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Arbitraging Emotions

The technical analysis of securities relies on three principal assumptions: The market already discounts everything; prices move in trends; and history repeats itself. Its primary objective is to spot trading patterns and predict market movements without any reliance on fundamental value analysis.

Eugene Fama’s competing random walk thesis contradicts these assumptions. It argues that the market efficiently adjusts to new information and does so quickly and unpredictably. Fundamental value analysis guides the market with no regard for past performance.

Conclusive evidence favoring either theory is lacking, perhaps because they are both extreme. Here is an attempt to marry the two.

Human beings undergo a cognitive process to convert input data into actionable knowledge. This process varies in duration, depending upon the complexity of the incoming information. It is also susceptible to biases, emotions, and social factors, as extensively studied in behavioral finance.

Hence, market participants operate under the constraints of bounded rationality. They continuously absorb new data while managing psychological impulses. Instead of being instantaneous, the market adjustment to a new equilibrium defined by fundamental value analysis follows a path – sometimes like that of a drunken dragon, as in the case of the 10-year Treasury yield.

It seems logical that technical analysis could shed light on that adjustment path based on historical chart patterns that naturally reflect human behavior, i.e., psychological patterns. From that perspective, technical analysts or ‘chartists’ are psychologists attempting to read the market’s mind. Their goal is to arbitrage emotions.

Fundamental and technical analysis can complement each other, like strategy and tactics. In M&A, for instance, a combined approach would help a buyer determine the optimal time to launch a bid for an undervalued company when the company is technically subject to a bearish trend.

Support and resistance levels belong to the core indicators of a technical analysis. Moving averages are commonly used to assess such levels. When below a stock’s price, moving averages act as support; when above, they act as a ceiling. Once a support or resistance level is broken, its role is reversed; e.g., if the price falls below a support level, that level becomes a resistance level.

As of last week's closing, an AI-generated technical analysis read: ‘The S&P 500 has broken the ceiling of the falling trend in the short term […]. The index is approaching resistanceat 4,380 points, which may give a negative reaction. […] A break upwards through 4,380 points will be a positive signal.

The S&P 500 actually flirted with the resistance level (4,380) for the whole week. It finally broke through that ceiling on Friday. 4,380 has become the new support level.

According to the market therapists, investors have turned cautiously optimistic. 4,520 is the next resistance level in the short term.

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