Swedroe: Problems With Technical Analysis

Technical analysis works great, until it doesn’t.

There is a wide body of evidence demonstrating the existence of momentum not only in stocks, but across asset classes. There’s also evidence that moving-average indicators provide higher risk-adjusted stock returns in recessions.

On the other hand, while major data vendors, such as MarketWatch and Bloomberg, report daily on technical market indicators (for example, advance or decline lines, the volatility index and the Arms index), they have drawn little attention from the academic community.

Jiali Fang, Yafeng Qin and Ben Jacobsen, authors of the June 2014 study “Technical Market Indicators: An Overview,” examined the profitability of 93 market indicators from the Global Financial Data database.

They used the longest-available sample from the database for each indicator to best avoid any problems arising from the data-snooping. The longest sample in the study is nearly 200 years, and the overall average sample length is 54 years. Following is a summary of their findings:

• The predictability of technical analysis can change over time. For example, the authors found that price-based technical trading strategies beat the market in their 90-year sample for the period from 1897 to 1986. However, they also found that this predictability disappears completely on a fresh 25-year sample for the period from 1987 to 2012.
• Even at a conservative 10 percent level of statistical significance, they found that just 10 of the indicators show an ability to predict returns.
• Compounding the problem is that some of the indicators exhibit sign-switching predictability in a subsample test.
• Once they accounted for risk and transaction costs, the authors discovered none of the technical trading strategies beat their naive buy-and-hold strategy in either Sharpe ratio or risk-adjusted alpha.

The authors concluded that there was no evidence any of the indicators show predictability for future stock returns. They write: “This conclusion consistently holds even if we allow predictability to be state dependent on business cycles or sentiment regimes.”

One problem with technical market indicators is there is no risk story to explain why they should work. If ever they did work, it would be a result of behavioral errors among investors.

Because that’s the case, we shouldn’t be surprised if—once research is published showing a market indicator works—the signal’s value rapidly deteriorates and eventually disappears. We can see this occurring in the above example, where a strategy worked for 100 years until the publication of that finding, when it then stopped working.

These findings confirm the wisdom of the following comments on the value of technical market indicators.

Burton Malkiel, author of “A Random Walk Down Wall Street,” writes: “Technical analysis is anathema to the academic world. We love to pick on it. Our bullying tactics are prompted by two considerations: The method is patently false; and it’s easy to pick on. And while it may seem a bit unfair to pick on such a sorry target, just remember: it’s your money we are trying to save.”

Martin Fridson, who currently serves on the editorial boards of Financial Analysts Journal, CFA Digest and the Journal of Investment Management, had this to say about technical analysis: “The only thing we know for certain about technical analysis is that it’s possible to make a living publishing a newsletter on the subject.”

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.