In Defense of (Discriminate) Technical Analysis
By Jesse Czelusta (from the November 2006 issue of Index Rx)
"Practical traders, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct mathematician." With these words, The Economist recently launched a print version of its formerly on-line financial column, "Buttonwood." Interesting that the inaugural column should be dedicated to an assault on the merits of technical analysis; interesting, and indicative of the rise of technical analysis in financial circles.
As both practical traders and technical analysts, who normally find little fault with the classically liberal arguments of The Economist, we thought we would take the liberty in this month's issue of defending investors of our ilk.
The core of Buttonwood's argument is a point-by-point summary of the usual beefs with rules-based trading. This argument is encompassed by five quotes from the column; let's respond to each in turn--
Quote 1: "(Technical analysts') arguments are often anecdotal: 'If technical analysis doesn't work, how come so-and-so is a millionaire?'"
Response: True, but not of Index Rx. Our arguments are grounded in 1) rational belief theory, 2) the defensible notion that beliefs are correlated, and 3) the empirical observation that these correlations are reflected in asset price movements. Sure, many of our subscribers are millionaires, but we're not claiming that this is a reason to follow Index Rx portfolios.
Quote 2: "'The root of the problem is the failure of technical analysts to specify their trading rules and report trading results in a scientifically acceptable way.'"
Response: Again, true in general but not true of Index Rx. Although our trading rules are proprietary, they are extremely well-defined (which is why they must remain proprietary); and there is no financial entity whose performance is more bona-fide. If only other technical analysts had rules that were as well-specified and results that were as well-verified as those of Index Rx, the task of finding truth amidst noxious torrents of marketing propaganda would be much easier.
Quote 3: "If the efficient market theory is correct, technical analysis should not work at all; the prevailing market price should reflect all information, including past price movements."
Response: Indeed. But efficient market theory is not correct. The problem with the above sentence is the word "reflect." Efficient market theory assumes that any given piece of information produces the same reflection in every investor's mind. In reality, investors can reach different conclusions on the basis of identical information. If Google buys YouTube for 1.6 billion USD, should the price of Google's stock go up? Down? Sideways? That depends on what everyone else is thinking, and everyone is allowed to disagree.
Quote 4: "Technical analysis tends to increase trading activity, creating extra costs."
Response: Amen. This is why it is critical to have limited trading frequency and index funds built into your trading rules. Our costs, even after trading fees and taxes, are much lower than those of actively managed mutual funds.
Quote 5: "All that talk of long waves (recurring patterns) is distinctly mystical and seems to take the deterministic view of history that human activity is subject to some pre-ordained pattern."
Response: It is here that Buttonwood comes closest to the crux of the matter. If it were true that all technical analysis were deterministic, then we would concede the argument and cease publication here and now. The above quote raises an important consideration, one that is completely absent from the article. Simply put, technical analysts fall into two quite distinct camps--"absolutism" and "relativism."
The absolutist believes in patterns that are fixed and contain no reference to contextual indicators. The Dow goes up in January, the S&P 500 will fall dramatically after reaching a level 61.8 percent above its lowest point since the last peak--these are examples of absolute patterns. They cannot hold for long periods, unless investors are irrational or unaware.
The relativist believes in patterns defined by movements relative to shifting targets. Dynamic Indexing is one of the most successful examples. The patterns tracked by Index Rx are not fixed; our system does not issue signals based on the merits of a particular fund alone. All valuation is relative and Dynamic Indexing revolves around this principle. Our system will work whether investors are rational or irrational, aware or unaware. The only requirement is that beliefs be dynamic and correlated.
Thus, Buttonwood's foible is indiscrimination. By way of illustration, consider John Kerry's recent comment that "getting stuck in Iraq" is a consequence of not succeeding in school. His quip was elevated to infamy by salivating pundits at Fox News, et al, and was most remarkable not for its indelicate content nor for the maelstrom it provoked. It was notable for what it revealed about the pitfalls of indiscrimination.
If Kerry had said that "While the military attracts many of our best and brightest, it also provides opportunity to young people with limited career options," a few zealous patriots might have objected. But no one could refute such a claim with evidence. Likewise, when those critical of deterministic technical analysis neglect to observe that there exist technical analysts of a different stripe, they commit a similar intellectual sin.
The Economist and The Politician--both would do well to discriminate.