The limitations of technical analysis

2011-JUN-25 Alisdair Macleod

It is generally encouraging for precious metals bulls when technical analysts are cautious or suggest that a correction is not yet over, because they have a knack of advising caution just before prices rise. Silver is particularly difficult for technical analysts who apply Elliott Wave theory: today, they see the possibility of an A-B-C correction, in which case a downward C-leg would take the price down to the $25–$30 level.

Technical analysis is for those who are unprepared to properly consider the true factors that drive a market. The laws of chance suggest that an unemotional technical analyst might be right 50% of the time. This is not to say that applied technical analysis is little better than tossing a coin, because some technical analysts do get reasonable results and some of their tools are worthwhile. Good technical analysis gives us a better understanding of the balance between greed and fear in the markets.

The people who really know where this balance lies are the market makers, or in the case of the futures market, the commercials. They learn with great rapidity the quality of business a floor broker has, and how successful that broker and his clients are in their trading activities. This is important knowledge that is denied to the rest of us, which is why the commercials were so successful in precipitating the severe shake-out in silver in late-April.

But if you are a technical analyst, all you see is a bullish trend that has been severely broken, raising the real possibility of a new bear phase, with an Elliott Wave C-leg to come. You think you are reading in graphic form the tussle between greed and fear. This is certainly valid in the narrow context of the Comex futures market, into which is corralled all the speculative interest from American punters. But it does not capture the emotion behind the physical market: the concealed activities of central bankers, the demand from Chinese and Indian investors and the developing panic in Europe. The central banks are secretive, the ordinary people are countless and uncounted. They were never greedy, only fearful that paper money might lose its value. In the overwhelming absence of greed, there can be no balance with fear, negating the very basis of technical analysis.

Perhaps the best lesson to learn from the recent shake-out in prices is that it has provided an opportunity for everyone around the world, fearful of the precariousness of paper money, to buy more physical. We have no definitive statistics on this, but you cannot ignore the recorded demand for gold and silver from China and India – the two most populous nations on earth – the announcement that the Mexican central bank has bought 100 tonnes this year, and that the Russians continue to accumulate gold. Nor can you ignore the draining of silver from the Comex warehouses. Nor can you ignore the fact that the investment management industry has virtually no client exposure to the sector, and that the general public in Europe and America is totally ignorant about what is happening to their paper currencies.

The way mistakes are made is by following advice based on the wrong information. That is the danger of technical analysis forecasts for gold and silver prices. They often become a reflection of analysts’ own emotions rather than of the market itself.