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Investing Articles

The Facts About Market Forecasting

It is no surprise that most who enter the trading arena find it hard to believe that anyone can forecast market tops and bottoms in advance. Yet, it is possible...to a degree.

Nobody can forecast with 100% certainty that a market top or bottom will happen on this or that day at exactly this or that price. Such certainty belongs to God alone. However, it is possible to forecast market tops and bottoms with a very high degree of accuracy and with a very small margin for error.

Ironically, even with all the skepticism that many have as to market forecasting, most still continue to look for some indicator or series of indicators that will do just that...tell the trader when it is best to enter a trade. And they search for this for one very good reason; because the closer one can enter a trade from a new top or bottom, the less risk exposure there will be and higher the profit potential.

Most traders can perform a simple market forecasting function with just the use of trendlines, for example. And no one would dispute that this is possible because it occurs so many times. For instance, take a look at the price chart below.

This is a simple illustration on market forecasting. When price rose and then dropped back down again, then started up again, it provided two swing bottom lows in which to construct a simple trendline. When it dropped down again where this line appears to be 'supporting' prices, one could easily determine with a high degree of certainty that a swing bottom would form from this price bar low (see arrow). In a limited sense, this is market forecasting.

It stands to reason, therefore, that if this limited form of forecasting is possible by such a simple method, that more sophisticated methods would provide even more sophisticated market forecasts.

One of the earliest discoveries about market price action is how often a market will retrace from a previous range by some mathematical ratio, such as 50% or 62%. Some have created complete trading methods simply off the 50% ratio alone.

Now while many would suggest that market forecasting tops and bottoms with any real accuracy is impossible, they will rely on these mathematical ratios or some indicator (also mathematical) that relies on historical price data.

In other words, every trader that uses a price chart and plots lines, indicators or anything else on what is clearly historical price data is in fact suggesting that historical price is key to discovering what is likely to occur in the future. Otherwise, why bother reading a price chart since it only provides information on what 'has already occurred'?

Historical prices do in fact hold the key to market forecasting. By understanding what has occurred will help us to determine what will occur. How well we are about to do this will depend mostly on our personal understanding on market action.

One example of this is that of looking for 'chart patterns'. You may have read books or attended seminars where a market analyst explains such patterns as flags, pennants, wedges, triangles, double or triple tops and bottoms, consolidation and accumulation patterns, head and shoulders, etc. And the reason for this is that these patterns can often help you determine what is likely to occur next, although not with complete certainty.

Again, this all points to the value of understanding 'historical price data' and its relationship with future price action. Why do certain patterns tend to form over and over and over again? The answer may surprise you.

Price action is mostly the result of natural laws as opposed to pure randomness. Because market action is not a random event, it makes price action relatively predictable.

For example, let's consider some of the commodities that are traded. We have the grains such as Soybeans, Corn and Wheat. Or there is Cocoa, Coffee, Sugar and Cotton. What do these have in common?

They are products that are grown. They require the seasons with its rain and shine. We know for a fact that the seasons are a cyclic event. Each year, we go through a winter, spring, summer and then fall, only to start over with winter once again. Thus, you have periods of rain, periods of sun, periods of planting and periods of harvesting. These events pretty much occur around the same time each year.

 


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Because of this, many look to 'seasonals' to help time the markets. What they may not realize is that they are in fact doing a crude form of cycle analysis. While not precise, it does have some advantages over no forecasting at all.

For many years, it had been noted that Live Cattle had the tendency to topped out around January, rally into March or April, then drop into summer. This had something to do with raising and slaughter schedules, for example. Again, we're dealing with a crude examination of natural law.

Whether you look at seasonals, or the repetition of chart patterns, or that of supply and demand, planting and harvesting, you are looking at cycles. The repetition of events that have occurred in the past and will occur into the future.

This repetition of events, when you go back to its source, always comes back to something tied to nature. Seasons are cyclic and a part of nature. Weather is cyclic and a part of nature. Day and night is cyclic. The tides are cyclic. Our getting up each day to work is cyclic. Our going to bed each nght is cyclic. And it is all part of nature. It is NATURAL LAW.

And when you think about 'natural law', you know this also extends to such laws as 'gravity'. What goes up must come down. We know that no market will go down or up forever. We know that a rising market will soon become a falling market and then back to a rising market once again. That is cyclic.

So the bottom line here is that all the events that occur around us, being cyclic in nature, are also directly and indirectly connected to the markets we trade. And by understanding these 'cyclic' events, we can anticipate with a high degree of accuracy when to expect a market top or bottom.

If you have ever used an oscillator indicator on your price chart, then you are aware of how often the oscillator will expose a 'cycle' pattern allowing you to 'anticipate' a top or bottom. Sometimes it just seems like an amazing crystal ball, and then at times it stops for a period.

Years ago I became fascinated with the Stochastic indicator. It would make a cycle pattern that would go up and then roll over and go down. The market would often do the same thing. You can actually anticipate when the top or bottom would occur just using this one simple indicator. If you have ever done this yourself, then you were actually analyzing your charts based on cycles, although in a very simple way.

What is important to understand is that the indicator had to rely on 'historical' price data in order to produce the pattern you used to time your tops and bottoms and time your trades. Historical prices do in fact hold all the information needed in order to forecast future price action.

So why then does the oscillator indicator work sometime and then other times it appears to stop working, only to start working again at a later time?

The answer is quite simple. If we were only talking about one cycle, say a 10 day cycle, then it would be a no-brainer. You could expect a market top or bottom every 5 days (5 days up and 5 days down would be one 10 day cycle). Be glad this is not the case because everyone would know when the top or bottom would occur and there would no longer be a market to trade.

In reality, there are MANY cycles of different time periods at work at the same time. And each market is affected by different cycles from one another. For example, grains have planting and harvesting cycles based on season and other factors that would not match exactly the seasonal factors of raising and harvesting cattle. Yet there would be an indirect relationship between the grains and cattle, seasonally, due to cattle's need to feed.

Because there are several cycles at play in any given market, these individual cycles will either work with or against each other at various points along their axis due to their different time periods. In other words, at one point in time several cycles may be moving up while some are moving down. These additive and opposing forces will result in a value that does not match any of the individual component cycles, resulting in a 'distorted' cycle pattern that we all know as the zig and zags of price chart swings.

There are several books on the subject of 'detrending' cycles from price data. Most would find this to be an extremely technical subject and requiring a strong understanding of mathematics. While detrending provides excellent advantages in forecasting, there are some random elements that keep even this approach honest from cornering any market.

If you have yet to discern where cycles originate from after reading all that I have written so far, consider this:

Where does night and day come from?

How do we get the seasons?

What affects the weather?

What affects the tides of our oceans?

Since night and day, seasons and the weather directly and indirectly affect our plantings and harvest, our supplies, when and what we feed our livestock as well as when they go to market, then these questions are important and relevant. As you can now understand, cycles originate from planetary action.

The rotation of the Earth.

The position of the Earth in relation to the Sun or Moon.

And it stands to reason that other planets may have some influence on Earth's polar forces, weather, seasons, etc.

Because of this, some have looked to Astrology to forecast the markets. It is my opinion that this is unnecessary. In fact, many who go this route start to use it to forecast human affairs, getting into the 'mystical'.

Market forecasting is NOT mystical. Instead, it is scientific and mathematical. Understanding where cycles originate helps you to focus your studies in an area of natural law and to understand that, just as one can mathematically forecast when next summer will arrive, or when night will fall, one can forecast market tops and bottoms by discovering the mathematical and cyclic keys of market behavior.

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