Wednesday, March 06, 2013

Does Lachmann Make a Case for Technical Analysis Here?

Technical analysis hasn't much of a reputation in academic circles, having been compared to astrology, but Lachmann seems to make a case for why it might be effective, although the following passage never mentions technical analysis explicitly:
Let us suppose that on a market a 'set of self-consistent expectations' has had time to crystallize and to create a conception of a 'normal price range'. Suppose that any price between £95 and £110 would be regarded as more or less 'normal', while a wider range of prices, say from £80 to £125, would be regarded as possible. We thus have two ranges, an 'inner range' from 95 to 110 reflecting the prevailing conception of 'normality', and an 'outer range' associated with what is regarded as possible price change. Many economists have started their study of expectations with the notion of a 'range', usually in the form of a probability distribution, but only to discard it at the next moment in favour of a point, a 'certainty-equivalent', 'to substitute for the most probable prices actually expected with uncertainty equivalent prices expected with certainty'. By contrast, we shall endeavour to show that the location and motion of actual prices within our ranges are of crucial importance for the formation of expectations, and that by compressing the range to a point we should lose the very frame of reference within which actual price changes can alone be meaningfully interpreted and shown to be relevant to the formation of expectations.

What is the significance of our two ranges for the formation and revision of expectations?
As long as actual prices move well within the inner range, between, say, 96 and 109, such price movements will probably be regarded as insignificant and due to random causes. In fact, where the 'normality' conception is strongly entrenched, it will be very difficult for the price to pass the limits. For as soon as the price approaches the upper or lower limit of the inner range, people will think that the movement 'cannot go much farther' and, anticipating a movement in reverse, will sell (near the upper limit) or buy (near the lower limit). In such a situation 'inelastic expectations' will tend to 'stabilize' prices within the inner range.

But suppose that in spite of sales pressure near the upper, and buying pressure near the lower limit, price either rises above 110 or falls below 95. Such an event will sooner or later give rise to second thoughts. As long as actual prices move within the outer range, between 110 and 125, or 80 and 95, it is true, nothing has happened which was not regarded as possible. But the more thoughtful market operators will take heed. The mere fact that in spite of the heavy 'speculative' pressure encountered near the limits of the inner range, and engendered by inelastic expectations and the sense of the 'normality' of the inner range, price could pass these limits at all is a pointer to the strength of the forces which must have carried it past such formidable obstacles. Such a movement can hardly be due to random causes.

But the force that carried the price past the limits, while strong, need not be a permanent force. It may spend itself sooner or later. The market will therefore judge the significance of price movements within the outer range by the supplementary criterion of the time factor. If prices relapse soon and return to the inner range this will of course confirm the prevailing notion of normality. But if they stay within the outer range, gradually opinion will swing round. First some, and then others, will come to revise their notion of 'normal price'. Such revision will express itself in a new willingness to buy at a price, say 118, at which formerly one would have sold, or to sell at a price, say 88, at which formerly one would have bought. This means that a price movement, once it has been strong enough to overcome resistant pressure at the limits of the inner range, and reached the outer range, will probably sooner or later be carried further by the very speculative forces which formerly resisted it. This is readily seen if we reflect that the sales and purchases near the limits must have been at the expense of normal stocks, so that a price of 115 would probably now find the market with low stocks, and a price of 90 with an accumulation of excess stocks which are now a mere relic of the unsuccessful speculation of the 'normalists'. A fast movement within the outer range may therefore be just as much due to re-stocking (positive or negative) as to the operation of more permanent forces. This is why in such a situation the market keeps a close eye on stock variations. In fact, in dynamic conditions price movements have always to be interpreted with an eye on the 'statistical position' of the market which thus becomes a second supplementary criterion for diagnosis

Once the price passes the limits of the outer range, rises above 125 or falls below 80, an entirely new situation faces us. The market, shocked out of its sense of normality, will have to revise its diagnosis of the permanent forces governing a 'normal situation'. It must now become clear to everybody that the hypothesis about the constellation of fundamental forces which formed the basis of our range structure has been tested and has failed. But while the failure of an experiment may invalidate a hypothesis, it does not by itself suggest a new one. It follows by no means that the really operative forces will be recognized at once. That must depend on the insight, vigilance, and intelligence of the market. Experience shows, for instance, that an inflation is hardly ever recognized as such in its initial stages, at least in a society which has no prior experience of it. Almost invariably, at one point or another in this early phase, people will think that prices are already 'too high', will defer purchases and postpone investment plans. In this way, they will, by their very failure to understand the modus operandi of the fundamental force, mitigate its impact for a time by reducing 'effective demand'. And if, as is not impossible, the inflation stops early enough, they may be right after all! But it is more likely that they will be wrong. And in so far as their action entails the undermaintenance of capital, the ultimate results for society may well be disastrous.

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