Fractals (sometimes called analogues) are historical chart patterns that repeat themselves. When a trader uses a fractal, he’s essential saying that Market XYZ is “copying” Market ABC. Here’s an example of a fractal between the S&P 500 and silver. The trader who created this fractal is predicting that the S&P 500 will “copy” silver’s direction in 2011.
Fractals are not consistently useful for trading and investing. Here’s why.
Fractals between markets
The above chart implies that the stock market today is “copying” silver in 2011. This makes no sense at all. There is no reason why the stock market should copy silver’s price action in 2011. These two markets are completely unrelated.
A lot of fractal traders come up with a market outlook first and then find a historical fractal to “support” their market outlook. Any 2 charts will “look alike” if you squeeze, compress, invert, and stretch it enough.
Get my book!
In other words, fractals between markets work until they don’t. You have no idea when the fractal will break (i.e. when the market today will stop “copying” another market’s historical chart).
Even worse is when some fractal traders overlap different time frame charts. For example, they might say that a weekly stock market chart today looks like a daily USD chart from 5 years ago. This is pure BS because they are manipulating the chart to “support” a predetermined market view. While they’re at it, why not compare a 5 minute chart for the S&P to a weekly chart for the NASDAQ from 10 years ago?
Fractals for the same market
Slightly more useful are fractals for the same market. For example, a fractal trader might say that the S&P 500’s chart today is like that of the Dow Jones’ chart leading up to 1929. Or a fractal trader might say that the USD Index’s chart today looks like that of the USD’s chart from 1995 to 2003.
These fractals somewhat make sense. The same market tends to have the same kind of patterns and price action. For example, both of the U.S. Dollar’s historical bear markets fell in a straight, nonstop line. Hence I can understand why traders expect the next USD bear market to “copy” the pattern of its two previous bear markets.
But there is also a problem with this kind of fractal. This fractal implies that history repeats itself.
History doesn’t repeat itself. It rhymes. No two bull markets are alike because every bull market has different events and bullish/bearish factors that influence it. Ssome bull markets are fiercer and longer. Some bull markets are tamer and shorter. Likewise, no two bear markets are alike because every bear market witnesses different events that influence the market’s price pattern.
In addition, fractals for the same market work until they don’t. For example, Paul Tudor Jones thought that the stock market would enter into a 1930 Great Depression after it crashed on October 19, 1987. This is because the stock market’s chart from 1987 “looked like” the stock market’s chart from 1929.
We all know how that played out. 1987 was nothing like 1929. The stock market rebounded after 1987 while it continued to crash after 1929. The fundamentals and valuations were different. A fractal is useless when the market’s fundamentals are different. For example, 1987 did not ultimately “copy” 1929 because the stock market’s valuations was much lower in 1987 than in 1929. There were a lot more investors willing to “buy the dip”, which is what prevented the 1987 crash from turning into a megacrash.
A fractal is only semi-useful when the market’s fundamentals today are similar to the market’s fundamentals from that comparative historical period.
Here are some other examples of “scary parallels” that failed.