As a business school student, I took a portfolio management class taught by a professor who didn’t think highly of technical analysis. I don’t recall his exact words, but I think “voodoo” was one of them and how it was all just about “people drawing lines on charts.” He believed in the efficient market hypothesis, which is that market prices always reflect all available information, and the expectation was that we would, too.
I was a bit indignant. I didn’t think it was smart to be dismissive of a technique that seemed to be working for lots of people. After all, isn’t the whole point of learning about finance to find ways to make money?
Acceptance of the efficient market hypothesis has waxed and waned over the years. At its inception in the 1950s, it was viewed as a radical idea. A few decades later, it was established orthodoxy. Now, we are back to voodoo and drawing lines on charts. Spend any time on financial Twitter, and you will see that 80 percent of it is people plotting trend lines and moving averages and passing around charts. There is not a lot of discussion about fundamentals.
Technical analysis has come back in vogue because we know a few things that we didn’t know in the 1990s. We didn’t have the computational power to figure out that, yes, there are some chart formations that, when traded properly, produce excess returns. You could say that this decade has been the golden age of technical analysis.
Most technical analysis consists of some form of trend following, which is the idea that there is serial correlation in markets. In a trend following regime, you don’t buy low and sell high, you buy high and sell higher. There are lots of people doing this. I have heard at least one person explain his strategy as follows: “I buy stocks that go up.” If that is your strategy, then you are a simpleton, and it is probably just a matter of time until that strategy fails to achieve the desired results.
Trading is supposed to be hard, and this decade has been awfully hard on a lot of “smart” people who generally consider themselves to be value investors, buying cheap, undervalued stocks. Personally, I have never had a great deal of success buying stocks that are in the upper right-hand corner of the chart. My entire investing career has been based on buying stuff that nobody else likes. It hasn't been easy the last few years.
The technical analysis gurus, who are all too happy to share their charts on the web, are mostly unaccountable. It is rare to see failure acknowledged when chart patterns fail to achieve the desired results. They typically move on to the next trade. When failure is acknowledged, it is usually because the chart pattern is voided in some imagined way, not that it was a failure of technical analysis itself. Technical analysis is like a religion to these people. Even when it’s wrong, it’s right.
The other thing about technical analysis is that it is a bit of a self-fulfilling prophecy. For these patterns to work, people must believe that they work. But if too many people believe that they work, the inefficiency will be arbitraged away — which is about where we are now.
Technical analysis is not a science, because its techniques are not testable and falsifiable. Technical analysis is an art. I’m fine with it being an art—much of finance and economics is also an art. But the difference between art and science is that you don’t completely trust your financial well-being to an art. You view it a little more skeptically.
I have seen some good technical analysts over the years. The best technical analysis doesn’t try to be predictive — it tries to be descriptive. Technical analysis looks at the past, not the future. It should give us better information on the past, which may or may not foretell the future. If it were really as easy as “Buy stocks that go up,” everyone would be doing it. Tragicomically, everyone is doing it.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of 'Street Freak' and 'All the Evil of This World.' He may have a stake in the areas he writes about.
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