How To Use Time
Using timing models to enhance your investment or corporate strategy decisions may take some getting used to. Many people assume that forecasts concerning time may possibly be accurate in the short-term, but they remain skeptical about long-term timing forecasts. Many argue that major political events, such as the upheavals in Russia, cannot possibly be forecast. To the contrary, such events would NOT take place unless the economic conditions had been in a steep decline. Computers cannot predict what type of revolution will unfold as a result of a collapsing economy, but they can predict when some sort of political change will take place due to economic pressures. Since the dawn of civilization, no revolution has ever taken place unless man has been economically deprived first!
Contrary to popular belief, quantitative long-term timing forecasts actually tend to display a greater degree of accuracy than short-term. The reason for this phenomenon is found in the laws of physics. Consider for a moment the example of a river. Long-term analysis will determine that the rushing water moving down the river will continue in motion until it reaches the lowest possible point available to it along its path. However, the river is not made up of a single huge drop of water but billions of individual droplets. A long-term forecast would attempt to predict the ultimate outcome of the collective action of the droplets, while the short-term forecast would attempt to plot the course of every individual droplet during its journey.
Timing forecasts in market action face exactly the same dilemma. We know the final outcome of the long-term as conclusively as we know that water will always seek the lowest level. But we cannot always determine when a particular droplet will move up or down as is the case with individual markets in the short-term. Most people look at a river and see only a body of water rather than its component parts of eddies and cross-currents. The same is true about markets and economies.
Because mankind is made up of individuals, there are many different minor trends within the collective whole. It is far easier to predict the collective sum of many small individual trends that compose the long-term than it is to forecast the course of each and every minor individual trend within the whole.
There are intraday traders who buy and sell numerous times within the course of a daily session. These traders usually do not hold positions overnight. Therefore, even if the overall trend is down, many of these people will be found on the long side of the market intraday. Likewise, there are still others who will be long for a few days. Consequently, an overall declining trend that unfolds over a 3-month period will never be straight down. Countless small counter-trends exist within the whole, providing a constant source of oscillation.
Timing models are capable of providing the points in time when a high or low will unfold which we call turning points. They do not predict whether or not we will see a specific event (high or low), just that an event (high or low) will materialize at a given moment in time.
Timing models are best suited to identify when a change in trend will unfold on short-term price activity, but they cannot forecast whether that change in trend will leave behind a specific high or low. However, it becomes obvious that if a market is declining moving into a turning point, then that turning point will most likely cause a price low to form instead of a high. Computer models can pinpoint the “ideal” periods where a high or low will unfold, but one must use some common sense given the current trend in motion.
The reason why turning points can be identified in the short-term, yet not always qualified, lies in the laws of physics. When light bounces off an object, a phase shift of 180 degrees takes place. Scientists can determine such things as whether the universe is still expanding rather than contracting based solely on the color of the reflected light.
This same principle applies in market timing. There are numerous timing frequencies in a single market created by the many minor trends from a variety of different investment strategies. We have found that the short-term frequencies ALWAYS become overpowered by the long-term frequencies. Therefore, an 8-week cycle “ideally” due to produce a low is overpowered by a 20-week cycle due to produce a high at the same time. One could say that the 8-week cycle is inverted (180 degree phase shift) or canceled out by the stronger 20-week cycle. As this process of long-term cycles dominating the short-term takes place, one eventually realizes that long-term cycles are more reliable than short-term because of the laws of physics.
In the option markets, almost everyone uses the famous Black and Scholes Price Models. Virtually every bank in the world relies on this model or a derivative thereof to offer foreign exchange markets to their clients. Very few people know what this model is based on. It is actually the formula used in physics to describe the volatile path during the transfer of heat to cold. It sounds preposterous that the transfer of heat to cold should have anything in common with market activity. Nonetheless, it does!
In thermodynamics, the Second Law concerning Entropy explains market behavior perfectly. Entropy deals with the fact that systems lose their capacity for spontaneous change; that every system, left to itself, changes in such a way as to approach a definite final state of equilibrium. Thus, water will always seek the same level, heat always passes from hot bodies to cold and concentrated solutions diffuse to dilute solutions. This law is also the source of the famous maxim: “Within chaos there is order and within order there is chaos.”
Still, some skeptics argue that market behavior has nothing to do with physics. These misguided souls would have us believe that the entire universe adheres to the laws of physics except man. If this were true, then man would be immortal.
There is nothing in this universe that does not conform to the Second Law of Thermodynamics. This is even the reason why we all eventually must die. At birth, our bodies are formed out of chaos. The molecules that comprise our bodies come together in a state of order. When maximum entropy is reached, our bodies begin to deteriorate, eventually causing the molecular order to give way once again to chaos. Hence, the biblical saying that man was created from dust and to dust he shall return. The molecules within our body are seeking to move from an ordered state back to chaos which in our case results in death.
The Second Law of Thermodynamics is also the reason why not one government investigation has ever found the infamous short-player that caused a stock market crash in 1907, 1929 or 1987. At the top of the stock market in 1987 the majority remained bullish. The laws of physics teach us that panic declines become possible because if the vast majority are long, then at the moment of maximum entropy the smallest amount of pressure will cause the greatest amount of change. The selling takes place initially due to profit-taking.
Massive declines are possible because it takes more courage to hold onto a long position in a declining market than it does to sell. Therefore, the greatest reservoir of sellers are never the short-players, but the long-players afraid of taking a loss. All the rules and regulations in the world cannot prevent another crash in the future unless we outlaw profit-taking itself! Likewise, the greatest bull markets always emerge when the majority become bearish. When sentiment is running close to 50/50, sideways trends prevail and major abrupt moves in either direction become impossible until sentiment shifts to one side or the other.