Technical Analysis/Psychology And Markets
At first blush technical analysis as applied to the stock market seems to be a bunch of voodoo. Interpreting chart patterns and attempting to predict future movement based on past behavior is considered by some to be no less rational than traditional fundamental analysis. One of the most succinct explanations of why many believe technical analysis works is that PSYCHOLOGY drives the markets. Buying and selling of stocks, futures, and derivatives sets a market in motion as participants negotiate a common price point. The exchange of goods is more or less driven by human psychology and future expectations.
The primal emotions upon which expectations are built are fear and greed, which in effect compels humans to repeat the mistakes and triumphs of the past. The watershed moment came as Charles Mackay published his 1841 book Extraordinary Popular Delusions and the Madness of Crowds in which he detailed the Dutch tulip mania of 1637, and 1720 meteoric rise in the stock prices of the Mississippi and South Seas Companies. The South Seas bubble was initially started as the company was given exclusive access to the South American trade and new world colonies. The frenzy that resulted as both peasants and lords feverishly snapped up shares inevitably resulted in credit defaults, bankruptcies, and economic hardship. When Sir Isaac Newton was asked about the continuance of the rising of South Sea stock.....He answered 'that he could not calculate the madness of people'. (Spence, Anecdotes, 1820, p368) Since then, history has only to reference the stock mania which gripped the United States in 1929, the 1989 Japanese Nikkei, the 2000 technology bubble, and the 2007 global real estate boom. History is littered with booms and busts - manias that lead to unsustainable price levels based purely in our primal emotions.
The key to technical analysis is that human behavior is considered invariant. Humans act predictably and market technicians have developed descriptions of emotional patterns that are reflected in the price action. This applies to both rational as well as erratic market gyrations. In the rare events where a mania bubble is present, they point to asymptotic lifts to unsustainable levels. Indecision is described in terms of 'consolidation ranges and triangles'. A consensus amongst market participants is reflected in a 'trend'. Incorrect assumptions and disappointment is considered a 'breakout or breakdown'. Whatever the nomenclature, these patterns simply imply a set of expectations on behalf of those with an emotional stake in the outcome. Once the market behavior is classified in terms of a pattern and context, the technical trader can then form an opinion of future price action.