Critically assess the usefulness of technical analysis to investors.

Use academic literature and empirical evidence to support your answer.

Technical analysis is the study of market action through the use of charts, for the purpose of forecasting future price trends. Murphy defines market action in terms of the three principal sources of information available to technical analysts; Price, Volume and Open interest. The concept of Technical analysis is in sharp contrast to the Efficient Market Hypothesis, and that of weak form efficiency. Weak form efficiency proposing that an assets past performance has no influence on future performance. The assumptions on which Technical analysis is based are summarised in Levy (1966). Firstly, the market of any good or services is determined solely by the interaction of supply and demand. Secondly, Supply and demand are governed by numerous rational and irrational factors. Thirdly, disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends which persist for appreciable lengths of time. Fourthly, prevailing trends change in reaction to shifts in the relationship between supply and demand. These shifts, whenever they occur can be detected sooner or later in the actual market actions.

The usefulness of technical analysis to investors comes down to the various advantages technical analysis presents. Firstly, as technical analysis is not dependent on financial statements you do not need to worry about the lack of detail in accounting statements. Equally, corporations may choose between different GAAP approved means of reporting expenses, assets and liabilities, meaning different values for each statistic in each case making it difficult to directly compare companies and make relative value decisions. In much recent research it also seems that many behavioural and non-quantifiable factors are affecting asset prices (see Avanidhar Subrahmanyam, 2007 for a review of the literature), these are not shown on financial statements. As you only need to analyze past price and relevant summary statistics technical analysis removes many of the costs associated with finding information on companies or other asset classes which for first class research can often be ver expensive. This is confirmed by Menkoff (1997) who finds that high information costs of fundamental analysis may contribute to the use of technical analysis. Undervalued securities found on the basis of fundamentals may adjust slowly to correct mispricing. The fact that a large area of technical analysis is heavily rule-based means that trades are less subjective and traders are thus less susceptible to the problems suggested by behavioural finance, such as the issues of overconfidence or self attrition (Daniel et al, 1998/2001). Overconfidence can lead to overreaction and thus issues like the book/market effect and longer-run reversals, whereas self-attribution whereby one attributes success to skill and failures to misfortune maintains overconfidence and allows prices to continue to overreact, creating momentum. Technical analysis rules can take advantage of this rather than getting caught in the

Critically assess the usefulness of technical analysis to investors. Use academic literature and empirical evidence to support your answer.

momentum. The rules based aspect means that you can also set up electronic trades to trade when the price indicators hit certain signals. This could be an effective time saving measure and many Funds now use Black Box trading systems as well as active trading. Clearly it is worth noting that you cannot stamp out subjectivity as there will always be a certain element of it when choosing how to formulate the rules, the different lengths of moving average or what technical indicators your rules will trade off. This subjectivity could be considered a disadvantage of technical analysis however it cannot be as subjective as trading on the basis of fundamental analysis due to trading rules one can introduce.

In order to evaluate the extent to which Technical Analysis is useful there are also a number of different disadvantages to consider. The most notable disadvantage is that it goes against the Efficient Market Hypothesis Weak form efficiency argument that firstly; security prices properly reflect whatever information is available to investors. Secondly, active traders will find it challenging to outperform passive strategies such as holding the market indexes, doing so would demand differential insight which in an immensely competitive market would be difficult to come by. The second point worth noting against Technical Analysis is that whether prices actually move in trends or do they just follow a random walk (Malkiel, 2008). One study find the negative first-order serial correlation in monthly stock returns highly significant, whilst significant positive correlation is found at longer lags the twelve-month serial correlation is particularly strong. It is also found that the returns on securities in all size-sorted quintiles exhibit qualitatively similar patterns of serial correlation. (Jegadeesh, 1989) From this we can see that there are trends in price patterns although from reading Menkoff 1997 it seems that although there are significant momentum effects, they are most effective over short periods of time. Some technical analysts seem to attach patterns to historical price data whilst these same patterns also occur in random data sets. However, a study by Grinblatt and Han, 2002 found a price underreaction to information as a result of an investor tendency to hold on to losing stocks and this leads to a spread between the fundamental value and its equilibrium price and a trend forming. This is consistent with prospect theory and mental accounting frameworks and this disposition effect can explain many asset pricing anomalies. The question of history repeating itself is often asked when forming a critique of technical analysis. In the literature, the predictive powers of price patterns such as Head-and-shoulders have often been analyzed. More recently, researchers have found strong evidence that the head-and-shoulder pattern was able to predict excess returns and these returns from the trading strategy conditioned on head-and shoulders price patterns were 5-7% in excess of the S&P 500 and Russell 2000 index performances respectively (Savin, Weller, & Zvingelis, 2007). One should note that the predictive ability of the pattern is partly due to its identification of negative momentum stocks.

Critically assess the usefulness of technical analysis to investors. Use academic literature and empirical evidence to support your answer.

Technical analysis has provided a talking point for academics and market players alike. There have been numerous empirical studies completed on its ability to predict future price movements and its use by fund managers and market practitioners too. Firstly, in terms of moving average (MA) studies there has been considerable empirical success: Lucak (1988) estimate that from 12 rule-based systems 4 systems generate significant profits. These systems include MA crossover and channel-type systems. Brock et al. (1992) look at a long sample of the Dow Jones Index between 1897 and 1986 with a simple MA and a trading-range breakout and find that this test of the presence of support and resistance levels successful. Ratner and Leal (1999) test variable length MAs for emerging markets and in three out of ten cases find evidence of significant profits. Foreign exchange (FX) markets have often been sighted as a home of technical analysis. This is because fundamental analysis is less relevant to FX markets due to less underlying variables, interest rates in different countries and macroeconomic factors being the only true variables leading technical analysis and momentum factors to having a greater effect on FX price changes. Lee et al. (2001) finds MA profits for 4 out of 13 Latin American currencies. Levich and Thomas (1993) and LeBaron (1999) both find large MA profits in FX markets. Clearly in the empirical cases outlined above, technical analysis would give an investor larger profits than a passive index purchasing strategy and so would be very useful. However, more recent studies show that MA profits seem to have decayed in FX markets, a study by Olson (2004): out of 18 FX rates, profits from a simple MA rule were about 3% in the late 70s but almost zero in the late 1990s. This could be due to the increasing efficiency of FX markets as markets move to electronic platforms and market execution speeds increase leading to the faster ironing out of market discrepancies. Bessembinder and Chan (1998) dispute the size of profits made by using technical analysis in terms of measurement errors due to nonsynchronous trading but profits were shown in their test. Ready (2002) updates the Brock et al. study for 1987-2002 and finds poor performance of the simple MA trading system.

In conclusion, it seems that technical analysis is useful. Evidence in support of the moving averages and momentum as well as support and resistance levels and patterns such as head-and-shoulders suggest that technical analysis as a practice is worthwhile. However, some areas of technical analysis such as Gann Theory and Elliott Wave Theory have had little supporting evidence (Sewell, 2008). Studies show it works best in FX markets, intermediate within futures markets and worst on equity markets (James, 2006). As Menkoff notes in his 1997 paper, technical analysis is important as an information category, with 87% of fund managers attaching some importance and 18% attaching a major importance to it. It is clearly useful but it is not

Critically assess the usefulness of technical analysis to investors. Use academic literature and empirical evidence to support your answer.

working as well as it used to due to falling transaction costs, improvements in technology and widening market participation. These effects all lead to improved market efficiency and could mean the effectiveness of technical analysis would diminish as the EMH emerges a s victor.

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References
BROCK, William, Josef LAKONISHOK, and Blake LEBARON, 1992. Simple Technical Trading Rules and the Stochastic Properties of Stock Returns. The Journal of Finance, 47(5), 17311764. Brown, K., & Reilly, F. (2009). Analysis of Investments and Management of Portfolios. South-Western Cengage Learning. Daniel, K. D., Hirshleifer, D. and Subrahmanyam, A., Investor psychology and security market under-and over-reactions, Journal of Finance, Vol. 53, 1998, pp. 18391886. Daniel, K. D., Hirshleifer, D. and Subrahmanyam, A., Overconfidence, arbitrage and equilibrium asset pricing, Journal of Finance, Vol. 56, 2001, pp. 92165 JAMES, Jessica, 2006. FX markets the most inefficient. The Technical Analyst, 19, 4. Malkiel, B. G. (2008). A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing. W. W. Norton & Co. PARK, Cheol-Ho, and Scott H. IRWIN, 2004. The Profitability of Technical Analysis: A Review. AgMAS Project Research Report 2004-04, University of Illinois at UrbanaChampaign, Urbana. Savin, G., Weller, P., & Zvingelis, J. (2007). The Predictive Power of Head-andShoulders Price Patterns in the U.S. Stock Market. Journal of Financial Econometrics , 243265. Subrahmanyam, A. (2007). Behavioural Finance: A Review and Synthesis. European Financial Management , 1229. TVERSKY, Amos, and Daniel KAHNEMAN, 1974. Judgment Under Uncertainty: Heuristics and Biases. Science, 185(4157), 11241131.