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When technical analysis fails

Tracking the collective ego can be more rewarding than following technical analysis


The more sophisticated among us would understand the ego as the id (the self), but there are layers to that. There is a sub-conscious id and a conscious id (the self-awareness that humans are uniquely known to have).

This self-image is very complex and hence very fragile. It is what sends a film star into depression when a film fails or prompts an old-timer corporate employee to die quickly after he retires or is fired. It builds up over time, is reinforced by repeated validation (as in the case of film stars) and gives you the crutch on which you live. It is why billionaires commit suicide when they are faced with sudden losses. Like the shattering of glass houses, it takes away more than just their livelihood; it takes away their identity. It doesn't really matter whether a Vijay Mallya or a Nirav Modi is actually sent to jail; their life is already finished.

But going back to the evolution of the collective ego in agglomerations of people, it is possible to observe the building up of the collective ego thread by thread. The more complex the inter-relationships in an organisation, the more complex the (organisational) ego. At the highest level of complexity (the inter-connected human brain), it develops self-awareness. The more order a system has, the more it will need to protect itself, especially the underlying order. This is seen in complex organisations or even marketplaces.

It is perhaps easy to make the point that a highly ordered human brain would have a complex, self-aware ego, or even that organisations have an instinct of self-preservation. But an awareness of the operation of the ego in culture, religions and markets is useful because the individual is also a player within this (collective) ego.

Let's evaluate this further. Human behaviour evolves and markets are sometimes called 'history in motion'. Technical analysis often tries to deduce 'rules' from this evolution, sometimes with disastrous results. The reason why there are no rich technical analysts is that they do not know how the interaction of their own actions creates a feedback loop that leads to their own demise. For example, once it is well-known that a stock is at a strong support, we know that such support level is mostly violated before the stock turns. For example, look back at the stock-price chart of Tata Steel over the last few months.

You will find that the stock bounced a few times from 540, which became the accepted 'strong support level'. And then two top commentators came on the top TV channels and touted the stock as the pick of the decade. Result: All the immature viewers got onto the stock (especially after the Thyssenkrupp announcement). This was sold into by someone who seemingly did not agree with the recent prognosis given out by the two market wizards. The stock was handed over to 'fools', who by their very action had increased the very risk that they were seeking to avoid. Net result: With no apparent trigger, the stock dropped 12 per cent, to 490. The 'fools' capitulated and the strong hands moved back in. Come the quarterly results and the stock moved back to 580, its starting point, all in about a month.

The casualty in this short example was the technical analyst and his believers. The only way to understand this is through the much softer rules of behavioural evolution. It is a big, wide subject that uses a lot of psychology, one small chapter of which is this idea of the collective ego.

Ego is defined as the (irrational) desire to maintain homeostasis. 'Irrational' because evolution does not care about the individual; it seeks to perpetuate evolution (which, in turn, is defined as the adaptation of the organism/organisation to the environment). Just as an organisation develops an ego because the complex inter-relationships inside the organisation seek perpetuity, a market develops an ego, which seeks to perpetuate the complex inter-relationships within and with itself.

Tracking this collective ego is a far more accurate way to track markets than to follow the rules of technical analysis. Egos develop, they are fed, they bloat and then they crack. Very similar to the boom-bust cycles in markets, think of both bullishness/bearishness as egotism of a very visible, measurable sort. Like individual egos, Mr Market has his ego. And like any ego, it starts by reminding him of the boundary between him and his environment but then builds up and creates the vested interest in homeostasis. Eventually, as with individuals, it takes over the very objective of his existence till it cracks and kills him.

The point is that these forces are much more linear and predictable than we can imagine. If you build a pictorial imagination that is able to track the build-up of collective ego, it will give you a much clearer understanding of market momentum than technical analysis.

One of the biggest examples of irrelevant correlations is the famous 'Dow Jones tracking the size of women's hemlines over 100 years'. This has been explained by Robert Prechter, the Dow theory guru, who believes that it is possible to track the 'social mood' through the collective unconscious, which is mostly reflected in the (collective) ego.

We know that the collective ego is more powerful than the individual ego and mostly even subjugates it. In the same market, why is the loss-making (and no-hope) Balrampur Chini at 1.2 times book value, while the seriously profitable and now-confident Tata Steel is also at 1.2 times book value. The former has an overhang of last year's once-in-a-blue-moon profitability, while the latter has the overhang of the 'China bust'. These are measurable egos. It's possible to quantify the excess of the valuation premium that Balrampur has over what it should be (by looking at its valuation when it was reporting similar-quality numbers earlier in its history), just as it is possible to project the valuation premium that Tata Steel will command as it spends more time mid-cycle.

So if markets were 'efficient', would such a thing exist? That's about as logical as expecting human beings to be 'rational' rather than 'egotistical', and that's my point. Markets are egotistical and seek homeostasis. Just like almost all commercial activity is focused on marketing to the individual ego and appeal to the limbic brain, all traders and market participants should be seeking to sell into the market's ego, rather than joining it. How much should you be paying for a loss-making sugar company that has no idea when the sugar demand-supply balance will tilt? Compare this with how much you should be paying for a profit-making steel company that is clearly the last man standing in a bankrupt sector that is still not officially out of the woods. And if there is a difference between the two, why is Mr Market offering you a free lunch?

So far, we've talked about what ego is, not what it does. In pursuit of self-perpetuation, the market pays a cost, which can be your profit. Why is the entire aviation valued at 30 per cent less, the consolidator and the consolidated? Indigo, with a billion dollars in cash, is down 30 per cent, while Air India and Jet Airways, both have a billion dollars in current losses. If the market is a forecasting machine, what is it forecasting? But if it is a reacting machine, then one can explain this current situation. In such cases, it's easy to do the maths. Between the reaction and the forecast, you don't even need numbers if you know the direction very clearly. What it should be doing versus what it is actually doing is a result of the self-perpetuation motive of the (sector) momentum. And it is possible that this will continue to bloat till it cracks. Betting on these cracks is a lot more profitable than betting on some pseudo-scientific support-resistance levels that have no basis other than to say 'if enough people think it will happen, it will (happen)'.

The author teaches, trades and writes at spandiya.blogspot.com.

Disclaimer: The views and opinions expressed here are solely those of the author and do not necessarily reflect the views held by Glade Guides and its employees.

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