Over the last few months,
we've looked at chart patterns that provide high-probability entry points,
e.g., 21-day lows,
gap openings and
"hammer" candlesticks.
Today, I want to introduce Markov chain analysis, a method that can be used
to assess significance of movement between various chart patterns. In
particular, I will answer questions like: What is the probability that the
S&P will be up this week if it finished higher last week on increasing
volume?
Markov chain analysis can
be used to assess pattern transitions over time. It's a method designed to
study processes that exhibit some dependence on prior events but still have
some degree of randomness. Though the statistical approach is straight
forward, my goal here is not to teach you how to perform the statistical
analysis but to provide tabulated results that might prove useful in
assessing where the market is likely to go next week given its behavior this
week. So what are we talking about?
Consider eight states
that the S&P-500 weekly index might find itself in at any point in time
(defined in Table I below): State 1, for example, has its 10-week moving
average greater than its 40-week moving average (a bullish environment), has
this week's volume greater than last week's and has this week's price
greater than last week's, while State 8 meets none of those criteria. The
accompanying weekly chart shows how these states transitioned among
themselves over a three-month period last year. Using a Markov approach,
one assess the likelihood, for instance, that next week the index will be up
given this week the index was up on increasing volume in a bullish
environment (10-week moving average greater than 40-week moving average).

For this analysis, 858
weeks (Oct '88 to Mar '05) of the S&P were classified by their state as
defined by the three criteria. Then their week-to-week transitions were
counted (enumerated in the Markov Chain Analysis Table II). For example,
there were 60 transitions from State 1 to State 5 and 857 total
transitions. The second table converts these numbers to probabilities (each
number is divided by its row sum). For the statisticians in the group, the
chi-square sum is186.9 for the matrix; much greater than the 66.34 needed at
the 5 percent level of significance with 49 degrees of freedom. Cells shown
in yellow are significantly greater than would be expected for random
transitions. So how can we use this information?

Assume the market is
bullish, i.e., the S&P's 10-week moving average is greater than its
40-week moving average--a "golden cross" has occurred. If this week, the
market was in State 1 (higher volume and greater index than last week),
there is a 0.564 probability (0.20 + 0.364) that the index will be up next
week. On the other hand, if this week the market was in State 5 (lower
volume and lower index than last week), there is a 0.624 probability (0.409
+ 0.215) that the index will be up next week. If the market was in a down
period--say in State 8 (0,0,0) this week--there would be a 0.157 probability
that it remains in State 8 versus a 0.549 probability that the index
increases (the chart shows three consecutive State 8 conditions--a low
probability event). After 4 days this week, the index remains in State 5
(1,0,0), where it was the week before, so statistically there is a better
than even chance that the index will be up next week. Over the coming
weeks, I'll introduce other patterns and their associated sets of
probabilities, all with the intention of finding either profitable patterns
of entry or accurate market forecasting tools.
