Opinion

Coincidence or not?

By Daryl Guppy (China Daily)
Updated: 2010-03-22 11:18

Is it realistic to believe, as some commentators claimed, that regional Asian markets toppled from seven-week highs last week because of weak US consumer data? This is a confusion of cause and effect. Weak US consumer data is hardy a surprise so it seems a little unfair to attribute market falls to this factor when the probability of a market retreat is already signaled by the patterns of existing price behavior.

Charting analysis is very useful for defining the potential limits of behavior. It is particularly useful when it is used to assess the probabilities of one behavior developing when compared with the probability of another behavioral outcome.

For the past few months the US market DOW index has been moving in a sideways pattern. This pattern started in November 2009. The lower edge of the trading band has support near 9,900 while the upper edge of the trading has resistance near 10,750. This is not advanced charting analysis because these support and resistance levels are well defined.

The pattern of past price and market behavior suggests there is a higher probability the market will retreat from the resistance level and rebound from the support levels. This is consistent with the behavior of a range-bound market that has lost the momentum from 2009.

Coincidence or not?

Understanding that there is a good probability of a retreat from resistance near the 10,750 area is not the same as knowing the particular event that will initiate the retreat.

A significant analysis danger comes about when people confuse cause and effect. As the market approaches the historical resistance level more investors become cautious. Their behavior changes and they begin to look for reasons that would prevent the market from moving higher. They do this because they believe the market is correctly valued near 10,750. It is this belief that creates the resistance level. As the market moves towards this level investors begin to sell, or they stop buying, because they believe the market will not move any higher.

There are many reasons why investors may believe this. Investors use many different methods of analysis, but if a significant number of investors reach the same conclusions and then behave in a similar fashion, as the market moves towards 10,750 they become sellers. The reverse occurs when the market moves towards support near 9,900. Investors who have been reluctant to join the market believe there is a lower probability the market will fall below 9,900. They initiate their buy orders and their buying creates a support level that puts a floor under the falling index. The result is a continuous oscillation between these broad support and resistance levels. It creates a broad trading range in a sideways trading band.

The high probability behavior of market participants is created by their combined impression of reasonable high value - resistance - and reasonable low value - support. As the market approaches these levels more investors take action based on a myriad of individual analysis conclusions.

It is convenient to associate this Asian market retreat with an easy-to-identify effect and call it the cause. It is convenient to suggest that the retreat was caused by the release of weak US consumer data because we mistake the coincidence for a correlation. There is a high probability the market would have retreated from 10,750 if the US consumer data had been stronger than expected. If this had happened then the reasoning may have been that the growth in consumer spending was unsustainable because wages were not increasing and unemployment was not shrinking.

The result of key market data may be above or below market analysts' consensus, but most times the market has already factored these results into the existing trending behavior.

The trading band behavior of rally and retreat within the confines of the trading band continues because this is the current behavioral characteristic of the US and regional markets. Warning of a new trend change will appear in the chart of price activity as new patterns of behavior that have a higher probability of trend continuation. This includes a sustained rise above resistance near 10,750. Until this develops, the retreats and rebounds may be associated with release of economic information, but ask whether this is a coincidental relationship rather than a correlated relationship. Hardly a day passes without the release of economic information so coincidental relationships are easy to create.

The author is a well-known financial technical analyst.