Vital Voo-Doo

In response to a question about moving averages from a
reader last week, I thought it would make sense – and,
perhaps, cents – to present a brief discussion of technical
analysis.

But, first, does it make sense – and cents?

My GRIP (Growth in revenue, Relative momentum, Insider
buying, Price to sales) subscribers know me as a cynical,
skeptical investor whose mantra is "I question, therefore I
am." So before we commit ourselves to an examination of
technical trading, let’s first determine whether it is, in
fact, worth our while – emphasis on "worth."

[I cover the subject extensively in my wildly popular
report, "The GRIP’s Take on T&A: Technical Analysis and
Other Weirdness Applied to Over-the-Counter Securities." It
comes gratis with your subscription to the GRIP.]

Proponents of technical analysis believe that by analyzing
a stock’s chart, they can pick up patterns that can predict
future price movement.

"Poppycock!" – or something like it – counter the
naysayers.

Benjamin Graham, the "Father" of value investing and author
of, "The Intelligent Investor," numbers among the
naysayers:

"The one principal that applies to nearly all these so-
called ‘technical approaches,’" writes Graham, "is that one
should buy because a stock or the market has gone up and
one should sell because it has declined. This is the exact
opposite of sound business sense everywhere else, and it is
most unlikely that it can lead to lasting success in Wall
Street.

Bill Gross concurs:

"Technical analysts are the witch doctors of our business.
By deciphering stock price movement patterns and volume
changes, these Merlins believe they can forecast the
future," asserts the nation’s preeminent bond fund manager
and author of "Everything You’ve Heard About Investing is
Wrong!"

Dr. Burton Malkiel, Chemical Bank Chairman’s Professor of
Economics at Princeton University, and author of "A Random
Walk Down Wall Street," also pooh-poohs technical analysis:

"The central proposition of charting is absolutely false,"
writes Dr. Malkiel, "and investors who follow its precepts
will accomplish nothing but increasing substantially the
brokerage charges they pay. There has been a remarkable
uniformity in the conclusions of studies done on all forms
of technical analysis. Not one has consistently
outperformed the placebo of a buy-and-hold strategy."

These are some pretty damning assertions from some pretty
smart people. But other smart people eagerly take the other
side of the technical analysis debate.

Enter William Brock, Josef Lakonishok, and Blake LeBaron
(BLL), whose 1992 study, "Simple Technical Trading Rules
and the Stochastic Properties of Stock Returns,"
contradicted the notion – and a slew of previous studies –
that technical analysis was futile. The trio kept it simple
– relatively so, anyway:

They analyzed moving averages and trading-range breaks on
the Dow Jones Industrial Average from 1897-1985. Signals to
buy or to sell were generated whenever long (50-day, 150-
day, and 200-day) moving averages intersected with short
(1-, 2-, and 5-day) moving averages. In addition, the
authors of the study tested a widely held belief among
technical analysts that investors should buy "breakouts"
(the moment when a stock trades through a relatively high
price that it has struggled to penetrate in the past) and
sell "breakdowns" (the moment when a stock falls below a
relatively low price at which it has tended to stabilize in
the past).

Buy methodically buying breakouts and selling breakdowns,
the study’s authors discovered that buy signals produced an
average annualized return of 12% over the ensuing 10 days.
Sell signals produced an annualized 7% decline over the
ensuing 10 days. Net-net, the authors concluded that the
results were "consistent with technical rules having
predictive power."

Technical analysts hailed the results as vindication, but
it’s important to note that returns were computed based on
a 10-day holding period, hardly long-term, and even the
authors cautioned that their "analysis focus[ed] on the
simplest trading rules" and that "transaction costs should
be carefully considered before such strategies can be
implemented."

The study – one of the few academic papers to document a
successful technical analysis trading strategy – was itself
the subject of a study by Ryan Sullivan, Allan Timmerman,
and Halbert White (STW) in 1999. "Data-Snooping, Technical
Trading Rule Performance, and the Bootstrap" was the
authors’ attempt to determine the effect of data-snooping
(culling data for correlations or patterns that would be
unexpected to occur randomly) on the results of the 1992
study.

They included the years 1985-1996, which not only provided
for a full 100 years of data, but also provided an out-of-
sample test for the years not included in BLL’s study. STW
also accounted for transaction costs, adding a 0.27% fee
per trade for the best performing trading rule for the full
period.

The authors found that the robust results of the BLL study
appear to be the result of data snooping. "The superior
performance of the [BLL] trading rule is not repeated in
the out-of-sample experiment covering the period 1987-
1996," Sullilvan, Timmerman and White conclude. "There is
scant evidence that technical trading rules were of any
economic value during the period 1987-1996."

But weep not for technical analysis. It boasts many fans.
Technical analysis has its defenders, and their faith is
not completely for naught. Over a narrow time span, stocks
do tend to adhere to a trend. A number of academic studies
have determined that winners keep winning over the short-
run, even though they tend to underperform over longer time
frames.

James O’Shaughnessy sang the praises of relative strength
in his book, "What Works on Wall Street." For the book,
O’Shaughnessy reviewed 40 years of market data and found
that stocks displaying high relative strength tended to
outperform for the calendar year.

Louis K. C. Chan, Narasimhan Jegadeesh, and Josef
Lakonishok’s paper "Momentum Strategies," (The Journal of
Finance, December 1996) analyzes the subject thoroughly.
Interestingly, the authors caution that any additional
returns earned via momentum strategies may be nullified by
additional trading costs. Technical analysis may be useful
in the short-term but even then it should be used
sparingly.

A million people can be wrong. But a million people being
wrong at the same time and in the same way can exert a
substantial influence. Technical analysis, at a minimum,
provides a real-time picture of the behavior of millions of
investors. That’s gotta be worth something, especially when
"herds" of investors can sometimes trample all over a
stock’s fundamental attributes.

So even if technical analysis is flawed, it still provides
insights of "value." Investors who fail to acquire at least
a working knowledge of technical analysis and charting
tools, therefore, risk investing in ignorance of important
market influences. A working knowledge of technical
analysis becomes increasingly important as market
capitalization decreases, which makes it particularly
important for us small-cap investors.