Correlation versus Causation and the Self-Fulfilling Prophecy

We have all had the class, lecture, or sermon about correlation versus causation. I still see this mistake happening all the time, as I am sure you do. We see events that happen together so often that we infer patterns. Traders and investors love patterns. We want to see them slightly before the rest so we can position ourselves accordingly, then when the huddled masses catch on they will fuel that pattern. Technical analysis is rife with correlation vs causation issues, particularly the segment that deals with the calendar (i.e. January barometer). To a lesser extent this is true of charting as well. So many calculated numbers and interesting shapes that have no real meaning, but have the support of math or history. However, these technical analysts and chartists are not completely mistaken.

I thought I would have more to say about correlation and causation, but that is pretty much it. Just because there seems to be a pattern because A and B are usually together, A is not the reason for B. It could be that C is the cause of both A and B. You might ask if A and B are always together, and if there is a small time difference between A and B then A can be as good a signal for B as C is. The world is more complicated than that. D might cause A, and E might cause B. If you spot A (the secret cause being D in this instance) and position yourself for B you might be in for a big loss. Especially, if you salivate at the chance of a fruitful pattern like last time, and go in too heavy thinking you see a logical connection.

Technical analysis has made prophets out of so many patterns hoping for profits (I know, I know no one likes puns). A lot of these work because of the self-fulfilling prophecy. Since everyone is aware of these patterns they act in a way that reinforces these patterns. One category is the calendar patterns, such as the January barometer mentioned above and sell in May adage. Another category is all the chart patterns such as head and shoulders, double top, etc.

I am not saying that these patterns are not based in reality. There are reasons for these patterns to exist outside of their mere existence. The seed of these patterns was based on some facts. Double tops can be explained bulls pushing back thinking the recent decline was a false downtrend, and we will continue the uptrend. If they were right the chart would look like it bounced off support and continued the trend. The double top means that the trend will change. You do not know for sure till it happens (a few weeks ago I saw a quadruple top). There are so many chart patterns now that everything is a pattern. To not be fooled we look at other indicators in a mash-up of initial indications and confirmations of what we think.

The last part I will discuss is something I mentioned in a previous article. I mentioned that I have my reservations about calculated numbers being used as actual information. Certain calculations are fine, but for example the moving averages can come out to numbers that were never really hit. Take a look at the GLD chart I posted in an older article. GLD has been gap heavy over the last year. Look at the moving average lines, some of them would be at points that GLD gapped past. I’m sure you all are familiar with using the 200 or 50 SMA as a line of support or resistance depending on where the current price is. Since nobody really had the chance to buy or sell stock at that level I find it a bit ridiculous to use it as real support. As I talked about earlier, I like using the actual local highs and lows with horizontal lines for my support and resistance.

You should still pay attention to these calculated numbers. The reason is that everyone else does. I think my lines are firmer resistance and support, but the moving averages are still valid since everyone looks at them. If they feel the 200 SMA will provide resistance then you need to be aware of that. As an aside, I will say the 200 SMA is a fantastic indicator to place faith in. The timescale is long enough that it is a realistic guide for the trend and its strength, but I do not use it for price targets. Shorter SMAs are a bit less important for those purposes. I still like them as signals for reversals, but the actual number it is sitting at matters less to me. I pay attention to the direction.

Since so many people are aware of these patterns/correlations they make them come true. There are so many traders and investors and computers programmed with these chart patterns and these calculated numbers. The same holds true for the calendar patterns. So why not just blindly go with it? Why do you have to be aware that these exist as if you were in a dream, where it only exists so long as you’re not aware its a dream? If you go with the masses then you might see good gains, but the tragedy of the commons probably means that these gains will be subdued. However, if you get caught on the wrong side of it you could lose a lot. You could also lose a major opportunity. These would be like the black swan events. The upside is limited because everyone is looking for the same stuff, but the downside can wipe you out.

Sell in May is a good example of a situation where common wisdom led you astray. After the beating following the Lehman collapse, the idea that the summer market decline would eat more wealth might have scared many into selling. That would have prevented them from enjoying the massive recovery in the market. “Sell in May” was a disservice that month. Be aware of the summer lull, be aware of the patterns everyone looks at, but don’t be blinded by them.

Do not become to heavily invested in those patterns, especially when you’re looking even a  few months out. In all markets, but more so in the current market there are so many pieces of news that send markets reeling. Markets have been choppy and unpredictable. Be aware that the foundation of your most basic assumptions are sometimes shaky. Do not get too attached to anything. Play both sides, and cover yourself for unexpected situations.