Technical market analysis 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, this is 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 following articles: investmentwatchblog.com/the-wave/, investmentwatchblog.com/flash-trash-talk/, and investmentwatchblog.com/greed-rules/ discuss the distortions introduced into financial markets by high frequency algorithmic (HFA) trading. HFA traders can move stock prices and, hence, the market in any direction they want using computerized 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 result of their analysis will be skewed, making the prediction of future market movements more of a crapshoot than a likely outcome. Over the past year and a half, 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. That is what happens when HFA traders keep market prices elevated by manipulating the market 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 6th during the flash crash. 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, and death crosses are signals that lack predictive value in a distorted market. The data that generates these bearish signals are partially, if not wholly, influenced by HFA traders. Therefore, the data cannot be trusted as a basis for making recommendations or sound investment decisions.
Technical analysts accept what they assume to be data generated by a fair and open marketplace and then apply the tools of technical analysis as best they can. After all, isn’t a fair and open marketplace, where securities are publicly traded, the cornerstone of our capitalist system? Unfortunately, that is only true if our regulators 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. After all, technicians are not cops.
The SEC and CFTC 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 is more than 70% of 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 does not translate into liquidity. When HFA traders leave the market en masse, as they did briefly during the flash crash, 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 a tiny group of 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 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 analysis and, consequently, their conclusions and recommendations assume that market data is not rigged. Perhaps, regulators will get the message. In the mean time, the wise guys always win.