Stock Market Technical Analysis

[chapka]

I've gotten involved on another message board in a discussion on "technical analysis" of stock prices. (Here if you're interested).

If you're not familiar with technical analysis or chart analysis, it's a school of thought among stock market traders who think that they can predict the movement of the stock market or of individual stocks by looking for certain patterns in a chart of past prices, without knowing anything at all about the company.

To me, technical analysis generally looks like a combination of the human tendency to look for patterns everywhere and some kind of obvious observations that you don't need a chart for (for example, if a stock stops going up, sometimes there's a reason, and sometimes that reason makes it go down again).

But I was wondering if there'd been any more expert skeptical discussion on this topic here. Have paranormal and conspiracy thought patterns invaded the financial world? And if not, why don't the combined trades of all of the technical analysts cancel each other out, as the efficient market hypothesis says they should?

Apologies if this has been done to death here; a quick search didn't find any threads on it.

 

[roger]

We haven't discussed it much here, but there is an excellent book on the topic:

Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals

Summary: 6400 TA methods were tested and found not to produce statistically significant returns.

Which is not to say that there is no possible TA rules that will produce significant returns. But it all reads like voodoo to me.

 

[IllegalArgument]

Yes, and read up on Nicholas Taleb.

Wiki:
http://en.wikipedia.org/wiki/Nassim_Taleb

 

[shep]

My own brief experience suggests that it can work for historical analysis -- ie. coming up with reasonable explanations for why things *have* happened the way they have, but it's not very useful as a predictive tool.

I agree re: the human tendancy to look for patterns. It is a habit I have myself, and it's handy in a lot of situations, but after lurking, reading, and posting in this forum for a while and talking more to my investor friends, I think I will go back to a more traditional investment strategy and stop poring (read: weeping!) over charts every day.

That is, it's probably more helpful to look for patterns in the sector/industry a particular company is in (and within the company itself), to see when earnings might rise, or figure out why they might be low, than look for patterns only in that company's stock price.

 

[a_unique_person]

I see it as being little different to astrology.

 

[a_unique_person]

Yes, and read up on Nicholas Taleb.

Wiki:
http://en.wikipedia.org/wiki/Nassim_Taleb

So he's a Marxist and a polyglot!

 

[Gazpacho]

why don't the combined trades of all of the technical analysts cancel each other out, as the efficient market hypothesis says they should?

What makes you think that they don't?

 

[Francesca R]

What makes you think that they don't?

. . . And that the ones who make money become the ones who "prove" that it works, whilst those who lose money don't spend the same amount of time writing dis-proofs.

 

[rjh01]

If you want to understand the stock market study Chaos theory.

 

[roger]

I think it makes some vague kind of sense in certain situations. Think about all the people throwing their money at the tech stocks in the late 1990s. You could look at that "momentum", jump aboard, and make a lot of money, until, um, you lost everything you had. Likewise, you can have a stock bouncing around in a range - typically a stock in trouble - it sells off until it goes so low it starts looking attractive, people buy at that price until it goes up, so people stop buying, then try to sell off to get their profit. Boing, boing, boing, until real news or a rumor stops that pattern.

And there is the real problem. After you factor in the very non-random yet unpredictable events like bad quarters, a turn in confidence, a bank failing, transaction costs (brokerage fees, margin, taxes) it just doesn't seem to work out.

And I'm with the OP; if any single technique did turn out to work very well, it would be quickly adopted and cause it's own market force, rendering it useless unless practiced on very obscure stocks. Institutional money is very quick to pick up and apply any edge they can.

 

[roger]

To provide a sort of counterexample, there's a popular book out there, Rule #1, by Phil Town. He sort of perverts some standard advise from Buffett, and adds in TA. Basically, he looks for companies that you understand, that have a moat (sustained competitive advantage), and that make good returns on invested capital (it makes little sense, generally, to place capital in a company that returns 2% on capital, yet people do it every day). So far, okay, albeit simplistic. Then he adds in TA.

The basic reasoning goes something like this - we are individual investors, and don't have our fingers on the pulse like the big money does. They will learn of a problem far sooner than we can, and get out before we do. So, if we watch for unusually heavy selling volume, get out while you can, even if you have heard no news, because somebody with more knowledge than you is dumping stock.

It almost makes sense; it certainly is appealing to try to ride on the coat tails of professional money. Yet watch people try to apply it. If you make your volume indicator too sensitive, you sell your stock on heavy volume days. If you make it less sensitive, you don't sell until the stock has hit near bottom. So people back test their settings. But, of course, history did not include that bad information coming to light, so the data does not include that information to back test against. So, in practice, people just get whipsawed out of their money. Furthermore, the whole argument is based on your own ignorance - I say, if you are that ignorant, don't buy individual stocks; buy an index. Cause you are not playing on a level playing field. If you don't have a competitive advantage to institutional money, don't play.

With that said, I'd certainly entertain the idea that some kind of TA could help give me information about a stock I researched and bought base on it's fundamentals, but I'm sure not going to waste my time on the search myself. It doesn't make sense to me how past data is going to help me understand unexpected events in the future. Also, if I bought a stock, I pretty much made a bet that I am smarter than the big money, or more flexible, or able to buy into a lower cap stock, etc. Does it make sense to now conclude I don't know what I am doing and then follow their lead on buy/sell decisions? Not to me.

 

[Francesca R]

If you want to understand the stock market study Chaos theory.

What has chaos theory got to do with technical analysis? And technical analysts (according to themselves) don't really want to understand the market, they are quite happy being oblivious to what drives it as long as they profit from it.

I've had experience with trend-following, moving-average crossover trading rules in foreign exchange rates. They have had long periods of working well (though I have not met anyone who consistently follows them) but seem to have lost money since about 2004. Since then it was "the carry trade" (which is not technical analysis but just as theoretically unsound) until the middle of last year, after which it has lost money spectacularly (and that is a strategy I have directly traded against in my job). Since there is no great explanation for why these trading styles should work, beyond the greater-fool theory, then similarly no explanation is needed when they break down and go into reverse.

 

[Huh-What?]

I've gotten involved on another message board in a discussion on "technical analysis" of stock prices. (Here if you're interested).

If you're not familiar with technical analysis or chart analysis, it's a school of thought among stock market traders who think that they can predict the movement of the stock market or of individual stocks by looking for certain patterns in a chart of past prices, without knowing anything at all about the company.

To me, technical analysis generally looks like a combination of the human tendency to look for patterns everywhere and some kind of obvious observations that you don't need a chart for (for example, if a stock stops going up, sometimes there's a reason, and sometimes that reason makes it go down again).

But I was wondering if there'd been any more expert skeptical discussion on this topic here. Have paranormal and conspiracy thought patterns invaded the financial world? And if not, why don't the combined trades of all of the technical analysts cancel each other out, as the efficient market hypothesis says they should?

Apologies if this has been done to death here; a quick search didn't find any threads on it.

I wouldn't be comfortable throwing my money at a company if I didn't know any thing about it. IMO, trading is too much like gambling. I believe to be any good at trading it would be more beneficial to have a background in psychology then charting. Being able to predict the fear or greed of others may have better short term potential then charting.

Charting does sound like astrology and may have a similar success rate.

 

[rjh01]

If you want to understand the stock market study Chaos theory.

What has chaos theory got to do with technical analysis? And technical analysts (according to themselves) don't really want to understand the market, they are quite happy being oblivious to what drives it as long as they profit from it.

Not sure if I should give your question an answer, but I will give you the benefit of the doubt and give you one.

Both technical analysis and chaos theory attempt to explain the movement of the price of stocks.

Technical analysis says that the price will move in a roughly straight line, give or take a bit, hence two parallel lines are used and the price will stay within those two lines. Knowing this you can then make money.

Chaos theory predicts all this is rubbish. You cannot make more money with technical analysis than putting money in random stocks and leaving it their. The price may move in a predictable way for some time but will then, at an unpredictable time break out of this pattern and behave in a different unpredictable way. These movements will be independent of time. In other words draw a graph of the price of a stock over time (without putting in any numbers) and no-one will be able to say over what time period the graph is for. They will not even be able to say what stock it is for!


All this assumes you have no knowledge of any stock other than historical prices.

 

[IllegalArgument]

So he's a Marxist and a polyglot!

I think he would be preferred to be know as a anti-platoist.

 

[jimbob]

Here is an earlier discussion about a similar type of situation:

Johnnyfive (for example) can explain why two examples of this equipment can not possibly predict the stockmarket.

If it started getting everything right, then the market would start following it, and the other copy would predict this too, and you end up in a chaotic oscillation between the two (if anyone acted on the information).

Jim

Good Grief! I've never thought of predictive woo from the POV of Control Systems Theory!

What if you added True Prediction (as opposed to learning algorithms, neural nets, etc.) to a loop? You'd not only be chasing the current signal, but a future signal!

ETA:
This thread was "Company / Computer Technology that can predict virtually anything"

but obviously, if such a predictive tool began to work, it would influence the market, and then you would need to analyse what the tools predictions would be, and so on...

 

[Francesca R]

I wouldn't be comfortable throwing my money at a company if I didn't know any thing about it. IMO, trading is too much like gambling. I believe to be any good at trading it would be more beneficial to have a background in psychology then charting. Being able to predict the fear or greed of others may have better short term potential then charting.

Charting does sound like astrology and may have a similar success rate.

Some technical analysis (the only valid kind IMO) is absolutely rooted in psychology (to be specific, the "heuristics and biases" type) and nothing to do with supernatural beliefs. Systematic trading rules serve two simultaneous purposes under this school of thought: first they measure price behaviour and interpret is as a proxy for the underlying collective psychology of market participants, and second, they offer a route to extract your own psychological attributes (those which act against rational decision making) from your investment decisions.

Would you agree that, no matter how much careful analysis you may do of about a market or a company's "fundamentals", there remains the risk that you are going to be heavily influenced by what you see others doing/saying?

There are a lot of good criticisms that can be levelled at technical analysis. I don't think it is necessary to suggest a likeness to astrology as one of them.

 

[Francesca R]

Not sure if I should give your question an answer, but I will give you the benefit of the doubt and give you one.

Benefit of what doubt? I honestly do not know what you are trying to say.

Both technical analysis and chaos theory attempt to explain the movement of the price of stocks.

No, technical analysis tries to predict. It could give two hoots about explanations. And as I understand chaos theory, it basically invokes the idea that price movement is not predictable even if it functions according to deterministic rules--like the weather.

Technical analysis says that the price will move in a roughly straight line, give or take a bit, hence two parallel lines are used and the price will stay within those two lines. Knowing this you can then make money.

I think you do not know about technical analysis, if you think this is "what it says"

These movements will be independent of time. In other words draw a graph of the price of a stock over time (without putting in any numbers) and no-one will be able to say over what time period the graph is for. They will not even be able to say what stock it is for!

This much is true, according to Benoit Mandelbrot's work.

 

[Huh-What?]

Some technical analysis (the only valid kind IMO) is absolutely rooted in psychology (to be specific, the "heuristics and biases" type) and nothing to do with supernatural beliefs. Systematic trading rules serve two simultaneous purposes under this school of thought: first they measure price behaviour and interpret is as a proxy for the underlying collective psychology of market participants, and second, they offer a route to extract your own psychological attributes (those which act against rational decision making) from your investment decisions.

Does this analysis take into account business risks? Like losing a competitive edge? Or is it like the OP mentioned "...looking for certain patterns in a chart of past prices, without knowing anything at all about the company."?

Or is it meant to be applied to stock prices of companies who are fundamentally the same for at least the last 52 weeks?

Would you agree that, no matter how much careful analysis you may do of about a market or a company's "fundamentals", there remains the risk that you are going to be heavily influenced by what you see others doing/saying?

Heavily? Me personally, no. Most investors, absolutely. I am no great investor, but I have learned that being disciplined and thick skinned will serve you better (in the market).

There are a lot of good criticisms that can be levelled at technical analysis. I don't think it is necessary to suggest a likeness to astrology as one of them.

It was more tongue-in-cheek.

 

[a_unique_person]

What has chaos theory got to do with technical analysis? And technical analysts (according to themselves) don't really want to understand the market, they are quite happy being oblivious to what drives it as long as they profit from it.

I've had experience with trend-following, moving-average crossover trading rules in foreign exchange rates. They have had long periods of working well (though I have not met anyone who consistently follows them) but seem to have lost money since about 2004.

Sounds like a lot of ideas, they work well until they don't.