NEW TECHNIQUES
Point, Figure, And Trade
Predicting Turning Points With Cobweb Theory
by Chris Satchwell, Ph.D.
Economics plays a role in the markets. Here's how the underlying
premise of point & figure theory is consistent with the tenets of cobweb
theory.
The methods used in technical analysis fall
into two broad types. The first, which includes most technical indicators,
treats price as a noise-corrupted signal, and seeks to find a true signal
that can be used to infer price's direction. The second type encompasses
ideas on support, resistance, and trading patterns. These concepts describe
the existence of barriers to price movements where turning points occur,
and try to infer price movement from one or more of those turning points.
I am interested in both; I am neutral as to which of them might work
best. For example, an article I wrote on regularization, published in the
July 2003 STOCKS & COMMODITIES, was on the methods of the first type.
S&C Contributing Editor John Ehlers subsequently showed how a regularization
parameter could be chosen to make this accessible method perform as effectively
as a two-pole Butterworth filter.
This article is about the second approach to technical analysis, and
how it ties in with a well-known hypothesis of economics known as cobweb
theory. Economists like their supply and demand curves; they have trouble
accepting technical analysis because so many of its signals are based on
price alone. However, cobweb theory, which is familiar to economists, provides
a basis for predicting the next turning point in a sequence without knowledge
of the supply and demand curves, or the quantities of whatever is being
bought and sold. I will demonstrate that the underlying premise of point
& figure theory is consistent with the tenets of cobweb theory, and
thus attempt to make this second approach to technical analysis more acceptable
to at least some of its critics.
PRICE/TIME PRADIGMS
To avoid confusion about when cobweb theory is applicable, note that
many price/time paradigms describe market behavior, and cobweb theory is
only one of them. Economist K.E. Wärneryd described three primary
psychological drivers behind price movements: a) price changes of the recent
past, b) historical price levels, and c) the effect of news. Each of these
effects has predominated in various historical situations.
For example, in the 1920s boom, price rises of the recent past were
used to "prove" that historical levels were irrelevant, which led to a
mistaken belief that poverty had been beaten. In the spring of 1940, the
DJIA had been flat for a while, but in May, an unexpected German conquest
of continental western Europe triggered a rapid fall of around 30%.
In contrast, in December 1941, the DJIA was in a bear market (making
it less inclined to search for a new direction), and the Japanese attack
on Pearl Harbor barely registered as a blip in that bear market. Price/time
paradigms a) and c) are situations in which cobweb theory is not generally
applicable, but paradigm b), where historical price levels predominate,
is where cobweb theory tends to be most useful.
Figure 1: Linear price/quantity relationship. The absolute
value of the supply curve (green line) gradient is greater than that of
the demand curve (red line). The result is a dampened fluctuation in price
(purple line).
...Continued in the August issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the August 2004
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2004, Technical Analysis, Inc.
