The European Journal of Finance 6, 196224 (2000 )

Fur ther in sigh ts on th e p uzzle of tech nical analysis p ro tab ility

BERTRAND MAILLET1, and THIERRY MICHEL2
1

TEAM, Universite Paris I, Pantheon-Sorbonne and A.A. Advisors/ABN AMRO Group, France 2 TEAM, Universite Paris I, Pantheon-Sorbonne and Direction de la Prevision, Minist ere de lEconomie et des Finances, France `

Th is p aper extend s current results concerning tech nical analysis ef cienc y on th e foreign exch ange market and at temp ts to deter mine wh eth er lter ing th e r aw exc hange r ate ser ies with some tr ad ing rule signi cantly changes its characterist ics. Because of th e non-normality of exch ange r at e series, b ootstr ap method s are used on th e main d aily exch ange r at es since 1974 to show tech nical analys is performance. Th e tech nical analys is str ategy test ed ge ner ates retur ns wh ose dis tr ibut ion is signi cantly d ifferent from the b asic series. Th e rob us t ne ss of t he results is tested in and out-of-sample and an exp lanat ion of t he technical analys is performance b ased on its lter ing p rop er ties is suggested. Keywords: internationa l nance, tech nical analys is , p er for mance, foreign exc hange mar ke t, nancial forecasting, ef cient market h yp othesis

1.

INTRODUCTION

Acad emic n ance still recognizes marke t ef ciency as one of its p rincip al p arad igms (see for exa mp le Fam a, 1965a , 1965b , 1970, 1991; Gro ssman, 1976; Grossman and Stiglitz, 1980 ). This co ntrasts with evid ence from auth o rs (Allen and Taylo r, 1989, 1990, 1992; Frankel, 1989; Franket and Froot, 1990 ) who rep or t th at most op erato rs u se tech nical analys is for th eir sh o r t-term in ve stm ent d ecisions. Gro ssm an and St iglit z (1980 ) h ave sh o wn th at with inform atio n costs, m ar ke ts can not b e p erfectly ef cient in Famas sense, th ough an ef cien t m arke t p r ice still fully re ects all th e costless in formation. Never th eless, tech nical analys is meth od s assume th at m ar ke ts are no t p er fect an d use th e ch ron icle o f p ast p rices to b ene t from th ese imp er fections. In an ef cient m ar ke t, an active strategy of b uying an d selling a secur ity would n ot outp erform b uy and h o ld (Co rnell, 1979, p . 387 ). And so , if th e tech nical analys is rule p ro ts are p o sitive , th en m ar ke ts are clearly inef cient, even in th e restricted weak form , b ecause current p r ices d o n ot in cor p orate all p u b licly ava ilab le in form ation (Fama, 1965a , p . 35).
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Th e rst tech n ical analysis r ules were d evelop ed at th e end o f th e nin eteen th cen tur y and h ave b een re ned since (see Mu rp h y, 1987; Prin g, 1991 for a b asic p resentation o f tech nical analysis m eth o d s ). Their fou nd ations were p u rely emp ir ical, with ou t an y relevan t th eoretical justi cation. Never th eless, som e auth ors h ave sh own, in a nois y ration al exp ectation mod el, th at exp ectations on asset returns o f informed agen ts d ep end on eq uilib rium asset p rices (see, for exa mp le, Ad mati, 1985; for a review essay see Ad mati, 1991; Ad mati and Ross, 1985; Treyn or an d Fergu sso n, 1985; Bro wn and Jenn ings , 1989 ). In th is p ar ticular context , Tech nical An alys is , or m ore p recis ely th e u se of p ast p rices to infer p riva te in form ation , h as valu e in a m od el in which p rices are not fully revealing and trad ers h ave rational conjectu rs ab out th e relation sh ip b etween p rices and signals . Therefore, seminal emp ir ical stud ies (Alexa nd er, 1961, 1964; Fama and Blum e, 1966) and m any recen t p ap ers tr y to test th e ve r y usefulness of th e tech nical analys is strategie s, ap p lied to d ifferent nancial assets (cash , sto cks , exc h ange rates, interest r ates, com mod ities ), in seve ral m ar ke ts (m ainly New Yor k and Lo nd on Marke ts ), var ying th e instru ments (sp o t an d futures ) and with mu ltip le d ata freq uencies (weekly, d aily and recently in tr a-d aily d ata ) (Sweeney, 1986; Neftci, 1991; Brock et al., 1992; Curcio an d Go od h ar t, 1992, 1993; Acar, 1993; Leb aron, 1993, 1996; Levich and Thom as, 1993; Taylor, 1994; Silb er, 1994; Kh o, 1996; Gen ay, 1996; Lee and Math u r, 1996, Neely et al., 1996; Neely and Weller, 1997; Curcio et al., 1997; Clyd e and Osler, 1997). So me auth ors p rovid e, for th e foreign exc h ange rate marke t, an econ omic exp lanation of th e ap p aren t p uzzle of tech n ical an alys is p er form an ce wh ich is b ased on th e b eh aviour of th e cen tral b anking auth orities (LeBa ron, 1996; see also Lee and Math ur, 1996 and Neely an d Weller, 1997 ). Th e tech n ical analysis trad in g r ules, accord ing to some auth ors, may p lay a p ar t in th e p rice formation p ro cess b ecau se th ey are wid ely u sed amon g p ractitio ners. They m igh t also d etect som e p rop er ties of th e p rice p rocess su ch as cyc les, no nlin earities or trend s (LeBaro n, 1992a , 1992b , 1992c , 1993; Clyd e and Osler, 1997 ) n ot d etected b y econom etric m od els incorp o ratin g ARMA, ARCH and GARCH p ro cesses (Bro ck et al., 1992; Taylor, 1994; Lee and Math u r, 1996; Kh o, 1996; Neely et al., 1996 ). Th is p ap er focu ses on th e main statis tical p rop er ties o f ch ar tis t r ule returns. The q uestion we tr y to answer is wh eth er lterin g th e raw exc h ange rate ser ies with som e tr ad ing ru le sign i can tly ch anges th eir ch aracteris tics. Th is p ap er is organized as follows. In Section 2, we sh all sum marize LeBaro ns main results an d ap p ly, in Section 3, h is ap p roach to a large r exc h ange rate d atab ase; we sh o w, in p ar ticu lar, th at som e r ules outp erform th e m ar ke t, eve n if th e exc ess m ean retu rn is not always signi cantly sup erior to th e m arke t retur n. In Section 4 we stud y th e rob u stness of tech nical analys is tr ad ing rules p erfor mance an d its consistency. A ge neralizatio n of th ese results sh ows th at th ey are h om oge neous ove r th e p eriod of estimatio n. In Section 5, we stud y in d etail th e ch aracteris tics o f em p irical ch ar tis t retur ns in th e foreign exch ange marke t. Th eir rst an d th ird em p irical mo ments are d ifferent from th e na ve on es. Once th is result is estab lish ed , we p ro p ose nally a gen er al exp lanatio n of th is ou tp erformance.

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2. DEFINITION OF TECHNICAL TRADING RULE AND METHODOLOGY OF TESTS LeBa rons (1996 ) p ap er focuses o n an econ omic exp lan ation o f p erform ance of tech nical analys is o n th e exch ange rate. It follo ws ear lier p ap ers on sto ck p rice ind ices (Bro ck et al., 1992 ) and o n nonlinear ities in th e foreign exc h ange marke ts (LeBa ron , 1992b ). His meth o d s, which are d evelop ed in Brock et al. (1992 ) and Levich an d Thom as (1993), m ainly use sim ulatio n and b ootstr ap p ing. 2.1. De nition of the moving average trading rule

One o f th e most p o p ular tech nical an alys is trad ing r ules is b ased on th e crossing of two mo vin g average s of p ast p rices. Accord in g to th is rule, b uy and sell signals are gen er ated b y two m oving aver age s of th e level of th e exch ange rate a long p erio d average and a sh or t p er iod ave rage. Here, th e long mo vin g ave rage is co mp u ted on p eriod s va r yin g fro m 15 to 200 d ays , while th e len gt h of th e sor t m oving average wind ow is fro m 1 d ay (in th is case, it is th e raw retur n ) to 14 d ays at m ost. Wh en th e sh o r t p eriod average is ab o ve th e lon g moving ave rage , th e ru le recom mend s h o ld ing th e foreign currency. The rule ad vocates h old ing th e d omestic currency when th e sh or t p eriod aver age is b elow th e lon g on e. Thus, a b uy signal is gen er ated when th e sh or t m ovin g average b reaks th e lon g o ne from b elow and a sell sign al when it b reaks th e long mo vin g ave rage fro m ab ove. Th e sh or t mo vin g aver age is th e sp o t exc h an ge rate at tim e t, noted Pt, and MA M(Pt ), th e lon g moving ave rage is d e ned in th e u sual way as: t MA M(Pt ) t
5

1 M i

M2 1

Pt 2
5

where M is th e lag used to com p ute th e m oving average .1 If th e b uy signal is d e ned as (st 5 1 st 2 1 5 2 1) and th e sell signal as (s t 5 2 1 st 2 1 5 1) where st is d e ned as:

st 5 and p t 5 xt 5

1 if Pt $ MA M(Pt ) t 2 1 if Pt , MA M(Pt ) t

ln(Pt ), th e return x t of th e trad ing strategy is th en: st (p t 1

1

Pt )

As sh o wn in Fig. 1, b uy and sell signals alternate and th e trad ing p osition is eith er sh or t or lon g in th e foreign curren cy. If th e in terest rate d ifferentials b etween th e two countries are take n into accoun t, th e cu mulative return of th e ch ar tis t strategy b ecom es:
1

See, for exa mp le, Broc k et al. (1992 ) an d LeBaro n (1996 ) for oth er speci cation s of this simple rule . Here aft er, th is rule will b e n ot ed VMA(x,y) fo r va ria b le m oving aver age , with x an d y respect ively th e len gt h o f th e sh o rt mo ving aver age and th e le ngt h of the long one.

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Exchange rate pt and moving average MAM(Pt): t

199

Corresponding cumulative return of the strategy xt:

Fig. 1. Trading rule example on the daily USD/DEM rate from 01.11.1990 to 01.11.1992

xt 5

st[p t 1

pt 1

ln(1 1

r* ) 2 t

ln(1 1

rt )]

with rt an d r* resp ectively th e d om estic and th e foreign interest rates. t 2.2. The performance tests A u seful trad ing r ule must ge nerate a p ositive retur n. Two kin d s of p erformance b ench mark are tr ad itionally u sed : th e na ve str ategy an d a str ategy b ased on som e str uctu ral econo mic o r statis tic mo d el. As imp lied b y th e market ef ciency h yp oth esis, no structural mo d el o utp er form s sign i can tly th e nave strategy, as sh own b y many auth or s (see, for exam p le, Meese an d Ro goff, 1983 for 1970s m od el p red iction accu racy and Frankel and Rose, 1994 and Ch inn and Meese, 1995 for recent su r ve ys on em p irical results ). Ind eed , to p rovid e continu ity with p revious works , we test b oth wheth er th e ch ar tis t retur n is signi cantly p o sitive , and als o th e signi cance o f th e sp read b etween ch ar tist and market retu rns. Some auth or s 2 test th e p ositivity of th e ch ar tis m returns,
2

See LeBaro n (1996), Lee and Math ur (1996) o r Neely et al. (1996 ).

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whereas th e usual p er form an ce test is to com p are th em with th e b uy-and-h old strategy retur ns, ge nerally used in th e p or tfolio p erfor mance liter ature. The p ur p ose of th is co mp aris on is to assess th e econ omic valu e o f ch ar tis t p red iction rath er th an its relative p red ictive p ower.3 We sh all con sid er in th is wor k th at a strategy is u seful only if it yield s a m ean return signi cantly h igh er th an th e market on th e sam e p er iod . 2.3. Recent evidence and explanations of the pro tability of technical analysis on exchange rate data LeBa ron (1996) con sis tently nd s signi cant p ositive ch ar tis t return s o n main reser ve currencies. Ever y t-statis tic is ab ove th e cr itical 5% va lue. Us in g b oo tstrap meth od s, th e estimated p-va lues are und er 1.5%. These resu lts h old whatever th e exch an ge rate con sid ered , and wh eth er th e interest r ate d ifferential is in clu d ed in th e cumu lative retu rn or not. The ch ar tis t retur n volatilities are ver y close to th ose o f th e r aw returns. The Sh arp e r atio s con rm th e good p erfor mance of th e ch ar tis t strategies, eve n when a realis tic transactio n cost is p aid for each trad e. Neely et al. (1996 ) use a ge netic p ro gram ming ap p roach to sh ow evid ence of exc ess retu rns o f trad ing r ules over th e m ain d ollar currencies. Th e ge netic p ro gr am ming meth o d allows non p ar am etric exib ility: th e tr ad ing ru les are end oge nously ge nerated and selected b ased on th eir tn ess on a sub samp le, and tested o ut-of-samp le. Neely et al. (1996) th en conclud e th at p ast p rices contain p ro tab le infor mation. Th ese p ositive resu lts are som ewh at q u estioned b y Lee and Math ur (1996 ), who h ave sh own th at th e tech nical analysis p erfor mances are no t h omo ge neous over th e ser ies. The tech nical analysis results on th e main Europ ean d aily exc h ange r ates are not as good as th ose on main d ollar cur ren cies. LeBa ro n p rop oses an eco nom ic exp lan atio n o f th e ch ar tis m p erfor mance on th e d ollar currencies (see als o Lee and Math ur, 1996 and Neely an d Weller, 1997 ). He sh ows a link b etween Fed eral Reser ve inter ve ntions and th e ch ar tist returns. The Fed inter ventio ns m igh t b e th e cause for so me of th e p red ictab ility seen in sever al foreign exc h ange series. LeBaron rep eats th e p reviou s tests remo vin g th e foreign exc h an ge in ter ve ntion p eriod s. Then, th e results of th e ch ar tis t str ategie s are d ramatically d owngrad ed . LeBa ron u ses comp lem en tar y tests to ensure th at th is resu lt is no t just a simulation arte fact. The rst test is to sim ulate a vir tual inter ven tio n series on anoth er curren cy. Rem oving th e sim ulated inter ven tio n p er iod s causes no d rastic ch an ge s in th e tech n ical analys is retu rns, which seems to p rove th e causal link b etween th e real Fed inter ve ntions an d th e ch ar tis t p er form ance. Th e statis tical exp lor ation of th e cen tral b ank b eh aviou r sh ows th at its p o licy is like ly to b e leaning against th e
3

As recomm en ded in Admat i an d Ross (1985 ) and as we are int ere ste d in th e ec ono mic va lue of tech nical an alys is fo recas tin g, we u sed th e n a ve strat egy as a b enc h mark (see Corne ll, 1979 fo r a justi cation and Cumb y and Mod es t, 1987 for ap p licatio ns ), ins tea d of o ther sta tistical p red ic tio n cr it er ia suc h as th e ave rage ab solu te er ror, th e sq ua re roo t of th e mea n of sq ua red er ro rs o r th e UTheil stat is tic of th e trad ing strat egy ret ur ns (see Lako nis ho k, 1980; Mees e and Rogoff, 1983; and Dieb old an d Maria no, 1994 and Broo ks , 1997 fo r a sur vey on p red ic tive ac cur ac y meas ure s). For alter na tive b en ch m ar ks , see als o Acar (1993), Chap te r 2.

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win d . Th e p ro t realized b y tech nical analys ts wou ld b e th e p rice p aid b y th e cen tral auth o rity in ord er to stab ilize th e foreign exc h ange r ate. In a related stud y on weekly futures con tr acts, Kh o (1996 ) su gge sted an altern ative exp lanation: th e exc ess retu rn ge nerated b y th e use of th e tech nical analys is ad vice is actually th e coun terp ar t of a time-va r ying sys tem atic ris k, eve n if th e o ve rall r is k of th is strategy d oes not d iffer fro m th e na ve one. 3. FURTHER EVIDENCE OF TECHNICAL ANALYSIS PROFITABILITY

These recent results on exc h an ge r ate and on stock m ar ke t ind ices ch allenge th e ef cien t market h yp oth esis. It seem s th erefore interesting to test th e stab ility and ro b ustness of th e tech nical analys is p erformance. We rep ro d uce th e m ain test o f LeBaro ns p ap er on th e p er form an ce of th e ch ar tist r ule, b ut we allow p ar am eters to var y so as to ge neralize th e p reviou s results. Our emp irical results are th at ch ar tis m mean retu rns are alm ost always h igh er th an th e na ve strategys return s and th at th e sign i can ce of th ose d ifferences h old s for a wid e r an ge of p arameters. For each ser ies, we d eter mine th e optim al ru le. We th en sugge st an alternative exp lan ation of th is ob vious p er form ance. 3.1. Database description and performance test results We use th e following d aily foreign exc h ange series, ext racted from DATAST REAM TM; DEM/USD, FRF/USD, JPY/USD, GBP/FRF, DEM/FRF, JPY/FRF fro m Januar y 1974 to Sep temb er 1996.4 Som e p revio us stud ies use weekly d ata (LeBa ro n, 1996 ), mo st auth or s ch o ose d aily d ata, and Curcio et al. (1997 ) ap p ly a ch ar tis t ru le on an in trad aily d ata set. We ch oose th e d aily freq uency b ecau se it is recognized th at ch ar tism is m ostly ap p lied o n a ver y sh or t h o rizon (Allen an d Taylor, 1992; Curcio et al., 1997) and als o in o rd er to allow com p ar is ons with m ost of th e p reviou s stu d ies on exc h ange r ates. In o ur d ata, th e ch aracteris tics of h igh freq uency exc h ange r ates are, as u su al weak return autocorrelations, signi cant (b ut low) ab solu te and sq uared return autoco rrelatio ns, h igh kur tosis ind ex an d a weak skewness coef cient (LeBaron, 1993, 1996; Sween ey, 1986; Neely et al., 1996; Pagan , 1996 ). We imp lem en t th e p er form ance test d escrib ed b elow on th is d atab ase and focus on th e return d ifferential b etween tech nical an alys is str ategy an d th e marke t retu rns on th e same p er iod . Tab le 1 d is p lays th e statis tics relative to o ur tests 5 for th e often used tech n ical analys is strategy tested b y LeBaro n (1996 ), and b ased on th e crossin g o f th e sp ot exc h an ge rate an d a moving ave rage comp u ted o ve r th e 150 last d ays .
4

We used th e la st quo te of ea ch d ay (mid-as kb id q u ot at ion ) on th e Lon don market an d th e cros srat es are b uilt fro m th e Ster ling rat es . 5 With out taking int o ac cou nt th e int ere st rat e d iffere n tia l, which d o es n ot mod ify th e res u lts (see Sweene y, 1986, p. 172 for a com p let e ju sti ca tio n and res ult s in LeBaron , 1996 ). Besid es, ou r simp le purp os e h ere is to un cove r p ot en tia l d is crep ancies b et ween raw an d trad ing rule lt ere d ser ies . We do no t int en d ye t to d esign th e b est winning strat egy, which would req uire not o nly in te res t rat e differentials, but als o in at ion rat es an d transact ion s cos ts of th is strat egy (e.g. d iffe rent cos t of a ca sh, fu ture or op tion b ased strat egy). Even th e d es ign of th e strat egy (i.e. th e way to ans wer to th e tra ding rule signa ls ) allows so me d egree of freed o m, as sho wn in Brock et al. (1992).

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Table 1.

Test of chartist strategy with M the lag of the long moving average MAM(pt) equal to 150 days t

Series 0.000152 0.000057 0.000173 0.000144 0.000196 0.000105 0.000113 0.000155 0.000278 0.000142 0.000258 0.000258 0.007238 0.002884 0.007238 0.007065 0.007922 0.002538 0.007394 0.005142 0.006924 0.005153 0.007732 0.006960 0.000097 0.000111 0.000097 0.000014 0.000153 0.000112 0.000015 0.000052 0.000168 0.000052 0.000154 0.000168 0.007239 0.002882 0.007239 0.007067 0.007923 0.002538 0.007395 0.005144 0.006927 0.005155 0.007734 0.006963

Sample

Number of signals

Mean return of the chartist strategy Mean return of the nave strategy 1.62 1.52 1.84 1.57 1.91 3.18 1.18 2.33 3.09 2.12 2.57 2.86

Standard deviation of the chartist strategy return

Standard deviation of the nave strategy return

Signi cance* of the chartist return (to 0)

Signi cance* of the return difference 0.42 1.02 2.03 1.00 2.40 4.65 0.94 1.09 3.50 2.05 0.73 0.71

DEM/USD DEM/FRF USD/DEM USD/FRF USD/JPY FRF/DEM FRF/USD FRF/GBP FRF/JPY GBP/FRF JPY/USD JPY/FRF

74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09 74.0196.09

171 147 165 187 163 152 182 154 126 163 141 134

Maillet and Michel

* t-statistic values; bold print 5% signi cance.

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On each series, th e VMA(1,150) trad ing ru le yie ld s a p ositive retu rn h igh er th an th e m arke t one. Moreover, in six cases out of 12, ch ar tist return s are signi cantly p ositive . Bu t th ey sign i cantly o utp er form th e m ar ke t only in ve cases (where th e n a ve return is negative ). As rep or ted in Tab le 1, ch ar tist returns are n ot d ifferent when th e ru le is ap p lied on th e d irect (or Eu rop ean ) exc h ange rate q uotatio n o r th e ind irect (o r Am er ican ) q u otation , b ut th e na ve return ob viously is . We consid er ind eed b oth n a ve strategies: h old ing th e national cu rrency or h o ld ing th e foreign currency for th e camb is t op erator (Neely et al., 1996). Therefore, and as exp ected , when th e na ve return is p ositive, th e d ifference b etween b oth strategie s is less signi cant th an when th e na ve retu rn is n egative. That is to say, it is mo re d if cult to b eat signi can tly a good strategy th an a b ad o ne, b ut als o th at it is d if cu lt to select signi cantly mo re b u llis h p erio d s and less b earis h p erio d s in series containing lots o f uptrend s and few d own-trend s. Neve r th eless, th e com p ar is on b etween ch ar tis t and nave returns is sligh tly less favo urab le to tech nical an alys is on a large r d atab ase th an we co uld exp ect fro m LeBa rons r st results. Howeve r, th is d oes not mean th at no rule signi cantly ou tp er forms th e m ar ke t. We sh ow in th e next section th at som e comb inatio ns of p ar am eters d o b eat th e market b y a signi cant m argin. 3.2. Trading rule performance sensitivity to its parameters

We stud y h ereafter th e trad ing ru le retur ns cond itio nal on th e set o f p arameters, in ord er to test th e h yp oth esis of th e stab ility of th e p erfor mance.

Sensitivity to the lag of the long m oving average

We va r y th e lag over wh ich th e lo ng m oving ave rage is com p uted , settin g th e sp ot p rice as th e sh or t moving ave rage . The retu rns cond itio nal on th ese lags are rep resented b elow. As we would exp ect, th e nu mb er of sign als d ro p s d r astically as th e lag of th e lon g moving ave rage increases. The sh or t m oving aver age can d iverge more easily from th e lo ng m oving ave rage when th e lag is lo nge r b ecause th en th e lon g moving ave rage is less sen sitive to a on e-d ay var iatio n sh ock. There is ob viou sly a relation sh ip b etween ch ar tis t returns and th e lag of th e lon g mo vin g aver age as sh own in Fig. 2. Figure 3 rep resents th e signi cance of th e ch ar tis t trad ing r ule, as a function of th e lag of th e lo ng mo ving average in o ur samp le. Two t-statis tics are rep resented in Fig. 3. These statistics are comp uted as usual as th e ratio of d ifference in means o ve r stand ard d eviatio ns. The rst one is th e statis tic for th e h yp o th esis th at th e tr ad ing rule return is eq ual to zero . The second one tests th e h yp oth esis th at th e ch ar tis t retur n is no t d ifferent fro m th e m arket return . Alth o ugh m ost of th e tr ad ing r ule returns are signi cantly p ositive and su p er ior to th e na ve ones for a lag u nd er 145, no ne ou tp erforms signi cantly th e na ve str ategy for a lag sup erior to 145. Howeve r, th ese return s are always p ositive and h igh er th an th e m ar ke t retu rn if not with

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Fig. 2. Number of signals and trading rule returns: function of M, the lag of the long moving average MAM(pt) on the USD/DEM rate from 01.03.1974 to 09.30.1996 t

Fig. 3. Signi cance of trading rule returns: function of M, the lag of the long moving average MAM(pt) on the USD/DEM rate from 01.03.1974 to 09.30.1996 t

a signi cant m argin. It m igh t th en b e wor th wh ile to stud y th e sensitivity fo th e p erfor mance of th e rule to b oth its p arameter s.

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Chartist perform ance sensitivity to the lags of both short and long m oving average
Figu res 4 and 5 (an d Fig. A.1 in th e Ap p en d ix) sh ow th e p erformance signi cance fun ction o f th e lags of th e m oving ave rages co mp ared using th e ru le. Th is signi can ce is m easured h ere b y th e t-statistic of th e d ifferential of return b etween th e na ve an d th e ch ar tis t strategie s when b oth p arameters var y. The lon g and sh or t mo vin g ave rage len gt h s are read resp ectively o n th e xaxis and th e y-axis of Fig. 4. The leve l o f grey of each p oint is a d ecreasin g fun ction of th e t-statistic. Th e b lack d ots in Fig. 5 rep resen t th e p air s o f p aram eters for which mo vin g ave rage co mp aris on d oes no t yield retur ns signi can tly h igh er th an th e m arke t returns. Th e results are no t stab le over th e whole range o f p aram eters; th e return d ifferences are n ot signi cant in some areas o f th e set of p ossib le valu es for th e length of mo vin g ave rage s. There is , h oweve r, a wide area of va lues wh ere th e ru les are signi can tly useful. Figure A.1 in th e Ap p en d ix ge neralizes th is b inar y rep resen tation o f th e results to th e whole d atab ase. The resu lts are fairly h o moge neo us for most of th e ser ies: eith er no ne (or almo st none ) of th e com b ination of p arameter s yield s signi cant p erformances, eith er for ever y (or almost ever y ) com b ination of p arameters th e return d ifferences are signi can t. In th e case in which n one of th e resu lts is sign i can t, using th e rules on th e un ive rse exc h ange r ate yie ld s

With y the length of short moving average MAy(pt) varying from 1 to 14, x the length of the long moving t average MAx(pt) varying from 15 to 300; the level of grey of each point is a decreasing function of the t t-statistic of the difference between the chartist and nave returns.

Fig. 4. Level of signi cance of the trading rule return as a function of both length of the moving averages used on the series USD/DEM rate from 01.03.1974 to 09.30.1996

Fig. 5. Signi cance of the trading rule return as a function of both length of the moving averages used on the series USD/DEM rate from 01.03.1974 to 09.30.1996

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som e signi cant p ositive p er form an ce. This is th e case for th e DEM/USD, DEM/ FRF and JPY/USD series. It is wor th n oting th at for nin e exch ange rates o ut of th e 12 com p ris in g o ur d atab ase, th e d ifferen ce b etween ch ar tis t returns an d m ar ke t returns is always p ositive. Figure A.2 in th e Ap p end ix rep resents th e sign of th is retur n d ifferen ce for th e th ree series wh ere it is no t always p ositive. For th e JPY/USD and JPY/FRF exc h ange r ates, th e n ega tive sign is exc ep tio nal. The DEM/FRF is th e only exc h ange r ate where th e resu lts are con tr asted . 4. ROBUSTNESS OF THE TRADING RULE PERFORMANCE

The results in th is sectio n concer n th e rob ustness of th e tr ad ing rule p erfor mance over th e d atab ase. We rst stu d y th e rob ustness o f tech n ical analys is p er form ance when th e rules are ap p lied on d ifferent sub samp les. We focus h ere on th e case of th e USD/DEM exc h ange r ate tr ad ing r ule p erfor mance. 4.1. Time consistency of the technical analysis performance The following resu lts are ob tain ed b y using th e lengt h s of mo ving aver age s which maximize th e retu rn d ifferences b etween ch ar tis t and na ve str ategies, d ivid ed b y th e sum of th e return stand ard d evia tions (in oth er word s, th e tstatis tic associated with th e d ifference b etween str ategie s mean returns ). For instance, we h ave found th at th e t-statis tic of th e d ifference in m ean return is maximal for th e length s of 9 d ays for th e sh or t and 16 d ays for th e long mo vin g ave rage s in th e case of USD/DEM exch ange rate.6 To ensu re th at th e p revious results are no t d ep end ent on th e p eriod of estim atio n, we r an seve ral tests o n d ifferent sub sam p les. The rst test con sists in ch eckin g th e rob u stness of th e resu lts o ve r th e wh ole p eriod . St ar ting from Januar y 1974, we comp u te th e cum ulative retu rns of ch ar tis t and na ve strategies and th e 5% con d ence in ter va ls each d ay until th e en d of th e to tal p eriod . Figure 6 com p ares th e optim al trad ing r ule return with th e na ve one and th e sup erior b ou nd of th e 5% con d ence inter va l. Th e cu mulative retu rn of th e optim al trad in g rule is ove r th e up p er 5% con d en ce b ound fro m May 1975. Tab le 2 d is p lays statis tics ab o ut th e tim e consis ten cy of th e ch ar tis t p er form an ce. The column s of th is tab le give th e nu mb er o f p eriod s where th e ch ar tis t retur n is resp ectively p ositive, h igh er and signi cantly h igh er th an th e nave retu rn o ve r th e total nu mb er of estimation p eriod s. Th e p er form an ce o f th e ch ar tis t r ule is h om ogen eou s over th e samp le since th e trad ing r ule regularly b eats th e market. Wh en th e ch ar tis t return s are h igh er th an th e n a ve o ne over th e whole set of p ar am eters, th ey are als o in sensitive to th e selection of a sub sam p le. Th is is th e case for th e USD/DEM, USD/JPY, FRF/ DEM, FRF/JPY, GBP/FRF rates. On th e contrar y, when no signi can t results are
6

In ord er to save sp ace, th e in-samp le maxim izatio n re su lts are no t rep rod u ced for the ot h er exch an ge rat es b ut are ava ila b le o n req ue st.

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207

Fig. 6. Cumulative returns of the optimal trading rule compared to the nave returns on the series USD/DEM rate from 01.03.1974 to 09.30.1996

fou nd b y va r yin g th e mo vin g average len gt h s, th ey are r arely signi can t. But, h ere aga in, as sh own in th e two rst co lumn s, it is ve r y like ly for th e en tire d atab ase th at th e ch ar tis t return s are p ositive and h igh er th an th e marke t return.
Table 2. Time consistency of the optimal trading rule performance over the sample from 01.03.1974 to 09.30.1996 Series DEM/USD DEM/FRF USD/DEM USD/FRF USD/JPY FRF/DEM FRF/USD FRF/GBP FRF/JPY GBP/FRF JPY/USD JPY/FRF Prob[xc > 0] 1.00 1.00 1.00 1.00 1.00 1.00 0.95 0.97 1.00 1.00 0.98 0.99 Prob[xc > xN] 0.99 0.99 1.00 1.00 1.00 1.00 0.93 0.94 0.95 0.98 0.98 0.99 Prob[Tc > 1.96] 0.56 0.02 0.92 0.59 0.79 0.89 0.68 0.69 0.85 0.95 0.01 0.02

Prob[xc > 0] is the estimated frequency of cumulative positive chartist return for the optimal rule. Prob[xc > xN ] is the estimated frequency of cumulative chartist return higher than the nave return for the optimal rule. Prob[Tc > 1.96] is the estimated frequency of cumulative chartist return signi cantly higher than the cumulative nave return for the optimal rule.

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Fig. 7. Cumulative returns of the VMA(1,150) trading rule compared to the nave returns on the USD/DEM rate from 01.03.1974 to 09.30.1996

Th is d oes not mean th at fro m 1974 to 1996 th e infor mation set availab le allowed to co nclud e th at th e ch ar tis t m eth od signi cantly outp erform ed th e marke t since we used th e wh ole p eriod to d etermine th e optim al r ule. Therefore, we again carried out th e test th is time using an arb itr ar y ex ante rule: th e comm only used r ule th at com p ares th e sp ot p r ice to th e 150-d ay mo vin g ave rage .7 Figure 7 and Tab le 3 illustrate th e test. As in Tab le 3 relative to th e optim al r ule, th e colu mns o f Tab le 3 give th e nu mb er o f p erio d s where th e ch ar tis t return is resp ectively p ositive, h igh er an d signi cantly h igh er th an th e na ve retur n over th e to tal n umb er of estimation p eriod s. Th e resu lts usin g an arb itrar y rule strongly d iffer fro m th o se p revio usly ob tained . In our exam p le of th e USD/DEM exch ange r ate who se cu mulative trad ing r ule retur n is p lo tted o n Fig. 7, th e com p ar is on of trad ing and na ve returns would h ave led to rejection of th e usefulness of tech n ical analys is mo re th an h alf o f th e time, eve n th ough its retur ns were always p ositive and h igh er th an th e na ve on es. Th e emp irical freq uencies in th e r st two columns in Tab le 3 are ob viou sly lower th an th ose in Tab le 2, b ut are als o ab ove 50%. However, th e p rob ab ility of conclud ing th e u sefulness of tech n ical analys is is th is tim e m uch lower. A stud y focusin g on th e signi cance of ch ar tis t outp erformance would h ave d eter min ed its in ef ciency b ut wou ld h ave missed th e regu lar ity of th is p erfor mance. Tab le 4 rep or ts th e freq u en cy of, resp ectively, p ositive , h igh er an d signi cantly h igh er return of th e VMA(1,150 ) ru le using, th is tim e, 15 000 rand om p eriod s of th ree years d rawn fro m th e series. These statis tics are th en in d ep end ent from th e p eriod of estim ation of th e ch ar tist p erformance. The con clu sion of an o b ser ver
7

Noted th ereaft er the VMA(1,150 ) rule fo r var iab le m ovin g ave rage with a on e-d ay sh or t movin g an d 150-d ay lo ng movin g aver age.

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209

Table 3. Time consistency of the VMA(1,150) trading rule performance over the sample from 01.03.1974 to 09.30.1996 Series DEM/USD DEM/FRF USD/DEM USD/FRF USD/JPY FRF/DEM FRF/USD FRF/GBP FRF/JPY GBP/FRF JPY/USD JPY/FRF Prob[xc > 0] 1.00 0.98 0.98 0.99 0.95 0.91 0.99 0.99 1.00 1.00 0.82 0.97 Prob[xc > xN] 0.94 0.87 0.99 0.88 0.87 0.92 0.95 0.80 0.95 1.00 0.81 0.88 Prob[Tc > 1.96] 0.00 0.00 0.52 0.00 0.48 0.86 0.26 0.00 0.85 0.25 0.00 0.00

Prob[xc > 0] is the estimated frequency of cumulative positive chartist return for the VMA(1,150) rule. Prob[xc > xN ] is the estimated frequency of cumulative chartist return higher than the nave return for the VMA(1,150) rule. Prob[Tc > 1.96] is the estimated frequency of cumulative chartist return signi cantly higher than the cumulative nave return for the VMA(1,150) rule.

Table 4. Time consistency of the VMA(1,150) trading rule performance over bootstrapped subsamples from 01.03.1974 to 09.30.1996 Series DEM/USD DEM/FRF USD/DEM USD/FRF USD/JPY FRF/DEM FRF/USD FRF/GBP FRF/JPY GBP/FRF JPY/USD JPY/FRF Prob[xc > 0] 0.92 0.92 0.84 0.83 0.84 0.77 0.93 0.93 0.84 0.90 0.95 0.92 Prob[xc > xN] 0.70 0.32 0.81 0.71 0.99 0.94 0.78 0.82 1.00 0.72 0.52 0.56 Prob[Tc > 1.96] 0.00 0.00 0.24 0.00 0.30 0.69 0.13 0.01 0.35 0.07 0.00 0.00

Prob[xc > 0] is the estimated frequency of cumulative positive chartist return for the VMA(1,150) rule. Prob[xc > xN ] is the estimated frequency of cumulative chartist return higher than the nave return for the VMA(1,150) rule. Prob[Tc > 1.96] is the estimated frequency of cumulative chartist return signi cantly higher than the cumulative nave return for the VMA(1,150) rule.

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after a th ree-ye ar stu d y would b e aga in th at no signi cant p erfor mance would b e ge nerated b y th e ch ar tis t m eth od as sh own in Tab le 4. To give signi cant results, th e ru le h as to b e ap p lied on a time p erio d greater th an th ree year s.8 Th e p rob ab ility of th e retu rns b eing p o sitive after th ree years is still h igh . The results rep or ted in th e seco nd colu mn are less hom oge neous. On th e th ree series DEM/FRF, JPY/USD, and JPY/FRF, th e p ro b ab ility o f th e ch ar tis m outp erfor min g th e m ar ke t is no t h igh er th an 50%. Our p reviou s resu lts (Fig. A.1 in th e Ap p end ix) h ave alread y sh own th at, on th ese th ree ser ies, th e ch ar tis t tr ad ing ru le retur n was no t als o sign i cantly h igh er th an th e market retu rn whatever th e moving average len gt h s are. Fro m Tab le 3 an d Fig. A.1 in th e Ap p end ix, we can say th at wh en tech nical analysis p erfor mance is insensitive to th e r ules p ar am eters, it is als o consis tent over time. This regularity su ggests th at th e tech n ical analys is o utp er form an ce is a real p h enom en on. 4.2. Out-of-sample tests of technical analysis pro ts

To make sure th ese results are not sp urio us 9, we set up out-o f-samp le tests (Bro ck et al., 1992; Silb er, 1994; Lee an d Math ur, 1996 10; Neely et al., 1996), op tim izing th e r ule on a ve-ye ar su b-samp le (01.197401.1979 ) and ap p lyin g th is optim al ru le for th e latter p er iod (01.197909.1996 ) for th e main curren cies. Tab le 5 p resents results of th ese out-o f-sam p le tests and Tab le 6 summ ar izes som e statistical p ro p er ties of th e r aw exc h an ge rate series. For th e tests in Tab le 5, we u se stud ents t-statis tic to co mp are ch ar tis t and na ve m ean retur n and als o b ootstr ap meth od s b ecause of th e n on-n orm ality of th e series.11 We test als o for th e d ifference b etween th e oth er emp irical mo ments of th e estimated m ar ke t retur ns, and th ose of th e ch ar tis t strategy returns. We th en com p ute th e statis tics of con d itional retu rns and set up 15 000 series o f na ve retu rns with rand om d raws, h avin g th e same investm ent h or izons. Fo r each m oment comp uted , th e associated p-statis tics are give n, i.e.
8

Tests set u p on ve-ye ar s b o ot strap p ed su b samp le s (no t rep ro duce d here ) yield th e sam e ge ner al res ult con cer ning th e high p rob ab ility level to reje ct th e utilit y of te ch nic al analys is . 9 See for exam p le Silb er (1994 ) for th e select ion b ia s p rob le m of te stin g in-samp le p erformanc e. 10 Lee an d Mat h ur (1996 ) op timize on a on e-ye ar p er iod . Acco rd in g to ou r rst re sult , we op timized ove r a lo nger p erio d : from Jan uar y 1974 to Janu ar y 1979. 11 However, we sh o uld no te h ere, acc ord in g to o ur o wn rst re sult s an d Broc k et al. (1992) and LeBaron (1996) an alys es , th at th e stud ent t-stat is tics lead s to a sim ila r ge ner al con clus io n abou t ch artis m p er formance. We co uld th en write as Curc io et al. (1997, p. 8, not e 8): It is well kn own th at the dis trib ut ion of exch ange rat e ret ur n s d eviat es fair ly fro m the no rmal. This implies that a mo re ap p ropriate way of tes ting th e sign i can ce o f trad ing rule ret ur ns would b e to us e a b oot stra p , as in Brock et al. (1992). Howeve r, th e res ult s in Broc k et al. (1992) are not q ua litat ively alt ered b y us in g b oo tstrap p ed stand ard er ror s and h enc e we fo cu s on trad it io na l t-stat is tic s to p ro vid e infere nce . More over, as sup p o sed imp licit ly b y Silb er (1994) and LeBaron (1996 ), the stud ent s tstat is tic is equiva le nt , if th e mean ret ur n and th e sta nd ard er ror are an nua lize d , to th e ex post Sharpe ratio (1966), u sed tra d itio na lly in th e p or tfolio p erfo rm an ce lite ra tu re. Finally, if th e trad er s ut ility fun ct ion is qu ad rat ic, h e is int ere ste d only in th e rst and sec on d empir ica l m oment s of h is stra te gys ret ur ns, eve n if th es e are n ot mu ltiva riate no rm al. Never th eless, we pres en t bot h tstat is tics an d p-stat is tics when th e ca lc ulation of th e b oot stra p ped p-va lu es are not unb ear ab ly co mpu te r tim e con sumin g.

The puz z le of technical analysis pro tability

Table 5.

Out-of-sample test of daily chartist performance on the main currencies from 01.1979 to 09.1996

Series 130 232 81 129 92 233 128 275

Number of signals for Number large of variations signals i

Chartist Optimal Mean mean (short-long) length of Maximal return moving signals length of (paverages ii signals statistic)iii

Standard deviation of chartist returns (pstatistic)iii 4.63 1.05 4.23 7.54 6.23 3.83 18.08 9.03

Skewness coef cient of chartist returns (pstatistic)iii

Kurtosis index of chartist returns (pstatistic)iii

Marginal probability ttof statistic statistic Wilcoxon iv v text T (xc > 0) T(xc > xN) vi 0.0099 0.9980 0.0017 0.0091 0.0001 0.0000 0.0050 0.0022

Correct sign c 2 Correct probability Goodness sign (for large of t probability variations) vii viii ix 11.596 18.674 11.626 2.631 7.928 10.085 2.778 9.665 0.37 0.30 0.37 0.44 0.40 0.35 0.34 0.36 1.00 0.75 1.00 1.00 0.89 1.00 1.00 1.00

DEM/USD 175

(6; 32)

25.1

DEM/FRF 107

(14; 49)

48.1

USD/DEM 182

10

(6; 31)

15.7

USD/FRF 184

(6; 26)

25.1

USD/JPY 202

(13; 24)

25.8

FRF/DEM 104

(14; 51)

41.4

FRF/USD

29

(12; 247)

25.4

FRF/GBP 127

(8; 42)

34

211

0.005718 (0.0930) 0.000764 (0.9953) 0.005227 (0.0243) 0.009056 (0.0035) 0.007975 (0.0000) 0.002407 (0.0000) 0.038702 (0.0386) 0.009313 (0.0042)

0.001365 (0.7583) 0.000209 (0.3871) 0.001346 (0.6728) 0.001232 (0.7944) 0.001244 (0.6380) 0.000224 (0.2566) 0.019715 (0.1188) 0.001208 (0.4656)

1.587112 6.221387 4.19 (0.0038) (0.1070) 1.011268 14.239914 3.66 (0.9777) (0.2431) 1.664556 6.425803 3.88 (0.0008) (0.1344) 1.662830 6.573139 7.35 (0.0066) (0.1370) 1.741976 8.060766 6.41 (0.0000) (0.0376) 2.937442 13.942528 10.75 (0.0000) (0.2339) 3.058403 12.278893 1.96 (0.0065) (0.0306) 2.073633 7.058230 7.71 (0.0204) (0.5772)

212

FRF/JPY 275 98 182 2.54 0.31 10.19 0.0052 10.347 3.39 0.40 8.74 0.0081 3.694 1.00 1.00 9.26 0.42 1.00 9.35 0.0001 3.507

36

(12; 159)

146.2

882

2.99 0.0621 0.33 1.00

16.72

4.050

GBP/FRF 138

(10; 33)

34.2

JPY/USD

81

(7; 88)

29

JPY/FRF

65

(9; 93)

30.2

0.027451 (0.0003) 0.009472 (0.0003) 0.012209 (0.3734) 0.015249 (0.5199)

0.009189 (0.2306) 0.001023 (0.5375) 0.003598 (0.5984) 0.006015 (0.1907)

1.486794 4.149727 (0.0307) (0.6651) 2.391386 10.002610 (0.0000) (0.0307) 3.147269 17.269441 (0.0240) (0.0357) 2.242204 7.232679 (0.1093) (0.4483)

For large variations, i.e. for xc such as 12s xc 0

where

2s

H1 1

2s

= 1 if (xc (xc+2s c) or xc (xc2s c)) = 0 otherwise

(ii) We use the term length of signal for the number of days between two consecutive signals (buy and sell signal or sell and buy signal). (iii) Bootstrapped p-statistic, i.e. the estimated frequency of 15 000 bootstrapped original series exhibiting a higher empirical moment that the ltered series one. (iv) t-statistic to test if chartist mean return xc is signi cantly positive. (v) t-statistic to test if chartist mean return xc is signi cantly higher than the nave mean return xN. (vi) Wilcoxon Sign Rank Test, i.e. the probability to have chartist mean return different from the nave one using Wilcoxon series sign comparison. (vii) Chi-squared statistic of the sum of the squared differences between chartist and nave return discrete distributions. (viii) Estimated probability that chartist forecasting has correct sign, i.e.

Sign(xc TxN T) = Sign(sT1) with T a signal date t where

H
(sT = 1 sT1 = 1 or . (sT = 1 sT1 = 1)

(ix) Estimated probability that chartist forecasting has correct sign for large exchange rate variations, i.e. with the previous notation, that:

12s Sign(xc TxN T) = 1 2s Sign(sT1) where 1 2s is de ned as in (i).

The p-statistic associated with each moment is noted under its value in brackets. Bold print indicates signi cant difference between chartist and nave return moments at 5% signi cance threshold.

Maillet and Michel

Table 6.

Statistical properties of the main currencies from 01.1979 to 09.1996

Seriesi 0.007569 0.002288 0.007422 0.008200 0.005087 0.006995 0.346376 6.505981 0.059993 14.118965 1 2 0.221885 5.149565 2 0.098532 7.956858 2 6.314648 131.925857 1 0.300409 6.217609 2

Studentized Range

Mean of nave returns

Standard deviation of nave returns Bartlett Lag statisticii Box-Pierce statisticiii Q(30)

Skewness coef cient of nave returns

Kurtosis index of nave returns

Adjusted LoMacKinlay statisticiii Q(30)

KolmogovSmirnov test of Normalityiv 0.4874 0.4957 0.4872 0.4868 0.4897 0.4884

DEM/USD

13.34

0.000038

DEM/FRF

30.62

0.000084

The puz z le of technical analysis pro tability

USD/FRF

16.98

0.000046

USD/JPY

10.73

0.000119

FRF/GBP

21.10

0.000011

FRF/JPY

13.55

0.000165

57.0357 (0.0021) 166.6223 (0.0000) 72.4987 (0.0000) 203.4496 (0.0000) 78.2937 (0.0000) 108.7409 (0.0000)

41.67116 (0.0764) 69.4894 (0.0000) 53.7133 (0.0050) 152.9981 (0.0000) 46.6877 (0.0267) 78.6054 (0.0000)

(i) All the series are rst order integrated I(1), using PhillipsPerron, Augmented Dickey-Fuller and KwiatowskiPhillipsSchmidtShin unit root tests. We used the Akaike and Schwartz Information Criteria for the choice of the lag on residuals in the unit root tests. (ii) The minimum lag to have non-signi cant autocorrelation using the Bartlett standard error, the rst three autocorrelations are BoxPierce corrected. (iii) The BoxPierce Q-statistic and the Adjusted LoMacKinlay Q-statistic for the rst thirty lags. The values in brackets indicate the chi-squared pstatistic of the null hypothesis of signi cant autocorrelations. (iv) The 1% signi cance threshold is equal to 0.0216. The normality hypothesis is rejected for all the series at 1% signi cance threshold.

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th e freq uencies of th e simulated m oments which are sup erio r to th e ch ar tis t return mom en ts. Th e gen er al ch ar tist p erformance results over th e entire (in-sam p le ) d atab ase are not give n h ere in ord er to save sp ace. The out-of-sam p le p erfor mances, gen erally d owngrad ed , are ver y sim ilar to th e in-samp le to tal d atab ase p er iod . Stu d en t tests at a 5% th resh old lead to th e conclusio n th at th e ch ar tist m ean returns are p ositive and h igh er 12 th an th e m ar ke t return. At th e sam e co n d ence leve l, th e tests using th e b ootstrap p ed return s are less favour ab le to ch ar tis t results, lead ing th is tim e to th e rejection of h igh er return s in four cases out of twelve : DEM/USD, DEM/FRF, JPY/USD, JPY/FRF.13 Mo reo ve r, th e ch ar tis t strategy d oes n ot seem to b e more ris ky 14 th an th e na ve o ne since th e stand ard d evia tions are not signi cantly d ifferent. Wh en th e ch ar tist m ean return is h igh er, th e em p irical p rob ab ility d ensity function o f th e cond itional returns is als o sign cantly mo re ske wed to th e righ t. As exp ected from th e comp aris o n of th e rst emp irical mo ments give n ab o ve , th e Wilco xon sign r ank test an d th e ch i-sq u ared good n ess-of- t con rm th at th e d is trib u tions of th e ltered ch ar tis t returns and th e nave one are sign i can tly d ifferen t. Never th eless, th e p red ictive p ower o f tech nical an alys is is ver y low. The correct sign freq u en cies are ind eed inferior to 50%. Howeve r, th e largest ch ar tis t retu rns (as in d icated in th e large variation correct sign colu mn of Tab le 5) h ave m ostly th e go od sign and it is th en likely th at th e over all go od ch ar tis t trad ing ru le p er form an ce is lin ke d with th is ltering p rop er ty. In ord er to con rm th ese results, we set up m ore ext en sive tests to assess th e rob ustn ess of th e ou t-of-samp le ch ar tis t p erfor mance. We evaluate th e emp irical p ro b ab ility of an arb itrar y r ule outp er form ing in-sam p le and ou t-of-samp le and th e p rob ab ilities of a rule givin g a consis tent p er form ance in and ou t-ofsamp le.15 We rep or t in Fig. 8 th e d ifferences of th e in- and out-o f-samp le ch ar acter is tics of th e tr ad ing ru les results. The freq uency of rules yie ld ing sup erio r return s is ab ou t th e same in- and out-of-sam p le, excep t for th e USD/ DEM, FRF/USD an d GBP/FRF ser ies.16 The two su b sam p les are nearly eq uiva lent in terms o f ch ar tis t trad ing rule p erformance for th e oth er exc h ange r ate. We no tice als o th at for th e series DEM/USD, DEM/FRF, FRF/GBP, JPY/USD, JPY/FRF, th e mean ch ar tis t returns are n ever signi cant on b oth sub samp les. We wanted to kn ow if goo d trad in g rule resu lts ob tained o ut-of-samp le co uld b e linked with th e go od results in-sam p le. Tab le 7 sh ows th e estimated
12 13

Wit h th e no tab le exc ep tion of th e DEM/FRF exc h an ge ra te . In th ese cas es , th e na ve re tu rn was sup erio r. 14 In oth er word s, the to ta l ris k of th e ch ar tis t strate gy is co mp ar able to th e na ve on e, even as suming th e p res ence of sys te mat ic time-var yin g ris k p rem ium (Kho, 1996). Moreo ver, as the su m of squared ret ur ns are th e same fo r b ot h strat egie s, th e var ian ce d iffer ent ial is eq ual to th e d iffe renc e in sq u are d mea n ret u rn s, which is foun d em pirically to b e ve r y low, i.e. with p re vious no tat io ns :
s
15 2

( x c) 2

( x N) 5

( x c)2 2

( x N ) 2 << s 2( x N )

Th es e te sts are similar to th o se set u p b y Lee and Math ur (1996 ) and Neely et al. (1996), b ut th e sor tin g of th e ru le is h ere le ss acc ur at e. 16 Th e freq uencies of suc ces sful ru les are , resp ect ively, for th e in- and out-o f-samp le 0.16 ver sus 0.93, 0.25 ve rs us 0.00, 0.20 ver su s 0.46 for th e th ree ser ies .

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P0,i is the empirical frequency that a rule yields out-of-sample a return signi cantly higher than the nave strategy (0), whatever the in-sample results (i); pi, 0 is the empirical frequency that a rule yields a return signi cantly higher than the nave strategy in-sample (0), whatever the out-of-sample result (i).

Fig. 8. Comparison of chartist trading rule in- and out-of-sample performances

p ro b ab ilities of consis tent signi cant results b etween in- and o ut-of-samp le p eriod s. Few ru les th at sign i can tly ou tp erformed th e market in-sam p le still d o so outof-sam p le. In oth er word s, th e in-samp le p erform ance is not a p red ictor of ou tof-sam p le p erformance, alth ou gh th e in-samp le optim al r ule still gives good results out-o f-samp le (see Tab le 7). The lack of p ositive results with th e optim al ru le on series DEM/USD, DEM/FRF, FRF/GBP, JPY/USD, JPY/FRF is consis tent with th eir ge neral low p er form an ce h ere, wh eth er in- or o ut-of-samp le. A ru le which h as yield ed a h igh er retu rn th an th e naive in-sam p le on e is, h owever, ve r y like ly to als o yield h igh er (if not signi can tly ) ou t-of-samp le retu rn. On th e o th er h and , it is un likely th at a rule th at d id n ot outp erfor m in-samp le d o es so out-o fsamp le. Therefore, while op tim izatio n is n ecesar y to ob tain signi cant ou t-ofsamp le results, any ru le yie ld ing h igh er retu rns th an th e market will continue to d o so. 5. STATISTICAL PROPERTIES OF THE OPTIMAL TRADING RULE RETURNS From n ow on, we sh all u se th e b est p air of p arameters for each ru le for th e whole sam p le, in o rd er to d is p lay clearly th e sp eci city of th e ch aracteris tics of th e tr ad ing rule retur ns. 5.1. Properties of signals We rst sor t th e signals accord ing to th eir length (i.e. th e lengt h of tim e b efore th e next sign al). We th us com p are, in Fig. 9, th e mean d aily retur n o f th e ch ar tist strategy for each h orizon with th e m ean return of th e m ar ke t over th e sam e h or izon. Figure 9 illustrates th e two followin g p rop er ties:

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Table 7. Consistency of chartist trading rule in- and out-of-sample performances for the main currencies Series DEM/USD DEM/FRF USD/DEM USD/FRF USD/JPY FRF/DEM FRF/USD FRF/GBP FRF/JPY GBP/FRF JPY/USD JPY/FRF p0, 0 / p90, 0 0.00 0.00 0.13 0.00 0.83 1.00 0.00 0.00 0.88 0.16 0.00 0.00 / / / / / / / / / / / / 0.76 0.00 1.00 1.00 0.99 1.00 0.84 0.20 0.99 1.00 0.19 0.45 p0, 1 / p90, 1 0.00 0.00 0.03 0.00 0.07 0.00 0.25 0.08 0.11 0.04 0.00 0.00 / / / / / / / / / / / / 0.23 0.00 0.00 0.00 0.00 0.00 0.16 0.80 0.01 0.00 0.74 0.03 p1, 0 / p91, 0 0.00 0.00 0.80 0.14 0.03 0.00 0.00 0.00 0.00 0.30 0.00 0.00 / / / / / / / / / / / / 0.00 0.97 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.31 p1, 1 / p91, 1 1.00 1.00 0.04 0.85 0.07 0.00 0.75 0.92 0.01 0.50 1.00 1.00 / / / / / / / / / / / / 0.00 0.03 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.07 0.20

p0, 0 (p90, 0) is the empirical frequency that a rule yields a return signi cantly higher than the nave strategy (resp. higher) out-of-the sample when this rule has given a return signi cantly higher than the nave strategy (resp. higher) in the in-sample. p1, 0 (p91, 0) is the empirical frequency that a rule yields a return not signi cantly higher than the nave strategy (resp. not higher) out-of-sample when this rule has given a return signi cantly higher than the nave strategy (resp. higher) in-sample. p0, 1 (p90, 1) is the empirical frequency that a rule yields a return signi cantly higher than the nave strategy (resp. higher) out-of-sample period when this rule has given a return not signi cantly higher than the nave strategy (resp. not higher) in-sample. p1, 1 (p91, 1) is the empirical frequency that a rule yields a return not signi cantly higher than the nave strategy (resp. not higher) out-of-sample period when this rule has given a return not signi cantly higher than the nave strategy (resp. not higher) in-sample.

c c

th e signal freq uen cy h as a ten d en cy to d ecrease with lengt h; th e m ean returns o f th e signals whose length is m ore th an 20 d ays are h igh er th an th e m ean m ar ke t retur n (for th e sam e h o rizon ), and th ose whose lengt h is u nd er 15 d ays are lower.

The mean lengt h of th e sign als is 15 d ays and th e m ed ian is 12 d ays . Mo st signals who se length is und er 12 d ays h ave a retu rn inferio r to th e market return. This m eans th at more th an h alf of th e signals h ave a retur n und er th e mean market return. The va riance of th e market return increases with th e length of th e inve stment p erio d . The ext rem e retu rns are ge nerally th ose of th e lon ge st signals . As th ose signals are nearly always ef cient, th e m ost extrem e returns sh ou ld b e asymm etric (ske wed to th e righ t ). This is con r med in Fig. 10. 5.2. Estimation of the conditional return distribution

We u se b oo tstrap meth od s (r an d om d r aw with rep lacem ent ) to co nstr uct an estim atio n of th e d is tr ib ution s of trad in g rule return s an d th e origin al market

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Fig. 9. Signal properties function of their lengths on the USD/DEM rate from 01.03.1974 to 09.30.1996

returns. We d rew o n th e origin al series retu rns with th e sam e in ve stm ent p eriod s as th e trad in g r ule signals until we h ad more th an 15 000 retur ns. We th en used a ke rnel meth od to estimate th e d en sity p ro b ab ility functio n of th ese returns. Figu re 10 illustrates th e d is trib utio ns ob tained .17 Th e tr ad ing r ule return s are skewed to th e r igh t, th e 5% m ost negative returns h ave b een ltered b y th e tech n ical analysis rule. Th e emp irical cumulative d is trib u tion o f th e ch ar tist return s is lower th an th e na ve on e wh en ever th e return co nsid ered is inferior to th e mean, i.e. th e ch ar tis t strategy is sup erior to th e na ve str ategy accord ing to th e rst- and second-ord er 18 stoch astic d o m inance criteria. Tab le 8 p resents som e n onp arametric tests for th e estim ated origin al and th e estim ated cond itional return d is trib u tio ns. The con clu sions o f th e four tests are h om ogen eo us and allow for rejection of th e null hypothesis of th e eq uality of b oth d is tr ib ution s at th e 5% signi cance level. Th e comp ariso n of cumu lative d ensity functio ns co n rm s our p revious results; th at is, with out any ad d itio nal assu mp tion on th e sh ap e of th e retu rn
17

For th e gr ap h , we u se a Gau ssia n ke rn el an d ch o os e the b and width which min imizes th e cro ssvalid atio n crit er io n (Efro n and Tibsh ir ani, 1993). 18 If th e seco nd-o rd er sto ch astic cr it er ion is ve ri ed when th e ch ar tis t m ean re tu rn in- or out-ofsam ple is h igh er th an th e n a ve o ne, th e rst-ord er stoc has tic dom in an ce cr it er ion is not h oweve r ver i ed fo r all oth er ou t-of-samp le co nd it ion al re tu rn serie s.

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Fig. 10. Comparison of the original and the conditional return distributions on the USD/DEM rate from 01.03.1974 to 09.30.1996

Fig. 11. Comparison of the original and the conditional empirical cumulative return distributions on the USD/DEM rate from 01.03.1974 to 09.30.1996

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Table 8. Nonparametric tests of the equality of the nave and chartist return distributions for the DEM/USD from 01.03.1974 to 09.30.1996 Test Statistic 5% threshold 5% signi cance test conclusion Test Statistic p-statistic 5% signi cance test conclusion
H0 :

KolmogorovSmirnov 0.2252 0.1010 reject H0 Wilcoxon 1596263929 0.0046 reject H0

Kuiper 0.2933 0.1832 reject H0 MannWhitney 2.8333 0.0046 reject H0

H xx

N C

~ +() ~ +()

where xN is the nave return, xC is the chartist return and +() is an unknown density function.

d is trib u tions, tech n ical analysis yield s signi cantly su p er ior return s. The ch ar tis t strategy is sup erio r o n th e b asis of th e mean-varian ce criterion and als o on th e b asis o f th e seco nd stoch astic d om inance cr iterion. From Tab le 5, we can say als o th at th e asymm etr y o f ch ar tis t returns is not d ue to ch an ce. Th e h eur is tic exp lanatio n of th is resu lt is th at m oving average ru les act as stop-lo ss lters. As soo n as th e sp ot p r ice crosses th e moving aver age fro m b elow, th e moving ave rage will ris e ceteris paribus, b ecau se it take s into accou nt th e cu rrent p rice. For instan ce, if a b uy signal h ad a lo ng lengt h , it means th at th e p rice h as in creased p ersistently for a lon g tim e. Ind eed , when th e sp ot p rice (o r th e sh or t m oving ave rage ) d ecreases, it crosses th e long m oving ave rage , which ris es as lo ng as it rem ains und er th e sp ot p rice.19 In th e case of a lo ng signal, th e sp o t p rice follo ws a lon g trend . It is th en like ly th at, when th e next crossing occu rs (sell signal), th e p rice will b e h igh eno ugh to ensure a retu rn h igh er th an th e m ean m arke t return. On th e oth er h and , th e moving ave rage trad ing rules d o not lead to h o ld ing a losing p osition for a lon g tim e, th u s avoid ing th e large st losses. For th e ch ar tis t r ule to b e p ro tab le, th e raw exch ange rate ser ies mu st exh ib it enough long trend s so th at th e good results on th ese sign als, corresp on d ing to large exch ange rate va riations, offset th e freq u en t sm all lo sses.

6.

CONCLUSIONS

The signi cance of ch ar tis t p er form an ce d ep end s on th e length of th e p eriod s over which th e m oving average s are com p uted . St ill, th e retur n d ifferential b etween th e na ve an d th e ch ar tis t strategies is p ositive for almo st eve r y
19

We do no t ta ke in to ac cou nt th e p ric es le aving th e compu tat io n of th e moving aver age and rea son ceteris paribus.

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comb inatio n of sh or t and long mo vin g ave rage on th e main in ternational currencies. This p u zzling result h old s whateve r th e exc h ange r ate tested and th e p er iod con sid ered . Mo reo ve r, th ese ch ar tis t retu rns are signi cantly h igh er th an th e na ve ones for sever al series an d for a large range of p arameter s. Non e of th e u su al statis tics allo w d is cr imin ation b etween th e series, b u t th e variab ility o f th e raw ser ies seems to b e relevant. Differences b etween b oth rst and th ird centred m oments o f ch ar tis t and nave retu rns are sh own to b e signi cant u sing b oo tstrap m eth o d ology. The trad ing r ule returns are h igh er, and th e ext reme losses are avoid ed . The ge neral ch aracter of th ose resu lts ind uces us to conclu d e th at tech nical an alys is p erfor mance is not simp ly d u e to sp ur ious p atter ns of ser ies tested , selection b ias p erformance, d ata-m ining or d ata-sn oop in g is sues. Seve ral eco nom ic h yp oth eses on exc h an ge rate d eterm ination could exp lain ou r results, such as central b ank b eh aviour or self-realizin g trad er s b eliefs as invoked b y so me auth ors (De lo ng et al., 1990; Lee and Math ur, 1996; Neely and Weller, 1997 ). This is als o com p atib le with th e fact th at th e ch ar tis t rule actu ally selects th e p er iod s wh ere th ere is a trend in th e p rices, b ut cannot forecast th em ex ante. These few go od results must offset th e low com mon resu lts for th e ru le to b e ef cient. Neve r th eless, b efore d rawin g conclusio ns rega rd ing th e inef cien cy o f th e market and th e ex ante ch ar tis t p erformance, we test wheth er it is p ossib le to u se th is statis tical result to d e ne a p ro t yield ing cash-futureop tion b ased strategy, in clud ing, th is tim e, b id ask sp read , transaction costs, yield and in ation sp read s, liq uid ity op p o r tu nity an d oth er nonp erfect marke t costs. Natu ral ext ension s of th is wor k would in co rp or ate oth er ad d itio nal var iab les such as vo lume statis tics or, as in Acar and Satch ell (1995 ), Taylor, (1994) and Clyd e and Osler (1997 ), a stud y of th e links b etween ch ar tis t p er form an ce and th e sp eci cation o f th e d ata gen er ating p rocess followed b y th e p rices.

ACKNOWLEDGEMENTS In p rep ar ing th is p ap er, we h ave b ene ted from th e com ments, suggestions and referen ces of Thierr y Ch auveau (CEBI, Un ive rsit e Par is I / CDC-FMR), H l` n e ee Ra ymo nd (CEBI, Un ive rsit e Par is I), Emm anu el Acar (BZW-Lond o n ), Paul Weller (University o f Iowa / Fed eral Reser ve Ba nk of Sain t Louis ), Sylva in Fried erich (CEBI, Unive rsit e Paris I / LSE-FMG) and CEBI sem inar p ar ticip an ts. We th an k als o th e ed itor for h is com ments and an ano nymous referee for h is d etailed rep or t. Re sp on sib ility for any no nsen se rests with us. An earlier ve rsio n of th is p ap er was p resen ted at th e CNRS conference Monnaie et Fin an cement, Aix en Pro ve nce, June 1996, at th e A.E.A. conference, Evr y, Octob er 1996, at th e A.E.A.Im p er ial College-BNP conference, Lond o n, May 1997 and at th e AFFI co nference, Gren ob le, June 1997.

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( y is the length of the short moving average MAy(pt) used in the trading rule varying t from 1 to 14 days (vertical axis) and x is the length of the long moving average MAx(pt) t varying from 15 to 300 days (horizontal axis) * Darker areas stand for the values pairs of parameters for which the return differences are not signi cantly positive. The series not represented here (e.g. DEM/USD, DEM/FRF, JPY/FRF, JPY/USD) yield nonsigni cant return differences when the chartist rule is applied, whatever the moving average parameters considered. Fig. A.1. Signi cance of the return differential between chartist and nave strategies function of both lengths of the moving averages used for the main currencies from 74.01 to 96.09

( y is the length of the short moving average MAy(pt) used in the trading rule varying t from 1 to 14 days (vertical axis) and x is the length of the long moving average MAx(pt) t varying from 15 to 300 days (horizontal axis) ** Sign of the return differential between the chartist and nave strategies is positive in the lighter areas, i.e. the chartist return is higher than the nave return, and negative in the darkest ones. For the others series in our database (e.g. USD/DEM, USD/FRF, USD/JPY, FRF/DEM, FRF/USD, FRF/GBP, FRF/JPY, GBP/FRF), the chartist return is always higher than the nave one whatever the value of the trading rule parameters considered. Fig. A.2. Sign of the return differential between the chartist and nave strategies function of both lengths of the moving averages used on the main currencies from 74.01 to 96.09

222 REFERENCES

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