Dismissal of Charting

Dismissal of Charting

Appraising the Counterattack

As you might imagine, the random-walk theory’s dismissal of charting is not altogether popular among technicians. Academic proponents of the theory are greeted in some Wall Street quarters without enthusiasm. Technical analysts consider the theory and its implications to be, in the words of one veteran professional, “just plain academic drivel.” Let us pause, then, and appraise the counterattack by beleaguered technicians.

Perhaps the mots common complaint about the weakness of the random-walk theory is based on a distrust of mathematics and misconception of what the theory means. “The market isn’t random,” the complaint goes, “and no mathematician is going to convince me it is.” Even so astute a commentator on the Wall Street scene as “Adam Smith” displays this misconception when he writes:

I suspect that even if the random walkers announced a perfect mathematic proof of randomness I would go on believing that in the long run future earnings influence present value, and that in the short run the dominant factor is the elusive Australopithecus, the temper of the crowd.

Of course earnings and dividends influence market prices, and so does the temper of the crowd. But, even if markets were dominated during certain periods by irrational crowd behavior, the stock market might still well be approximated by a random walk. The original illustrative analogy of a random walk concerned a drunken man staggering around an empty field. He is not rational, but he’s not predictable either.

Moreover, new fundamental information about a company (a big mineral strike, the death of the president, etc.) is also unpredictable. It will occur randomly over time. Indeed, successive appearances of news items must be random. If an item of news were not random, that is, if it were dependent on an earlier item of news, then it wouldn’t be news. The weak form of the random-walk theory says only that stock prices cannot be predicted on the basis of past stock prices. Thus criticisms of the type quoted above are not valid.

The High Park contains Toronto`s largest pond and approximately 110 acres of remnant oak woodland communities, once common on the Great Lakes sand plains. Photo by Elena

The technical analyst will also cite chapter and verse that the academic world has certainly not tested every technical scheme that has been devised. That is quite correct. No economist or mathematician, however skillful, can prove conclusively that technical methods can never work. All that can be said is that the small amount of information contained in stock-market pricing patterns has not been shown to be sufficient to overcome the brokerage costs involved in acting on that information. Consequently, many condemn the author for not mentioning in the earlier editions of these texts, a pet technical scheme that the writer is convinced actually works.

Being somewhat incautious, the author will climb out on a limb and argue that no technical scheme whatever could work for any length of time. I suggest first that methods which people are convinced “really-work” have not been adequately tested; and second, that even if they did work the schemes would be bound to destroy themselves.

Each year a number of eager people visit the gambling parlors of Las Vegas and Atlantic City and examine the last hundreds of numbers of the roulette wheel in search of some repeating pattern. Usually they find one. And so they stay until they lose everything because they do not retest the pattern (Edward O. Thorp actually did find a method to win at blackjack. Torp wrote it all up in Beat the Dealer. Since then casinos switched to the use of several decks of cards in order to make it more difficult for card counters, and as a last resort, they banish the counters from the gaming tables.) The same thing is true for technicians.

If you examine past stock prices in any given period, you can almost always find some kind of system that would have worked in a given period. If enough different criteria for selecting stocks are tried, one will eventually be found that selects the best ones of that period.

Let me illustrate. Suppose we examine the record of stock prices and volume over the five-year period 1985 through 1989 in search of technical trading rules that would have worked during that period. After the fact it is always possible to find a technical rule that works. For example, it might be that you should have bought all stocks whose names began with the letters X or I, whose volume was at least 3,000 shares a day, and whose earnings grew at a rate of 10 percent or more during the preceding five-year period. The point is that it is obviously possibly to describe, after the fact, which categories of stocks had the best performance. The real problem is, of course, whether the scheme works in a different time period. What most advocates of technical analysis usually fail to to is to test their schemes with market data derived from periods other than those during which the scheme was developed.

Even if the technician follows my advice, tests his scheme in many different time periods, and finds it a reliable predictor of stock prices, I still believe that technical analysis must ultimately be worthless. For the sake of argument, suppose the technician had found that there was a reliable year-end rally, that is, every year stock prices rose between Christmas and New Year’s Day. The problem is that once such a regularity is known to market participants, people will act in a way that prevents it from happening in the future (if such a regularity was known to only one individual, he would simply practice the technique until he had collected a large share of the marbles. He surely would have no incentive to share a truly useful scheme by making it available to others.

Any successful technical scheme must ultimately be self-defeating. The moment I realize that prices will be higher after New Year’s Day than they are before Christmas I will start buying before Christmas ever comes around. If people know a stock will go up tomorrow, you can be sure it will go up today. Any regularity in the stock market that can be discovered and acted upon profitably is bound to destroy itself. This is the fundamental reason why I am convinced that no one will be successful in employing technical methods to get above-average returns in the stock market.

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.