Technical analysis has taken a back seat to other methods of investment
analysis in recent years. The skepticism about technical systems is
strongest in the academic investment community, where the prevailing
religion is efficient markets and random walks. Since the assertion of
the technical analyst that past prices can be used to forecast future
prices is in complete opposition to the efficient market view - that
prices move in a random and therefore unforecastable manner - it is no
wonder that serious study of technical systems is regarded as sacrilege.
The academic approach to technical analysis can be encapsulated by the
words of a finance professor at a prominent midwestern school of
business who was walking across campus one afternoon with a student.
As they came around the corner of a building, they saw a ten-dollar bill lying on the sidewalk. The graduate student was about to bend over to pick it up, but the professor shook his head and kept on walking. "Don't bother," he said. "If it were really there, someone would already have picked it up."
The logic may be compelling, but it cannot take the place of reality.
The efficient market school does not concede that there is any trading
method that makes abnormal profits. If such a method did exist, they
contend, more and more investors would start to use it, and any profit
opportunities would evaporate as these investors all bid against one
another. And any system based on an obvious and readily available information source as past prices simply cannot work, since past prices
are so widely followed. The most universally accepted form of the efficient market hypothesis is that past prices give no information about the future price. The hypothesis immediately implies that technical systems based on past prices are of no value.
Unfortunately (or fortunately for those who are using technical analysis successfully), there are many investors who have not been swayed by the arguments for efficient markets and who still persist in following the "irrational" if not "heathen," ritual of looking at the entrails of past prices to try to divine the future. And perhaps it is just luck, but there are those who are quite content to make profits by doing so. In this article, I wish to explain why, to paraphrase Agrippa, I have been persuaded to be a technician.
The academic view of technical analysis can most tellingly be laid out
in the following dialogue. Harold Williamson, a budding technician, entered the Wall Street office of the Warden Fund for his four-thirty appointment with William Crandon. After a few brief pleasantries, Williamson got down to business."For the past ten years, I have been studying the market, trying out different trading strategies. Five years ago, I narrowed myself down to three strategies. I am now convinced they work and want to use my track record to attract more capital."
Crandon was sitting straight up in his chair, with his hands folded like a choirboy's. "I don't want to pry into what you might consider
proprietary, but could you give me some idea of the nature of your
strategies? For example, are they arbitrage strategies to take advantage of relative mispricing, or do they involve some unusual information resource?"
"Oh, no. None of that. All they need are past prices. All I do is put the past prices into my computer, and then out come the buy and sell rules."
Crandon took off his glasses and put them on the table, then slumped
back slightly in his chair. "We are, of course, always interested in
updating our investment methods to include more sophisticated methods, to some extent, proven methods, that is. But I am afraid we are not really interested in using technical systems. We simply have evolved to a level of understanding of the markets that would preclude our investing based on anything as simple as past prices."
"But it does work. And I have the track record now to prove it."
Crandon replied, "I'm sure you think it works. In fact, I'm sure it has
worked over the past years. But some rule is always going to end up
working after the fact. Look, if I took a thousand investors, and had
each come into my office and throw a dart at a stock, and then tracked
that stock over the next year, I would find that half of them would have done better than average, just by chance. And if I had those five
hundred or so winners come back again next year, half of that group
would do better than average, again, just by chance. I could do it again and again, and finally I would have around twenty-five who would have beat the market five years in a row. But do you think I would put them in an office with a golden dart and follow their stock picks the nextyear? Of course not. For all I know, you are just one of those who has, by luck, hit them right. There is no reason to think the pattern you have discovered will continue... any more than there is to think the darts of the five-time winner will continue to hit the right stocks."
"Well, that may be, but it seems you have nothing to lose by trying. How can you be sure there isn't something to it without trying it?"
"I suppose I can't, in the particular. But I know enough about these
markets to know in general that no simple system of past prices can
really do the job. If it were that simple, everyone would have caught
onto it by now, and its very popularity would eliminate the profits for
all those trading by it."
Crandon shook his head and gave a leathery smile. Really. I could never
buy something that involves torque ratios, triple-peaked prime
resistance levels, and that sort of thing."
Williamson started to speak, but Crandon raised his arm and continued.
"My argument is simply this: just by luck, out of every thousand
investors, there will be a few dozen who end up with a favorable track
record. There will also be a few dozen who go completely broke. Of
course, I never see them. But you can bet the ones who have done much
better than average will end up at my door. And if I put ten dollars on
each system I've seen work in the past, I'd go broke too."
"I'm sorry, Mr. Williamson, that I can't be more positive about your
system's potential. But I suppose it all boils down to this: past prices are free for everyone to look at. If your system really worked, everyone would be using it already."
Williamson gave a forced smile and a shrug and walked to the door. As he closed the door behind him, he looked back and said, "Not if everyone in the market is like you".
The Case for Technical Analysis
by Richard Boostaber
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