V. 22:8 (34-39): Predicting Turning Points With Cobweb Theory by Chris Satchwell, Ph.D.

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.