from: http://www.aci.net/kalliste/ Click Here: <A HREF="http://www.aci.net/kalliste/">The Home Page of J. Orlin Grabbe</A> ----- Stock Market Charts, Not Darts A head-and-shoulders bottom only sounds kinky. Economists used to dismiss as mere snake-oil salesmen technical analysts who use simple patterns in past data to predict future share prices. Now, some think that stock charts can reveal valuable information THE popularity of business television channels such as CNBC has done wonders for the careers of Wall Street�s technical analysts, who claim to be able to predict future share prices by spotting trends in past prices. Their market charts, showing descriptively named patterns such as �head and shoulders��a big peak surrounded by two smaller peaks�or �broadening bottoms��a series of troughs, each lower than the preceding one�make ideal graphics for television producers in need of something pretty for viewers to watch while the glamorous reporters are busy off-camera, catching up on the latest market gossip. The simple trading advice conveyed by charts is, for CNBC�s stock-tip-hungry viewers, manna from heaven. But technical analysis is not merely for gullible CNBC-watchers. It has been around a long time, dating back a century to Charles Dow, the founder of Dow Jones, who invented the �Dow theory� for identifying trends in share prices. Charts are used by some of the world�s most successful investors, such as Stanley Druckenmiller, who until recently managed George Soros�s Quantum hedge fund, and Jeffrey Vinik, who used to run Fidelity�s huge Magellan mutual fund and is now a star hedge-fund manager. Nevertheless, economists who study financial markets have long regarded technical analysis as mumbo jumbo, bearing much the same relationship to rigorous economic �fundamental analysis� that astrology does to astronomy. Since the 1960s, economists have believed, more or less, in �efficient-market theory�. In an efficient market, prices reflect all available information, and so scouring past prices for patterns can tell you nothing useful about whether in future prices will go up or down. Instead, prices will move unpredictably, in a �random walk�. In the past decade some economists have challenged efficient-market theory, by finding numerous examples of apparently predictable movements in share prices. But there is still a fierce debate about whether these movements are predictable enough for investors to make money trading on the basis of expected price changes. The evidence was described at length in �A Non-Random Walk Down Wall Street� (Princeton University Press, 1999), a book by Craig MacKinlay, of the Wharton School, and Andrew Lo, of the Massachusetts Institute of Technology. Mr Lo and two new co-authors have now come to the defence of technical analysis.* Using American share prices during 1962-96, they investigated the predictive ability of five pairs of widely used technical patterns: �head and shoulders�, �inverse head and shoulders�, �broadening tops and bottoms�, �triangle tops and bottoms�, and �double tops and bottoms�. The study focused on technical indicators that were especially controversial among economists. It did not test many other widely used indicators, such as the relationship between the current price of a share and its 200-day moving average. The results showed that the various technical patterns mostly occurred far more frequently than they would have done if they were truly random events. The most common patterns were double tops and bottoms�two peaks (or two troughs) at similar prices to each other�followed by head and shoulders and inverted head and shoulders. In general, the charts contained useful information about future share prices. The study does not test whether this information was useful enough to allow investors to make sufficient profit trading on it to justify the extra risk. But Mr Lo thinks this is likely. However, there was a significant difference between the results for different markets. For shares listed on the New York Stock Exchange and American Stock Exchange, only seven of the ten technical patterns had enough predictive power to be statistically significant. For Nasdaq shares, all ten of the patterns did. Why the discrepancy? Individual investors account for a much larger slice of trading in Nasdaq shares than they do in NYSE and Amex shares, where institutional investors matter more. It may be that the predictive power of these technical patterns comes from the behaviour of individual investors. Certainly, that is Mr Lo�s hunch: that updating the study for the past three years, when individual share-trading has grown to an unprecedented level, will show that the technical measures have worked even more strongly for Nasdaq stocks. The study does not explore what causes the patterns: that is for future research. But one possibility is that they reflect changes in investor psychology. The appetite of investors for risk may change in predictable ways in response to particular changes in share prices. Nor is it clear, yet, whether the predictive powers of the technical patterns would be�as one might expect�eroded if investors traded to take advantage of them. Since investors have been using charts for 100 years or so and they still seem to work, the patterns may be so deeply ingrained that their predictive powers will persist come what may. The traditional patterns used in technical analysis were, of necessity, fairly crude, determined by what was readily visible to the eye. As a result, technical analysis has always been more of an art than a science. Using computers, Mr Lo next hopes to model traditional patterns in a much more precise, systematic way�and perhaps to detect entirely new patterns that do not leap out so clearly from share-price charts. This is an intriguing prospect for investors. But if Mr Lo really wants his new, more scientific technical analysis to catch on, he may need to find a way to make it look good on the telly. *�Foundations of technical analysis: computational algorithms, statistical inference, and empirical implementation�, by Andrew Lo, Harry Mamaysky and Jiang Wang, Journal of Finance, August 2000. The Economist, August 19-25, 2000 ----- Aloha, He'Ping, Om, Shalom, Salaam. Em Hotep, Peace Be, All My Relations. Omnia Bona Bonis, Adieu, Adios, Aloha. Amen. 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