Technical Analysis and the Random-Walk Theory

Technical Analysis and the Random-Walk Theory

Does technical analysis work?

Things are seldom what they seem. Skim milk masquerades as cream (Gilbert and Sullivan, H.M.S. Pinafore)

Not earnings, nor dividends, nor risk, nor gloom of high interest rates stay the chartists from their assigned task : studying the price movements of stocks. Such single-minded devotion to numbers has somehow yielded the most colorful theories and has produced much of the folk language of Wall Street:

• “Hold the winners, sell the losers.”
• “Switch into the strong stocks.”
• “Sell this issue, it’s acting poorly.”
• “Don’t fight the tape.”

All are popular prescriptions of technical analysts as they cheerfully collect their brokerage fees for churning your account.

Technical analysts build their strategies upon dreams of castles in the air and expect their tools to tell them which castle is being built and how to get in on the ground floor. The question is: Do they work?

Holes in Their Shoes and Ambiguity in Their Forecasts

University professors are sometimes asked by their students, “If you’re so smart, why aren’t you rich?” The question usually rankles professors, who think of themselves as passing up worldly riches to engage in such an obviously socially useful occupation as teaching. The same question might more appropriately be addressed to technicians. For, after all, the whole point of technical analysis is to make money, and one would reasonably expect that those who preach it should practice it successfully in their own investments.

Toronto CN Tower. Photo by Elena

On close examination, technicians are often seen with holes in their shoes and frayed shirt collars. I, personally, have never known a successful technician, but I have seen the wrecks of several unsuccessful ones (this os, of course, in terms of following their own technical advice. Commissions from urging customers to act on their recommendations are very lucrative.) Curiously, however, the broke technician is never apologetic about his method. If anything, he is more enthusiastic than ever. If you commit the social error of asking him why he is broke, he will tell you quite ingeniously that he made the all-too-human error of not believing his own charts. To my great embarrassment, I once chocked conspicuously at the dinner table of a chartist friend of mine when he made such a comment. I have since made it a rule never to eat with a chartist. It’s bad for digestion.

When Joseph Granville, probably the best known and most followed chartist of the early 1980s, was asked how his “foolproof” system had led him to make some egregious errors during the 1970s, he answered calmly that he was “on drugs” during that period and simply had not paid proper attention to his charts. The “drug” in his case was golf and Granville was convinced that his joining “golfers anonymous” had made him a born-again savior. He believed that he would never again, for the rest of his life, “make a serious mistake on the stock market.” When asked why he didn’t simply use his system to play the market himself and thereby make a fortune, he exclaimed that his mission in life was to enrich others, not himself: “Everyone I touch I make rich.” (Granville predicted not only stock tremors, but earth tremors as well. In 1980, he predicted that Los Angeles would be destroyed in May 1981 by an earthquake measuring 8.3 or more on the Richter scale).

While technicians might not get rich following their own advice, their store of words is precious indeed. Consider this advice offered by one technical service:

The market’s rise after a period of reaccumulation is a bullish sign. Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the Dow, so it is clearly premature to say the next leg of the bull market is up. If, in the coming weeks, a test of the lows holds and the market beaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downtrend is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range.

If you ask me exactly what all this means, I’m afraid I cannot tell you, but I think the technician probably had the following in mind: “If the market does not go up or go down, it will remain unchanged.” Even the weather forecaster can do better than that.

Obviously, I’m biased against the chartist. This is not only a personal predilection but a professional one as well. Technical analysis is anathema to the academic world. We love to pick on it. Our bullying tactics are prompted by two considerations: 1) The method is patently false and 2) it’s easy to pick on. And while it may seem a bit unfair to pick on such a sorry target, just remember: It’s your money we are trying to save.

While the advent of the large-scale electronic computer may have enhanced the standing of the technician for a time, it has ultimately proved to be his undoing. Jus as fast as the technician creates charts to show where the market is going, the academic gets busy constructing charts showing where the technician has been. Since it’s so easy to test all the technical trading rules on the computer, it has become a favorite pastime for academics to see if they really work.

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.