Price action cannot say much about many important issues that are of concern to investors and traders although some mistakenly think it can.
Yesterday I saw a chart of S&P 500 with a simple indicator that attempted to time the next top. The person who posted it in social media was quite excited. But can charts with simple indicators forecast market tops?
Below are S&P 500 charts with three indicators I have developed with successful forecasts of the previous two major market tops. These are called the Correction indicator, the Bear Market Probability and the Hurst Exponent, from left to right. Click on images to enlarge.
The Hurst exponent failed in its forecast of a top in 2015 because volatility collapsed. The Bear Market Probability indicator generated a major market top signal in 2015 and since it has not even generated a bull market signal although the index has made significant gains. Again, the reason is the low volatility. The Correction Indicator is still signaling a major top although prices keep rising higher.
In my opinion, most indicators of this sort no longer work well because market conditions have changed. Specifically, a prolonged period of very low volatility has impacted the ability of many indicators to forecast top.
However, there is a more fundamental cause as to why most indicators that attempt to time tops or bottoms fail: they are fitted to past data and as a result data-mining bias is high and the indicators are not significant.
What price action cannot tell you
(1) Price action cannot tell you if a market is being manipulated
This is extremely hard to figure out from price data only. Analyzing transactions at the tick level is required and this is specialized analysis that only few people know how to perform.
(2) Price action cannot say much about future returns
A model of price action is required to forecast future returns based on the assumption that market conditions will remain the same. This was the wrong assumption that caused the failure of the three indicators above that predicted a major top in 2015.
(3) Price action cannot forecast major tops
Even if a model is used, as with the three indicators above, changing market conditions can invalidate its forecasts. Price action is more useful for short-term forecasts in the order of a few days in the future depending on model used.
(4) Price action cannot forecast recessions
Price action reflects past information and expectations. Often, the expectations are wrong because future information is missing.
(5) Price action does not reflect intrinsic value
Even well-known economists and experienced traders make this mistake: price action reflects investor behavioral patterns. This is one reason bubbles are formed. This is also the reason that indicators based on P/E ratio and other metrics do not work well or at all.
The objective of trading and investing should not be the timing of tops or bottoms but the development of trading and allocation models that minimize losses during adverse market conditions and maximize gains during favorable conditions. But 90% of the financial blogosphere and social media activity is now about timing the next top.
If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY
Charting and backtesting program: Amibroker
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