A Rigged Market and the Death of Technical Analysis

by LV

The heavy influence of the Federal Reserve and high frequency algorithmic trading has distorted fair market price discovery, making the application of chart theory nothing more than a crapshoot.

Technical market analysis, employing chart theory, is based strictly on market action (i.e. price movement and volume) as opposed to fundamental market analysis, which concerns itself with the factors that drive the market to change.  Technical analysis assumes that price movements are a reflection of everything that is known to the market that could have an impact on the market.  Prices fluctuate and move in patterns and trends that can be modeled using mathematical formulas.  Based on historical data, technical analysis uses mathematical equations to uncover patterns of market behavior and places a high probability that these patterns tend to repeat themselves on a regular basis.  At least, that’s the theory.

What happens, however, if the data that technical analysts depend on does not reflect everything that is known?  What if the data; i.e. prices and volume, are corrupted by market manipulation?

The main distorter of market data, of course, is the Federal Reserve.  The stock market has benefited mightily by the Fed’s Zero Interest Rate Policy and serial bouts of Quantitative Easing. Much of the newly printed money over the past six years has found its way into the market pushing share prices up dramatically.  The strong correlation between an expanding Fed balance sheet and a rising S&P 500 Index since 2009 underscores the powerful effect that Fed monetary policy has on the stock market. The process of fair price discovery, which is vital for a sound marketplace, is undermined when the forces of supply and demand are unduly influenced by central bankers.

Distortions are also introduced into financial markets by high frequency algorithmic (HFA) trading.  Manipulative HFA traders can move stock prices in any direction they want using computerized front-running and pump-and-dump strategies.  Manipulated prices mean the data, upon which technical analysts depend, is tainted and, therefore, the results they produce can be misleading.  Data generated in such a fashion does not reflect the true market forces of supply and demand.  HFA traders who engage in market manipulation place their thumbs on the scale of greed and fear, disturbing the balance.

Chartists can apply their craft to perfection but the results cannot be trusted because garbage in equals garbage out.  At best, the results of their analyses will be skewed, making the prediction of future market movements more of a crapshoot than a likely outcome.  Over the past six years, many reputable technical analysts have called repeatedly for a major stock market correction or even a crash based on a host of bearish indicators, which they have observed in chart patterns.  Time after time, they have been frustrated in their bearish forecasts as the stock market continues to defy the pull of gravity.  Permabulls have ruled the roost.  Those who continually advocate buying the dips have been right for years. Dumb money is winning. Even bears, who know better, are now fully invested (with tight stops) in a market where fighting the Fed means getting your head handed to you. This is what happens when Fed monetary policies intervene to support prices at the macro-level and when HFA traders alter fair market prices at the micro-level by manipulating stocks through faceless computerized trading strategies.

The fundamental problem is that any market, particularly a contrived one, is vulnerable to dislocations at any time.  HFA traders will immediately exit the market and leave investors to fend for themselves under such conditions.  We got a preview of this on May 6, 2010 when the so-called flash crash occurred.  Since that time, we have observed numerous mini-flash crashes in the trading of individual stocks.  Market technicians will continue to be frustrated when they attempt to read the tea leaves of manufactured data.  The bearish indicators and patterns, which technicians see in market charts, such as dojis, inverted hammers, haramis, spinning tops, topping tails, rising wedges, bear flags, falling moving averages, head-and-shoulders formations, and death crosses are signals that lack predictive value in a distorted market.  It’s like trying to see an image of Jesus in a piece of toast. The data that generates these bearish signals are partially, if not wholly, influenced by the Fed and HFA traders.  Therefore, the data cannot be trusted as a basis for making recommendations or sound investment decisions.

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Chartists accept what they assume to be data generated by a fair and open marketplace and then apply the tools of technical analysis to the data as best they can.  After all, isn’t a fair market, where securities are publicly traded, supposed to be a pillar of our capitalist system?  Unfortunately, it is only true if our market watchdogs enforce the rules to prevent anyone or any firm from gaming the system.  Technical analysts are not at fault, unless one blames them for accepting market data without considering the possibility that the data may not be reliable or trustworthy.  Technicians are not cops.  Further, chartists cannot filter out the aberrant impact on price and volume data when the Fed and HFA traders are actively manipulating the market for their own purposes.

The Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission regulators should have never allowed HFA traders to control the market as they do.  Market manipulation is illegal and has been that way since the 1934 Securities Exchange Act.  Because HFA trading accounts for more than half of total market volume, it is critical that the regulators make sure the rules of engagement are followed so there is a level playing field for all market participants.  If not, investors are at a decided disadvantage because the market lacks integrity.  HFA traders generate most of the volume, but volume doesn’t necessarily translate into liquidity.  When HFA traders leave the market en masse, as they did briefly during the flash crash of 2010, liquidity leaves with them. As a result, prices fall and they fall quickly and precipitously.

The integrity of our capital markets is under attack by the Federal Reserve and a formidable group of manipulative traders armed with computers and algorithms, and no one is there to protect investors from their depredations.  It does not appear that the SEC and CFTC will address the root of the problem in a meaningful way until they are forced to do so.  Unfortunately, it may take a major market crash to get them off dead center.  In the interim, technical analysts should recognize that market data could very well be compromised, which means the results of technical analysis would also be compromised.  Any recommendations they make to clients should include the disclaimer that their analyses and, consequently, their conclusions assume that market data is not rigged.


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