a negative total return of about -5%, i.e. they are still losing money. They will be breaking even soon if this rally continues and may start a second round of selling like in 2011 to secure their break-even point and say bye-bye to the stock market. Retail investors will stay in only if the market is exceptionally strong and basically in my opinion this is what central banks are trying to accomplish at this point so that there is no selling. The most crucial inflection points in markets are not only when they top or bottom but also when investors break even.

Disclosure: no relevant positions at the time of this post

Charting program: Amibroker (Charts created with AmiBroker – advanced charting and technical analysis software. http://www.amibroker.com/”)

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