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Article Title:
The Logic Behind Technical Analysis

Article Description:
Let me first say that I do not now engage in technical analysis; 
nor, have I ever engaged in technical analysis. I do not believe 
doing so would be a productive use of my time.

Additional Article Information:
1416 Words; formatted to 65 Characters per Line
Distribution Date and Time: Fri Feb 24 02:17:09 EST 2006

Written By:     Geoff Gannon
Copyright:      2006
Contact Email:  mailto:[EMAIL PROTECTED]

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The Logic Behind Technical Analysis
Copyright © 2006 Geoff Gannon
Gannon On Investing

Let me first say that I do not now engage in technical analysis; 
nor, have I ever engaged in technical analysis. I do not believe 
doing so would be a productive use of my time.

Having said that, I do not claim technical analysis has no 
predictive value. In fact, I suspect it does have some predictive 
value. The Efficient Market Hypothesis is flawed. It is based 
upon the (unwritten) premise that data determines market prices. 
As Graham so clearly put it in "Security Analysis":

"...the influence of what we call analytical factors over the 
market price is both partial and indirect – partial, because 
it frequently competes with purely speculative factors which 
influence the price in the opposite direction; and indirect, 
because it acts through the intermediary of people's sentiments 
and decisions. In other words, the market is not a weighing 
machine, on which the value of each issue is recorded by an 
exact and impersonal mechanism, in accordance with its specific 
qualities. Rather should we say that the market is a voting 
machine, whereon countless individuals register choices which 
are the product partly of reason and partly of emotion."

I've seen a lot of people cite this quote, without bothering to 
notice what's really being said. Graham had a very broad mind, 
much broader than say someone like Buffett. That's both a 
blessing and a curse. At several points in Security Analysis 
(and to a lesser extent in his other works), Graham can not help 
but explore an interesting topic more deeply than is strictly 
necessary for his primary purpose. In this case, Graham could 
have said what many have since interpreted him as saying: in the 
short run, stock prices often get out of whack; in the long run, 
they are governed by the intrinsic value of the underlying 
business. Of course, Graham didn't say that. Instead he chose to 
describe the stock market in a way that should have been of great 
interest to economists as well as investors. 

Data affects prices indirectly. The market is a lot like a fun 
house mirror. The resulting reflection is caused in part by the 
original data, but that does not mean the reflection is an 
accurate representation of the original data. To take this 
metaphor a step further, the Efficient Market Hypothesis is based 
on the idea that the original image acts on the mirror to create 
the reflection. It does not recognize the unpleasant truth that 
one can interpret the same process in a very different way. One 
could say it is the mirror that acts on the original image to 
create the reflection. In fact, that is often how we interpret 
the process. We say an object is reflected in a mirror. We rarely 
use the active "an object reflects in a mirror". 

For some reason, when we talk about the market we like to use 
inappropriate metaphors. We talk about wealth being destroyed 
when prices fall. Yet, no one talks of wealth being destroyed 
when the price of some product falls. When the market rises, we 
talk about buyers, as if there wasn't a seller on the other side 
of the trade. Above all else, we talk about "the market" not as 
a mere aggregation of transactions, but as some sort of object 
all its own. 

The Efficient Market Hypothesis does not recognize the true 
importance of interpretation. Saying that data (publicly 
available information) acts on market prices omits the key step. 
After all, the same data is available to every blackjack player. 
Casinos just don't like the way a card counter interprets that 

The Efficient Market Hypothesis is not the only argument against 
technical analysis. There is also empirical evidence that 
questions the utility of technical analysis. However, empirical 
evidence alone is not sufficient to prove technical analysis has 
no predictive power. If most knuckleball pitchers had limited 
success, the knuckleball might be an inherently ineffective 
pitch, or there might be a better way to throw it. The same 
is true of technical analysis.

The adjective "random" is a very strange word. Although it is 
rarely the definition given, the most appropriate definition for 
random would have to be "having no discernible pattern". The word 
discernible can not be omitted. If it is, we will take too high a 
view of science and statistics. There's a great introduction to 
economics written by Carl Menger which begins:

"All things are subject to the law of cause and effect. This 
great principle knows no exception, and we would search in vain 
in the realm of experience for an example to the contrary. Human 
progress has no tendency to cast it in doubt, but rather the 
effect of confirming it and of always further widening knowledge 
of the scope of its validity."

All things are subject to the law of cause and effect; therefore, 
nothing is truly random. A caused event must have a pattern – 
though that pattern needn't be discernible. Even if one argued 
there is such a thing as an uncaused event, who would argue that 
stock price movements are uncaused? We know that they are caused 
by buying and selling. Stock prices are the effects of purposeful 
human actions. Several sciences study the causes of purposeful 
human action; so, it would be hard to argue any human action is 
uncaused. Furthermore, each of our own internal mental 
experiences suggests that our purposeful actions have very 
definite causes. We also know that the actions of some market 
participants are based in part on price movements. Many investors 
will admit as much. They may be lying. But, there is plenty of 
evidence to suggest they aren't. 

If the actions of investors cause price movements, and past price 
movements are a partial cause of the actions of investors, then 
past price movements must partially cause future price movements. 

Technical analysis is logically valid. Not only is it possible 
that some form of technical analysis might have predictive power; 
I would argue it necessarily follows from the above assumptions 
that some form of technical analysis must have predictive power. 

So, why don't I use technical analysis? I believe fundamental 
analysis is a far more powerful tool. In fact, I believe 
fundamental analysis is so much more powerful that one ought not 
to spend any time on technical analysis that could instead be 
spent on fundamental analysis. I also believe there is more than 
enough fundamental analysis to keep an investor occupied; so, he 
shouldn't devote any time to technical analysis. Personally, I 
feel I am much better suited to fundamental analysis than I am 
to technical analysis. Of course, there is no reason why this 
argument should hold any weight with you. I also believe there 
is sufficient empirical evidence to support the idea that 
fundamental analysis is a far more powerful tool than technical 

Even though I believe there must be some form of technical 
analysis that does have predictive power, the mental model of 
investing which I have constructed does not allow for such a form 
of technical analysis. In other words: logically, there must be 
an effective form of technical analysis, but practically, I 
pretend there isn't. 

Why? Because I believe that's the most useful model. One should 
adopt the most useful model, not the most accurate model. I'm 
willing to pretend technical analysis does not work, even though 
I know some form of it must work. 

Really, this isn't all that strange. In science, I'm willing to 
pretend there are random events, even though I know there must 
not be random events. In math, I'm willing to pretend zero is a 
number, even though I know it must not be a number. A model with 
random events is useful. In most circumstances, a refusal to 
allow for random events would be harmful rather than helpful. 
The model with random events is simpler and more workable. The 
situation is much the same with zero. It isn't a number. To 
include zero as a number, you would have to put aside the 
principles of arithmetic. So, we don't do that. In school, you 
were taught that zero is a number, but that there are certain 
things you must never do with zero. You accepted that, because
it was a simple, workable model. 

I propose you do much the same in the case of technical analysis. 
You should recognize the logical validity of technical analysis, 
but create a mental model of investing in which technical 
analysis has no utility whatsoever. 

Geoff Gannon is a full time investment writer. He writes 
a (print) quarterly investment newsletter and a daily value 
investing blog. He also produces a twice weekly (half hour) 
value investing podcast at:



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