Reading Clouds in Coffee Futures

Long ago, Manhattan punters gathered under an American Sycamore tree at 68 Wall Street to swap stories and trade whatever it was that could be traded on a New York sidewalk in the 18th century. The sycamore tree, also known as a Buttonwood tree, became the namesake of a 1792 agreement that formalized a trading association later known as the New York Stock Exchange.

The Buttonwood Agreement helped transform the once ordinary intersection of Wall Street and Broad into the world's most important financial district, host to the most important financial institutions in the world (until many of them left for Connecticut and New Jersey).

Some fifty years after the Buttonwood Agreement, a weekly news and international affairs publication dubbed The Economist began circulating in London. In continuous print since 1843, it aims to "take part in a severe contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress".

The editorial column related to financial matters in The Economist goes by the name of Buttonwood, in honor of the famed sycamore tree, in recent years these opinions having been relegated to the online edition of the newspaper. That is, until last Thursday when it began appearing in a much thicker print edition, likely an effort to offset the increased amount of advertising (the absence of voluminous advertising has been a notable feature of this publication for many years, and it is feared they have now changed direction).

Of course none of what you have read here so far has anything to do with the subject of today's offering - it has been but a casual stroll through history seeking to understand from whence things come and why they are the way they are.

Magic Numbers

In a week that so far has been dominated by fare from the "thicker than usual" Darkside of Debt issue from The Economist, that trend is continued today with a discussion of the current Buttonwood column, Technical Failure. This week Buttonwood has some fun with a subject that has for many years been the object of first wonder then mild derision here - technical analysis of financial markets generally, and Fibonacci sequences in particular.

Believers in Fibonacci numbers are part of a school known as technical analysis, or chartism, which believes the future movement of asset prices can be divined from past data. Some chartists follow patterns such as “head and shoulders” and “double tops”; others focus on moving averages; a third group believes markets move in pre-determined waves. The Fibonacci fans fall into this last set.

Buttonwood, who is daringly defying the tide of history by moving from Economist.com into the newspaper, has bad news for the numerologists. A new study by Professor Roy Batchelor and Richard Ramyar of the Cass Business School, finds no evidence that Fibonacci numbers work in American stockmarkets. The academics looked at the Dow Jones Industrial Average over the period 1914-2002 and found no indication that trends reverse at the 61.8% level, or indeed at any predictable milestone.

This research may well fall on stony ground. Experience has taught Buttonwood that chartists defend their territory with an almost religious zeal. But their arguments are often anecdotal: “If technical analysis doesn't work, how come so-and-so is a multi-millionaire?”. This “survivorship bias” ignores the many traders whose losses from using charts drive them out of the market.

Fibonacci retracement levels are bogus? That's going to come as a shock to the many technical analysis curmudgeons that whip up charts with lines and notations, all in an attempt to predict the future - sometimes actually getting it right.

At first dazzled by chartism, awed by its mystery and complexity, many are keen to believe that the future can indeed be divined from magical sequences, historical patterns, or enduring waves.

It just spoils everything when someone actually looks at the data to see how well this sort of prognostication actually works long after the thrill of the prediction has worn off - kind of like seeing how Cramer's picks fare over time.

The problem with Fibonacci's numbers, unlike other qualified soothsayings derived from technical analysis, is that the rules are all too clear.

Furthermore, the recommendations of technical analysts can be so hedged about with qualifications that they can validate almost any market outcome. As Professor Batchelor writes: “The root of the problem is the failure of technical analysts to specify their trading rules and report trading results in a scientifically acceptable way. Too often, rules are so vague and complex as to make replication impossible.”

Fibonacci numbers at least have the virtue of creating a testable proposition; one that they appear to fail. But chartists will not be completely discouraged. A review of the academic literature finds that, of 92 modern studies of technical analysis, 58 produced positive results (although the researchers say some of these studies may be flawed and that the best results occurred before the early 1990s).
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All that talk of long waves is distinctly mystical and seems to take the deterministic view of history that human activity is subject to some pre-ordained pattern. Chartists fall prey to their own behavioural flaw, finding “confirmation” of patterns everywhere, as if they were reading clouds in their coffee futures.

Besides, technical analysis tends to increase trading activity, creating extra costs. Hedge funds may be able to rise above these costs; small investors will not. As illusionists often proclaim, don't try this at home.

And thus we arrive at the heart of the technical analysis lure of the last ten years - the culmination of hundreds of years of stock trading that started under a lonely sycamore tree. The modern incarnation of the daily deeds of the 24 signatories of the Buttonwood Agreement seems embodied today for ordinary individuals by the likes of ChannelingStocks.com and GorillaTrades.com.

Both of these annoying CNBC sponsors, and many more like them on late night TV, seem to be all-too successful at transforming ordinary individuals into less-than-ordinary traders, in the process, generating revenue for the brokerage houses and stock exchanges that are more than happy to place their trades, winning with every order.

Everyone wins, or so the charts would imply, after all, if these systems don't work, how come so-and-so is a multi-millionaire?

Don't get me wrong, like many others, there is much that is not understood here when it comes to technical analysis, and passing judgment along with Buttonwood would seem the expedient course to take today. But, doesn't it all seem rather improbable?

Ordinary individuals trying their hand at trading stocks based on technical analysis, using the same tools that are sold to thousands and thousands of other ordinary individuals? Trading is a zero sum game - for every winner there is a loser, yet the attraction persists and new traders are born every day.

Though not nearly as exciting as trading, a much more sensible approach might be to simply buy what everyone else will want before everyone else knows that they want it.