The Fallacy Of Analogs

One of the key tenets of technical analysis is that we can use previous patterns to forecast what might happen in the future. It is not the same easy modeling of fractals (please tell me you get the sarcasm). We cannot build the big picture from a lot of little pictures as we can with snowflakes, coast lines and galaxies. And if you think that patterns are self fulfilling prophesies, please stop reading now and navigate to Ihaveaclosedmind.com.

Patterns do not predict the future. They give us a better probability of a future outcome because people act in similar ways when faced with similar situations. You get to define what is similar.

Note the liberal use of the term "similar." Also note the term "probability." If these things worked perfectly as expected then there would be no market. Who would take the other side of an upside pattern breakout if the probability were 100% that the market would rally? That little level of uncertainty allows bulls and bears to place their bets, manage positions and even operate in different time frames.

Now that I've established that patterns work, at least with a decent enough probability to make correct calls, let's look at two patterns together. These are called analogs and they are used to find similar behavior in the past so we can forecast what will happen in the future. Or, patterns in one market vs. another, including a commodity and stocks that gather that commodity.

Who has not found patterns in the Dow that look a lot like the one in place in 1929 just ahead of the crash? Who has not compared the tech bubble to the housing bubble? You get my drift.

Sometimes these analogs are useful (asterisk). But sometimes they look great until you realize you've stumbled upon coincidence?

Check out this overlay of bitcoin and the Nasdaq-100 for a recent six-month period. Both markets were soaring. Super performing FANG stocks (the acronym for the go-go technology names) drove the Nasdaq-100 to dizzying heights. And bitcoin, the new crypto-currency was making different but equally as powerful waves as the next great thing. It kind of made sense that these two world changing markets looked the same.

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Disclosure: No positions in anything covered.

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