Charting the stock markets: does technical analysis work?

Maybe it’s best to ignore the analysts and instead stick to a buy-and-hold approach

What’s going to happen? Technical analysts try to predict future price trends by studying past price action and charts

What’s going to happen? Technical analysts try to predict future price trends by studying past price action and charts

 

Some investors aren’t interested in spending hours studying a company’s fundamentals. They look for answers by studying price action and charts. Is there something to technical analysis, or is this age-old practice little more than financial astrology?

Technical analysts try to predict future price trends by studying past price action and charts. Different practitioners use different methods, although a trend-trading approach is common.

Investors who rely on fundamental analysis might sell a stock because it appears too expensive, whereas technicians will tend to hold on to the position as long as it continues to rise. Some traders use strict technical trading rules, others take a discretionary approach. Moving averages, technical indicators that measure if a stock is overbought or oversold, trading volumes, chart patterns, measures of market sentiment – these and other tools are used by the technical community.

Resistance

Technicians often say price has memory, and keep a close eye on so-called support and resistance levels. For example, the Euro Stoxx 600 index is currently just below the 400 level, which marked major market tops in 2000, 2007 and 2015. The 400 level would be seen as resistance, a point likely to be met by increased selling.

If the index decisively breaks above 400, technicians would see that as bullish. While they might not want to buy the index at 390, they would be perfectly happy to buy at 410. Similarly, many technicians turned bullish in 2013, when the Dow Jones index hit ll-time highs for the first time in 13 years, clearing the 14,000 level that marked major tops in 2000 and 2007.

Academics largely see technical analysis as pseudoscientific nonsense. Stock prices are random, says efficient market theorist Burton Malkiel, author of the classic A Random Walk on Wall Street. Investors who rely on technical analysis “will accomplish nothing but increasing substantially the brokerage charges they pay”, he writes.

Legendary investors such as Warren Buffett and Peter Lynch agree. Buffett has said he “realised that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer”. To Lynch, charts “are great for predicting the past”.

Popular

The practice remains popular among investors, however. Research indicates up to 40 per cent of foreign exchange traders see technical analysis as important for predicting price action over short time horizons. About one-third of equity fund managers utilise technical analysis, according to a major 2012 survey.

Though technical analysis is usually associated with shorter time frames, some long-term investors who eschew speculative activity use technical analysis to supplement their fundamental investment theses. Rory Gillen, co-founder of Dublin-based Merrion Capital and now running GillenMarkets.com, has argued that technical analysis helps assess market psychology and that some medium-term technical indicators are “useful tools in the investment bag”.

Though a “fundamentally-oriented person”, Josh Brown of Ritholtz Wealth Management “can’t imagine doing without charts in some way, shape or form”. Similarly, legendary investor Anthony Bolton, often dubbed Britain’s answer to Warren Buffett, says combining fundamental analysis with chart analysis is better than using fundamental analysis on its own.

“If I were on a desert island and allowed just one investment tool,” Bolton once said, “it would be the chart.”

The continued prominence of technical analysis in financial circles was highlighted earlier this year by a squabble between Bill Gross and Jeffrey Gundlach, the world’s two most prominent bond managers. The multidecade bond bull market would be over, Gross declared, if 10-year US government bonds exceeded 2.6 per cent “because it’s so strong and so important in terms of technical analysis”. Not so, said Gundlach: “The last line in the sand is 3 per cent on the 10-year. That will define the end of the bond bull market from a classic-chart perspective, not 2.6.”

While technical analysis remains widely used, that doesn’t mean it’s not bunkum. Indeed, many technical traders would be the first to accept that the field is full of charlatans. As bond expert and author Martin Fridson has written: “The only thing we know for certain about technical analysis is that it’s possible to make a living publishing a newsletter on the subject.”

Such newsletters are full of references to obscure Japanese candlestick chart patterns, Elliott Wave theory, Fibonacci numbers, and all kinds of other vague and unverified assertions.

The same can be said of fundamental analysis, however. Billionaire investor Mark Cuban once scoffed that “fundamentals is a word invented by sellers to find buyers... metrics created to help stockbrokers sell stocks, and to give buyers reassurance when buying stocks”.

That may be cynical, but it’s a documented fact that most fundamental managers underperform the markets. Most investors would be better adopting a buy-and-hold approach rather than painstakingly studying stockbroker notes in a futile attempt to gain an edge.

Studies

What do the studies say? Academics are generally very sceptical of technical analysis. One study that analysed the performance of technical trading rules did find some moving average strategies outperformed between 1934 and 1986 but they have since stopped working. David Aronson, author of Evidence-Based Technical Analysis, tested the performance of 6,402 technical rules; none outperformed the S&P 500.

However, some studies have yielded more positive results, including research conducted by Andrew Lo, a highly-regarded quantitative expert at MIT. Additionally, a mountain of academic research confirms momentum strategies outperform, confirming what technical traders have always preached – that “prices are never too high to begin buying or too low to begin selling”, as 1920s Wall Street legend Jesse Livermore once put it.

Others argue that technicians often combine technical rules, and that this is not accounted for in studies. Similarly, the best strategies are likely to be tightly-held secrets. Accordingly, they suggest the best approach is to analyse the performance of investors who use technical analysis.

Here, the evidence is mixed. One study that examined the portfolios of more than 10,000 fund managers over a 20-year period found that funds that made use of technical analysis “appear to have provided a meaningful advantage to their investors” compared to those who relied solely on fundamentals.

Among ordinary investors, however, the picture is very different. One study that examined the trading records of Dutch investors over a six-year period found those who used technical analysis were much more likely to overtrade and to speculate, the net result being they underperformed investors who didn’t use technical analysis by 8.4 percentage points annually.

Combined approach

For most people, the best approach is to ignore the analysts – both technical and fundamental – and instead stick to a buy-and-hold approach. Investors seeking to outperform, on the other hand, can always combine the two approaches, à la Anthony Bolton, while being mindful to steer clear of technical approaches that encourage excessive trading.

How can they be married? Bolton, now retired, would take a bigger position if the technicals confirmed his fundamental views; if the technicals deteriorated, he reviewed his investment thesis to see if he was missing something.

If he discovered a new interesting company, the first thing he wanted to know was if others had already recognised what he was just discovering, and the price chart would “normally tell me this at a glance”. Andrew Lo agrees; ultimately, fundamental and technical investors “should be able to learn from each other”.

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