Some Elaborate Technical

Some More Elaborate Technical Systems

Since many of the technical analysis systems tested are very popular, let’s briefly examine a few in detail.

The Filter System

Under the popular “filter” system a stock that has reached a low point and has moved up, say 5 percent (or any other percent you wish to name here and throughout this discussion), is said to be in an uptrend. A stock that has reached a peak and has moved down 5 percent is said to be in a downtrend. You’re supposed to buy any stock that has moved up 5 percent from its low and hold it until the price moves down 5 percent from a subsueqent high, at which time you sell the stock and, perhaps, even sell short. The short position is maintained until the price rises at least 5 percent from a subsequent low.

This scheme is very popular with brokers, and forms of it have been recommended in a variety of investment books. Indeed, the filter method is what lies behind the popular ll “stop-loss” order favored by brokers, where the client is advised to sell his stock if it falls 5 percent below his purchase price to “limit his potential losses.” The argument is that presumably a stock that falls by 5 percent will be going into a downtrend anyway.

Exhaustive testing of various filter rules based on past price changes has been undertaken. The percentage drop of rise that filters out buy and sell candidates has been allowed to vary from 1 percent to 50 percent. The tests covered different time periods from 1897 to the present, and involved individual stocks as well as assorted stock averages. Again, the results are remarkably consistent. When the higher brokerage commissions incurred under the filter rules are taken into consideration, these techniques cannot consistently beat a policy of simply buying the individual stock (or the stock average in question) and holding it over the period during which the test is performed. The individual investor would do well to avoid employing any filter rule and, I might add, any broker who recommends it.

Elaborate System. Photo by Elena

The Dow Theory

The Dow theory is a great tug-of-war between resistance and support. When the market tops out and moves down, that previous peak defines a resistance area, since people who missed selling at the top will be anxious to do so if given another opportunity. If the market then rises again and nears the previous peak, it is said to be “testing” the resistance area. If, on the other hand, the market “fails to penetrate the resistance area”, and instead falls through the preceding low where there was previous support, a bear-market signal is given and the investor is advised to sell.

The basic Dow principle implies a strategy of buying when the market goes higher than the last peak and selling when it sinks through the preceding valley. There are various wrinkles to the theory, such as penetration of a double or triple top being especially bullish, but the basic idea is followed by many chartists and is part of the gospel of charting.

Unhappily, the signals generated by the Dow mechanism have no significance for predicting future price movements. The market’s performance after sell signals is no different from its performance after buy signals. Relative to simply buying and holding the representative list of stocks in the market averages, the Dow follower actually comes out a little behind, since the strategy entails a number of extra brokerage costs as the investor buys and sells when the strategy decrees.

The Relative-Strength System

Here an investor buys and holds those stocks that are acting well, that is, outperforming the general market indices in the recent past. Conversely, the stocks tat are acting poorly relative to the market should be avoided or, perhaps, even sold short. While there do seem to be some time periods when a relative-strength strategy would have outperformed a buy-and-hold strategy, there is no evidence that it can do so consistently. A computer test of relative-strength rules over a twenty-five-year period suggests that such rules do not, after accounting for brokerage charges, outperform the placebo of a buy-and-hold investment strategy.

Price-Volume Systems

These strategies suggest that when a stock (or the general market) rises on large or increasing volume, there is an unsatisfied excess of buying interest and the stock can be expected to continue its rise. Conversely, when a stock drops on large volume, selling pressure is indicated and a sell signal is given.

Again, the investor following such a system is likely to be disappointed in the results.The buy and sell signals generated by the strategy contain no information useful for predicting future price movements. As with all technical strategies, however, the investor is obliged to do a great deal of in-and-out trading, and thus his brokerage costs are far in excess of those necessitated in a buy-and-hold strategy. After accounting for these brokerage charges, the investor does worse than he would by simply buying and holding a diversified group of stocks.

• Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc