Predicting Turning Points With Cobweb Theory by Chris Satchwell, Ph.D.
Economics plays a role in the markets. Here’s how the
underlying premise of point & figure theory is consistent with
the tenets of cobweb theory.
The methods used in technical analysis fall
into two broad types. The first, which includes
most technical indicators, treats price
as a noise-corrupted signal, and seeks to find
a true signal that can be used to infer price’s
direction. The second type encompasses ideas on support, resistance, and trading patterns. These
concepts describe the existence of barriers to price movements
where turning points occur, and try to infer price
movement from one or more of those turning points.
I am interested in both; I am neutral as to which of them
might work best. For example, an article I wrote on regularization,
published in the July 2003 STOCKS & COMMODITIES,
was on the methods of the first type. S&C Contributing Editor
John Ehlers subsequently showed how a regularization parameter
could be chosen to make this accessible method
perform as effectively as a two-pole Butterworth filter.
This article is about the second approach to technical
analysis, and how it ties in with a well-known hypothesis of
economics known as cobweb theory. Economists like their
supply and demand curves; they have trouble accepting
technical analysis because so many of its signals are based on
price alone. However, cobweb theory, which is familiar to
economists, provides a basis for predicting the next turning
point in a sequence without knowledge of the supply and
demand curves, or the quantities of whatever is being bought and sold. I will demonstrate that the underlying premise of
point & figure theory is consistent with the tenets of cobweb
theory, and thus attempt to make this second approach to
technical analysis more acceptable to at least some of its critics.