Critically asses the ability of technical analysis to generate excess returns

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. Burton G. Malkiel (1996, p. 138)

There is a plethora of research surrounding the ability of technical analysis to generate excess returns over a buy-and-hold strategy. Academics, typically adopting the Efficient Market Hypothesis, believe that as markets instantly and fully incorporate all available information, no investment strategy can generate excess returns. Further, academic consensus finds that stock prices exhibit a random walk

distribution therefore no active strategy can consistently predict future prices and outperform the passive buy-and-hold strategy. This is refuted by chartists who claim to generate excess returns from analysing patterns in historic stock price data. This is allegedly possible since information is not instantly

incorporated in the securitys price, but rather there is a gradual adjustment of the price after information is processed to a new equilibrium price. Empirical evidence for the effectiveness of technical analysis is mixed - those studies that do identify significantly positive economic returns are often criticised for failing to incorporate transaction costs or incorporating ex post selection bias. This paper continues with a brief outline of technical analysis and a number of the most popular techniques explored in the literature. It then expands on the Efficient Market Hypothesis by exploring the weak, semi-strong, and strong forms of this theory and builds the argument against the effectiveness of technical analysis. A technical analysis literature review follows; it considers both sides of the empirical argument in the context of the aforementioned concepts. It concludes with a discussion of the central arguments made throughout the paper and a short suggestion for future avenues of research.

Technical Analysis Technical analysis seeks to predict future changes in price through studying historical market information technicians believe that there are systematic statistical dependencies in asset returns i.e. that history tends to repeat itself (Lhabitant, 2006, p. 354). The process involves examining price or volume data1 in order to uncover any recurring patterns or correlations that generate buy or sell signals through the application of systematic rules (ibid, p. 354). These rules may take a number of forms, such as

These are the most common data inputs, although theoretically technicians may use any published data to perform their analyses.

moving average or filter rules, which are comprised of an infinite number of variations according to the traders preferences. Moving Average The moving average is simply an average of past prices applied over a certain period as determined by the trader. As the moving average lags the real-time price that is, when the price is rising the moving average is below and when the price is falling the moving average is above sustained shifts in the price2 will cause the real-time price to intersect the moving average in either direction, generating a buy or sell signal (Dunis and Ahmed, 2004, p. 10). Filter Rule The filter rule, when applied to stock prices, generates a long signal when the price increases by a predetermined percentage from its minimum over a given time period. Similarly, it generates a short signal when the price falls by the same percentage amount from its maximum over the same time period (Neely and Weller, 1997, p. 20). As with other technical trading rules, there are limitless combinations of variables subject to the traders manipulation based on his opinion of the optimal strategy.

Efficient Market Hypothesis The efficient market hypothesis is categorised into three forms the weak-form, semi-strong-form, and strong forms of efficiency. The weak-form of efficiency states that prices today reflect all the

information in past prices, hence analysing historical data (technical analysis) would not identify mispriced securities (Lucey, 2012). The semi-strong form follows the weak form but includes that prices today capture all publicly available information also and therefore no form of extrapolation (fundamental analysis) from this information may identify mispriced securities (ibid). Finally, strong-form efficiency states that current prices reflect all publicly and privately available information instantly and therefore no form of analysis can be used to identify mispriced securities (ibid). From strong form efficiency, academics have evolved the argument of the random walk, whereby the actions of the many competing participants
2

Sustained shifts are often seen where there is a large volume of trades. This increased volume provides the price with enough momentum to cross the lagging moving average line.

should cause the actual price of a security to wander randomly about its intrinsic value (Fama, 1965, p. 4), such that the efficient market causes prices to reflect intrinsic value. In reality, prices are neither weak-form efficient nor strong-form efficient. The latter is true such that if everyone believed the market was not efficient then they would analyse securities until the market became efficient (Lhabitant, 2006, p. 172). The former is true such that if everyone believed the market was efficient then they would devote no time to analysis therefore causing it to become inefficient. Having explored the relevant theoretical concepts of market efficiency and the random walk, and discussed the prominent analytical techniques used by technicians, this paper goes on to critically review the empirical literature regarding the effectiveness of technical analysis to generate excess returns. The following section is grouped under the relevant analytical methods.

Literature Review The literature review is loosely categorised into studies that focus on moving average and filter rule methods of technical analysis. The empirical reviews are followed by a discussion of the primary findings within the respective papers. Moving Average In their study analysing trading methods on the Dow Jones Industrial Average (DJIA), with 90 years of daily data, Brock, Lakonishok and LeBaron (1992) find positive predictive powers of moving average rules that cannot be explained through autocorrelation or changes in volatility3 (ibid, p. 1734). Analyses into variable (ibid, p. 1740) and fixed-length (ibid, p. 1741) moving averages returned significantly positive results that outperformed the DJIA before transaction costs. In a similar study, Neftci and Policano (1984) conduct a moving average analysis on daily futures prices4 between 1975 and 1980. Their results are persuasive, highlighting that there appears to be a significant relationship between the dummy variables representing the moving average signals and the futures prices*suggesting+ some
3

Trading profits proved inconsistent with tests for a random walk, an AR(1), a GARCH-M model, or an Exponential GARCH (p. 1734). 4 They use January soybeans; February, April, June, and December gold; May and December copper; and March, June, September, and December T-bills (p. 473).

predictive power in MSE sense (ibid, p. 477). It is unclear whether the authors adjust for transaction costs in this study. Alternatively, Neely and Weller (1998) use genetic programming to select their analytical approach. Such a process avoids ex post selection bias inherent in studies of this nature whereby

researchers select data (accidentally or deliberately) that fits their hypothesis5. Their study uses daily currency data6 between 1979 and 1996 (ibid, p. 7). Their rules produce economically significant excess returns after transaction costs over a ten-year period (ibid, p. 27), however they emphasise that much of the success is solely due to the performance of the Italian lira (ibid, p. 27). Contrastingly, Allen and Karjalainen (1999) report negative results from their process utilising genetic programming using a 50day moving average, they find that the markets for these stocks are efficient in the sense that it is not possible to make money after transaction costs using technical trading rules (p. 246). Their study uses daily S&P500 data from 1928 to 1995 and compares with the risk free return from Treasury bills (p. 256). From the literature it is evident that technical analysis is capable of generating returns in excess of a buy-and-hold strategy. However, this paper argues that the majority of the literature reviewed may be subject to ex ante selection bias and that Neely and Weller (1998) and Allen and Karjalainen (1999) provide a more robust sampling methodology through genetic programming. Additionally, neither of the other papers control for transaction costs which, given the short term bias of technical trading, are likely to be significantly large. As their sample data is dissimilar it is hard to constructively comment on the overall effectiveness of moving average as a trading rule, however the evidence for its effectiveness is weak given the low success rate in the Neely and Weller (1998) paper, and its total failure in the Allen and Karjalainen (1999) paper. Filter Rule Dooley and Schafer (1984) conduct a filter rule study using exchange rates between March 1973 and September 1975. Their results are predominately positive with the 1, 3, and 5 per cent filters *proving+ remarkably profitable (ibid, p. 26) across all samples, with the 1 per cent sample showing the greatest

5 6

Such practice is referred to as data snooping and is discussed later in this paper. Daily U.S. dollar spot exchange rates and ECU central rates for the German mark , French franc, Italian lira, Duch guilder and British pound (P. 7).

profits. These economically significant results lead them to reject the martingale model for spot exchange rates (ibid, p. 27), therefore highlighting that the sample currency exchange markets do not efficiently incorporate price information. Sweeney (1986) also conducts a study using filter rules in spot exchange markets whilst drawing on the postulation of the CAPM to explain his findings in relation to a buy-andhold strategy. By drawing on previous literature, he describes how abnormal filter profits in exchange markets have been associated with the increased speculative nature of this approach and therefore these profits may not be excessive or indicative of inefficiency (ibid, p. 179). Interestingly, Sweeney (1986) does not seek to disprove market efficiency through his results, rather he states that CAPM simply fails to adequately describe exchange markets (ibid, p.179). The corollary being that one can earn excess profits and the market is inefficient, or the market is efficient and profits are earned through excess speculative risk (ibid, p. 179). Alexander (1961) also conducts a filter rule study, though he uses the DJIA and the Standard & Poors industrial averages from 1897 through 1959 (ibid, p. 23). His results are mixed. Although they uniformly favour the smaller filters over the buy and hold method 7 (ibid, p. 23), he summarises that stock prices adopt a random walk over time (ibid, p. 26) therefore eroding the usefulness of the trading rule as time progresses. That much of the literature explored in this section (and previously) relates to Forex markets is of significance as Forex variables are so vast it would be economically infeasible to fundamentally analyse exchange rate movements (Park and Irwin, 2004, p. 50). Given that exchange rates usually trade within a range and are not responsive to earnings news like that of a stock, it seems appropriate that technical analysis would prove profitable in this form of analysis. A distinction should be realised between the applicability of results to the Forex market and the general market for stocks.

Conclusion This paper has critically assessed the ability of technical analysis to generate excess returns. Through an exploration of the Efficient Market Hypothesis and the random walk theory, it explained the

These results are pre commission.

academic view of the inability of technical analysis to generate excess returns the only condition which would make this feasible would be under the situation of weak form efficiency. This paper uncovered some of the academic evidence in favour of technical analysis, with the majority of authors finding positive results in Forex markets, and some in more traditional markets for stock. A significant criticism regarding the empirical literature is that of data snooping, whereby authors are prone to ex ante bias when selecting their sample and technical analysis methods. It was encouraging that some authors sought to mitigate this bias through genetic programming. It would be interesting to compare identical samples with and without the use of genetic programming. In summary, this paper argues against the effectiveness of technical analysis in generating excess returns. This is based on a number of the failings of the literature; namely, that many of the studies fail to incorporate transaction costs which significantly reduce profits of actively traded portfolios; that the authors fail to deal with ex ante selection bias; and finally, that markets in reality8 are not weak form efficient but rest somewhere between the semi-strong and strong form efficiency. Valuable studies might seek to categorically disprove the effectiveness of technical analysis. After reviewing the literature, and many more studies than those mentioned in this paper, it appeared that the volume of specific research into technical analysis was that which proved its effectiveness and not ineffectiveness. Research regarding the latter mainly revolved around proving the Efficient Market

Hypothesis which, consequently, rejects technical analysis.

One need only look at the profitable investment strategies of Warren Buffet and George Soros for evidence that fundamental analysis may earn excess returns.

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Brock, W., J. Lakonishock, and B. LeBaron. (1992). Simple Technical Trading Rules and the Stochastic Properties of Stock Returns. Journal of Finance. 47: 1731-1764.

Dooley, M. P., and J. Schafer. (1983). Analysis of Short-Run Exchange Rate Behaviour: March 1973 to November 1981. In Exchange Rate and Trade Instability: Causes, Consequences, and Remedies. Cambridge, MA: Ballinger.

Dunis, C. L., and R. Ahmed. (2004). Modelling and Trading: Portfolio Using Technical Trading Rules. Working paper: Liverpool Business School and CIBEF.

Fama, E. F. (1965). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance. 25: 383-417.

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Park, C-H., and S. H. Irwin. (2004). The Profitability of Technical Analysis: A Review. AgMAS Project Research Report.

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