Technical Analysis Pulled Out Of The Bin

Three years ago in this space I noted that Dow Theory had given an important technical signal on 23 November 2007 indicating that the US equity market had entered “a primary down trend”. Although the equity market looked temporarily oversold, what it appeared to mean, if you believed in such things, I suggested, was that “investors should be preparing for a market whose underlying trend from here is down, not up”.

Well, that didn’t turn out to be a bad call, as the Dow Jones index subsequently fell by 50% to its March 2009 low, and as of last week was still trading 15% below its level at the time the signal was given.  If making market predictions was my only business, as opposed to a sideline, I would by now be trumpeting my amazing track record as a forecaster to anyone who cared to listen. (Please feel free however to mention this to anyone you meet).

As it happens, while the technical signals were one of the things that made me very cautious on the equity markets in late 2007, in truth my bearish stance was driven more by experience and the negative things I was hearing from professional contacts of mine (including central bankers who admitted privately to having no confidence that they could stop the escalating banking crisis).  Honesty also requires admitting that most of my 800 words were not about the coming market crash, but a discussion of whether technical analysis had any value. My conclusion was that it did best when interpreted by experienced market practitioners with good judgement. “Its real value” I suggested “lies in the quality of the interpretation, and that is ultimately subjective, rather than scientific”.

Well, I wouldn’t change a word of that conclusion, but it is fair to say that technical analysis, in the broadest sense, is undergoing a revival from the days when it was routinely dismissed in the academic literature as little more than charlatanism. In his seminal book A Random Walk Down Wall Street, published in 1973, Professor Burton Malkiel dismissed technical analysis with a withering conclusion: “under scientific scrutiny, chart-reading must share a pedestal with alchemy”.

Of course, we now know that the random walk, and the efficient market hypothesis to which it is related, were just beginning to dominate the way that academics thought about financial markets. Neither theory seemed to leave any room for technical analysis, which self-evidently was based on the assumption that there was information in security prices which could be exploited by investors either for profit or the avoidance of loss.

The fact that so many investors have continued ever since to rely on price charts to assist decision-making suggests that the market itself refuses to accept that technical analysis can be so easily refuted. Technical analysis remains the dominant form of analysis in commodity and foreign exchange trading. Dr Sushil Wadhwani, an academic who later moved into investment management, says that overcoming the prejudice against technical analysis was the most important lesson he had to learn when moving from the ivory tower into the laboratory of real life experience as a trader.

As a new book by Professor Andrew Lo and Jasmina Hasanhodzic makes clear, the last twenty years have seen the start of a serious re-evaluation, to the point where it is no longer credible to sweep it away as worthless. Prof Lo, one of the brightest stars in the MIT finance faculty, has done as much as anyone to demolish the credibility of the efficient markets hypothesis, and while far from starry-eyed about what technical analysis can rightly now claim to be, concludes that it is “a legitimate and useful discipline, tarred by spurious associations and deserving of further academic study”.

The authors track the first use of a form of technical analysis for commercial purposes as far back as ancient Babylon. Prof Lo argues that the discipline has suffered unfairly from its early association with astrology, and suggests, only partly tongue in cheek, I think, that using the movement of the planets as an input was in some ways no different to introducing a random number generator into a modern trading algorithm.

A number of recent academic studies have been able to test various trading strategies in computerised tests and found scope for potential profit in them, contrary to what was once thought. Other studies have used complex programming to work out from actual market movements trading strategies that would have worked well; quite often it turns out they correspond closely to seemingly simplistic charting formulae involving moving averages.

The most intriguing finding, though, to my mind, is the evidence the authors present, based on research by Professor Emanuele Viola of Northeastern University, that the human eye is capable of detecting sophisticated and meaningful patterns in price charts which even the most sophisticated computer programmes cannot do. They show that human beings can consistently distinguish between graphs of actual financial market returns and those generated at random.  This opens up the intriguing possibility of harnessing the extraordinary human skills of pattern recognition to computer-generated algorithms that are designed to counter the inconsistency and emotional biases to which human investors are also notoriously prone.

Even though the world of investing world has been totally transformed over the last generation by extraordinary changes – the arrival of computers, the end of fixed commissions, decimalised trading – which seem to make the trading saws of old time market participants meaningless, one has to conclude the exceptional power of the human brain to find meaning in complex patterns lives on.  Investors who go on reading price charts, in any event, no longer need to apologise for their strange pastime.

Andrew W. Lo, Jasmina Hasanhodzic. The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals is published by John Wiley. You can buy a copy through the Independent Investor bookshop by following this link.