Despite all dictates of logic against it, technical analysis actually works some of the time. I’m not talking about the random luck of any scheme working, but the fact that an uncanny amount of the time, “support” and “resistance” theories seem to be borne out in actual stock data. Assuming I’m not just imagining this, the obvious answer as to why is that it’s a self-fulfilling prophesy. If enough people believe in technical analysis, the patterns inherent to its doctrine will occur because the market is just composed of humans and their beliefs. It’s no more odd than the fact that stocks go up when earnings go up, except that belief at least has some basis in fact. The point is, having a basis in fact is irrelevant to the market.
Also obvious, however, is that when a stock pattern really works, it will draw attention to itself and it will stop working as people try to capitalize on it. Thus, while it may be a self-fulling prophesy that technical analysis will work, the same logic suggests that it should also fail, on average, because the market is mostly a zero-sum game. So, what gives?
It occurred to me that we are missing one vital factor: there are a lot of people who think technical analysis is utter hogwash. Ironically, however, if enough people think technical analysis is bogus, it just might work. It then dawned on me what technical analysis may really be and why it might actually work: a legal form of market collusion.
Technical analysis may work out to be a somewhat effective form of conspiracy among a subset of the market participants. The rules of TA are essentially a language, allowing adherents of the art to manipulate the stock market through mass distributed collusion. I think it is entirely possible that the “rules” of technical analysis are successful because they manipulate the market in a way that gives an advantage to adherents of those rules relative to those who don’t.
The net effect is that a group of people in the market cause prices to oscillate by all “colluding” to buy and sell at certain points. Another group of people then end up making trades at what the other half know to be the “wrong times” in a predictable cycle. The common rules of TA form a system of collusion that doesn’t require any back channel conversation between participants, and thus it is completely legal; the market itself is the channel through which the mass collusion occurs. The general disregard among academics for the possibility that TA could work results in a situation where there are always enough market participants who aren’t in on the game so that the game works. In fact, perhaps the best thing that ever happened for TA was the publication of “A Random Walk Down Wall Street.”