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Predictive power

Created:
2 December 2005

Gann Theory is probably one of the stock market's best-kept secrets. It is said that many professional traders use Gann's methods - arcane though they may seem - to inform their buying and selling decisions. Often they do so quietly. That's because Gann's methods, which involve natural law, numbers and even astrological cycles, are considered too controversial, or even wacky, by sober investment banking chiefs - whatever the results they generate.

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So traders, even though they may use Gann secretly to make their trading decisions, often dress up the reasons for their trades in a more fundamentalist hue, and so more acceptable to their bosses.

Admittedly, Gann's theories are so nuanced that no one exponent of them uses his writings or his techniques in precisely the same way. In fact, even Gann's most accessible book, 45 Years on Wall Street, is pretty hard going. As a result, although many traders and analysts study his works, there are many different constructs placed on them. Fred Stafford of Gann Management, arguably the UK's foremost exponent of Gann Theory, has written a short introduction to Gann Theory, available from www.gann.co.uk.

But much of what Gann can offer investors can be reduced to some simple tests and rules involving a combination of levels in the market (or in individual stocks) at which buy and sell decisions are most likely to be profitable, provided that strict trading disciplines are followed.

There are, for example, the major Gann levels. These are given the designations G1, G2, G3 and G4. For example, a 50 per cent retracement from a previous all-time high might be a point at which a renewed upward movement begins. If that doesnt hold, the next key level might be a drop of 75 per cent, then 87.5 per cent. A third key level is the midway point of the all-time high and low. Gann buffs call these levels, respectively, the G1, G3 and G2 levels. A quarter of the all-time high/low range added to the all time low is the G4 level.

The point is that these are not predictions. You watch to see how the market behaves when it reaches one of these levels. On a fall, the idea is to watch and see if the index breaks down through the level, then rallies back to it before resuming its fall. At that point, further recovery is unlikely and the market is likely to fall sharply until the next decision point is reached. Then the same process is followed.

Percentages represent another important plank in Gann theory. These can be used to measure distances from all-time highs and lows, but also from subsequent or lesser highs and lows. The percentages take their cue from numbers and major fractions, 1/2, 1/3, 1/4, 1/8, 1/12, 1/16 and 11/2, 11/3, 11/2, 12/3 and so on. Halves, quarters, thirds, doubles and trebles are considered the most important parameters for movements in major stocks and indices.

Gann angles are a separate subject. These are also based on natural number sequences, 1 price unit by 1 time unit, 2 price units by 1 time unit, 1 price unit by 2 time units, 1 price unit by 3 time units, and so on. These angles, when superimposed on a chart, add an extra dimension to the analysis of key price levels, by introducing a time element into the equation. What Gann buffs are seeking is the coincidence of key levels and angles, as defining not just the level at which a reversal might occur, but also when it might happen.

One of Gann's pet theories was that, in general, markets moved at particular speeds, but could shift gear. Once the angle representing a particular rate of change was breached, a share or commodity might fall or rise to the next most appropriate angle, in effect changing gear.

Finally, some Gann theorists look to a 10-year cyclical pattern that Gann observes, with strong bull markets typically occurring in particular years each decade.

How does all this tie in with the market's past performance? The table, opposite, shows the main Gann levels for several world indices, based on all-time highs and lows, and also based on the assumption that the 2003 lows and the most recent highs represent a complete trough-to-peak movement. Reading behind the numbers, we can see that the predictive power of the Gann levels might be considered approximate, rather than exact.

For example, the FTSE's downward move from the bull market peak was slightly more than the 50 per cent that observation of the Gann levels might have indicated, although the bulk of trading around the market bottom was very close to the G1 Gann level of 3465 as indicated by the mid-point of the all-time high and low.

The fall in the S&P 500 over the same period was to within 20 points of the G1 and G2 levels. The Nikkei, which burst through all four Gann levels on its way down from the late 1980s peak of 38915 did not come to rest at any of the indicated levels, but did fall by a round number percentage (80 per cent) from its high. The Dow likewise does not appear to have conformed to Gann.

Gains from trough to peak in the bull market from 2003 to 2005 were 67 per cent for the FTSE 100 and close to 75 per cent for the Nikkei, both of which might be construed as significant numbers but, in this most recent phase, US indices do not on first sight seem to have conformed to the theory. All of which suggests that interpreting Gann levels and trading on them is rather more complex than you might think, although Gann Management's Fred Stafford says not: "I've spent 30 years trying to make it simple," he says.

So what about the outlook for the future?

Using the 2003-05 lows and highs as the parameters for calculating the level, does point up a few areas to watch for in the indices in future. These are shown on the right hand side of the table. Levels of 1015 and 900, in addition to the 765 level, look critical for the S&P (currently 1220). For the FTSE, the key levels are 4394 and 3840, in addition to the 3959 level based on observation of the all-time high and low. The index is at 5460 at the time of writing. For the Nikkei, now trading at 13895 - a 2005 high - 10879 is the nearest critical juncture, and below that the 9,372 area.

Key levels for the Dow Jones, currently 10568, are 9221 and 8362. The longer-standing Gann levels based on all-time highs and lows are much lower than current levels, around the 5900 level, which suggests - on the basis of Gann Theory, at least - a much greater degree of potential vulnerability.

Having said that, Gann experts tend to take a rather more optimistic view at the moment than this survey of support levels and the 'air pockets' above them might suggest.

Gann Management's Fred Stafford suggests that the FTSE 100, having retraced to the mid-point between this year's high and low is now set for a gain of 8.33 per cent - a significant number in Gann Theory - from its recent low of 5150 up to around 5580. "The Footsie is currently bouncing between a rising Gann angle and the 2005 high. Time will tell if it breaks through," says Mr Stafford.

David Hunt of Ganntrading (www.ganntrading.com), which markets the Ganntrader software package devised by Peter Pich, takes a longer-term view. "The FTSE 100 and the S&P are approaching significant levels related to the 2000-03 bear market. Continued strength in FTSE 100 past the recent highs should yield an attack towards the highs of the previous bull market recorded in December 1999. The balance of probabilities strongly favour a higher equities market as far out as August 2007. The year five in Gann's decennial cycle is usually the strongest for the US market and a break above 1255 for the S&P could see an explosive move to much higher levels very quickly. Years six and seven of the decade are usually bull years," he says.

Mr Hunt believes, however, that any failure to thrive this year on the part of the US market would be seen as a very negative long-term sign for US stocks - it would be the first 'down' year in the middle of a decade since 1900-10. If so, it could, he believes, be tied in with the beginnings of a waning in US economic power and the eventual replacement of the dollar as the world's reserve currency.

So Gann's ideas continue to cast a long shadow over the markets. But experts differ in the emphasis they place on different aspects of his writings. Most agree a crunch point is coming, possibly between now and the end of 2005. You have been warned.

Gann the man

William D Gann was a Texan who started trading in 1902 and moved to New York City in 1908 to set up his own brokerage firm. And his overall stock market profits over his trading career are estimated to have been in the region of $50m. Eventually, Gann retired from trading, but continued his researches and writing about the stock market from his retirement home in Miami until his death in 1955.

He published several books and articles on trading, and on his own methods, but many are abstruse and hard to interpret. What they do show, though, is that Gann was flexible. He said: "A wise man changes his mind: a fool never." He was an exponent of using stop-loss orders to take the emotion out of selling decisions, advising: "Action, not delay, makes money on Wall Street. There is no use hoping, as that will not beat the game. Men who gamble on hope always go broke."

But Gann's techniques were only partly behavioural. They seem mainly to stem from the belief that there are certain immutable laws in the universe that govern everything, including the way securities and commodity prices move. According to Gann, in part, these movements are based on the numerical relationship between past highs and lows in the market, and on key numbers - halves, quarters, eighths and thirds, sixths, twelfths and so on - and, in part, dependent on timing on cyclical patterns, sometimes linked to key numbers and even to astrological phenomena.

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