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Is Technical Analysis Profitable?

Technical analysis is a method of attempting to predict future movements in stock prices based upon data about past movements in prices. For example, when you see an article or book discussing the significance of patterns found in stock price charts, the writer is using technical analysis.

As I’ve mentioned before, when considering an investment strategy, the three questions I ask are:

  1. How well has it performed in the past?
  2. Why has it worked?
  3. Why should it continue to work (even if everybody finds out about it)?

Three gentlemen recently performed an extremely thorough study in an attempt to answer question #1 regarding technical analysis.

What they Tested

They tested 5,806 technical trading rules and applied them each to 49 different countries–the 49 countries (some developed markets, some emerging markets) that make up the Morgan Stanley Capital Index (MSCI).

The trading strategies they tested were broadly categorized as:

  • Filter rules,
  • Moving average rules,
  • Support and resistance rules, and
  • Channel break-outs.

The Conclusion?

“We find no evidence that the profits to the technical trading rules we consider are greater than those that might be expected due to random data variation, once we take account of data snooping bias. There is some evidence that technical analysis works better in emerging markets, which is consistent with the literature that documents that these markets are less efficient, but this is not a strong result.”

Wow. That’s not terribly promising. But what about that bit regarding emerging markets? Is it worth exploring further? Here’s what the authors of the study have to say:

“The closest any market gets is Colombia, whose best performing rule only just fails to be statistically significant after data snooping bias adjustment.”

So if you’re looking to invest in Columbia, technical analysis is almost likely to be profitable. Everywhere else, things don’t look so rosy. Who could pass up such an opportunity for riches? :)

One Additional Concern

In regards to my three tests above, technical analysis doesn’t seem to make it past the first one. But even if it did, I don’t see how it could make it past test #3. I don’t see any credible reason why profitable technical analysis methods should continue to be profitable once word gets out about them.

Our financial markets may not be perfectly efficient, but surely by the time I (or you, or any other individual investor) hear about reliably profitable technical analysis strategies, the big market players have already found out about them as well, thereby eliminating any hope we may have previously had of profiting from them.

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Comments

  1. Not to stir up the pot, but this is one of the problems I see when I look at Mr. Bennett’s investing strategy. It’s another technical analysis tool – although it does take a longer term view.

    But if everyone follows Mr. Bennett’s advice, what would happen? The markets would smooth out considerably, thus negating any benefit you might get from his strategy.

    Sorry, Mike. I know that’ll probably cause an explosion in the comments. But your points just made me think about the things Rob keeps harping on.

  2. @ Paul – (in ultra-slow motion with arm extended) NNNNNNNNNNNNNNNNOOOOOOOOOOOOOOOOOOO

  3. :D Sorry, Dylan! I’m not trying to start a war, though it probably wasn’t wise in retrospect. Maybe Mike can kill it if he doesn’t want to deal with that mess.

  4. :) Oh well, the bell has been rung (every possible pun intended), and we can’t un-ring it. But you are spot on in your assessment.

    There is one way for technical analysis profitable. Create some rules that sound good and would have worked in the past and then package and sell the rules. People buy this stuff because they want to believe it works so they rarely don’t look any further than Mike’s first test. I do not advocate anyone actually doing this, but it’s how it’s done.

  5. @Dylan has a good idea how to make money with technical analysis. You can also become a technical analyst at a Wall Street firm. They make good money, too.

    The good news is that technical analysis is irrelevant to the average investor. If you invest for the long term, other rules are much more important than trading rules based on technical analysis.

  6. @ Paul
    I think you are correct- but you are opening a can of worms….

    But if we are going to do it might as well add one more worm:

    If we use PE/10 ==16 (or any constant) as a screen there is no adjustment for changes in the overall number of investors. Just adding more investors with rational demand curves would push up the price a stock should sell at. This isn’t a bubble or increased risk if the change in numbers is stable- say people in India start investing for their retirement.

    -Rick Francis

  7. The problem with Rob’s valuation informed scheme and why it cannot universally work is that everyone cannot reduce their stock allocation at whatever high P/E level signifies the correct point to reduce equity exposure. If you sell stock, someone else has to buy it.

    But if, as Rob claims, investors can accurately (at least enough to beat out “the Passives”) identify that critical P/E level, you won’t be able to sell at that level because no one will be buying, so the price drops until that situation is corrected. By then it’s too late. If we could find that magical valuation level, we couldn’t act on it; it would be gone the moment it happens (kind of like how you find out where the bullet is in Russian Roulette).

  8. I do trade stocks (about 5 percent of my portfolio) for fun. I like the gamble and the exitment that I might have found a real winner. The technical analysis is a huge part of my strategy. Why you might ask? It’s simple once I’ve found the stock I want to invest in I then use technical analysis to decided WHEN to get in not if.

    Technical analysis is always protrayed as the golden egg. All you have to do is by our program that automatically does it for you and you can be rich.

  9. “Tech analysis only works if you make money until it doesn’t.”

    The same is true of fundamental analyses, and I don’t think the odds of being on the right side of a trade can be any different based on how one arrives at a decision (even using the dart board method).

    I’m not defending either form of analysis, I just haven’t seen anything to indicate that one is more of a sham than the other.

    I’m actually a fan of a variation of the dart board method … as Rick Ferri puts it, “buy the whole dart board.”

  10. I’m don’t see why a strategy should only be said to work if it would still work if everyone used it? I totally get that a strategy once ‘outed’ should have its edge eroded away, but it doesn’t seem to me that everyone being able to use it in future should be an inherent component of saying it works today.

    (I’m v suspicious of tech analysis myself, for the record).

    I’ve said before that if *everyone* passively invested, it wouldn’t work, but IIRC Mike disagreed. But it seems obvious – there has to be at least one active agent responding to earnings and putting a price on the stock.

    So by this (admittedly stretched!) token, you could say passive investing doesn’t work because if everyone did it, it wouldn’t work.

    (I wouldn’t say that, just extending that line of thinking!)

  11. Monevator:

    I’m not saying it needs to work if everybody does it, I’m saying it needs to work if everybody knows about it. (If everybody knew about a given technical analysis rule that had previously proven profitable, it would only take a handful of institutional investors using the strategy to eliminate its usefulness to me.)

    Part of my reasoning is an acceptance of the fact that, by the time I find out about a given trading strategy, surely more than enough institutional investors have heard about it (before me) to have eliminated its profitability.

    And for the record, you remember correctly. I do think buy & hold indexing would work if everybody was using it. The results and the lifetime experience of an investor would surely be quite different than they are now–in some good ways, some bad–but I think we’d continue to enjoy a share of the profitability of our companies.

  12. We are very unlikely to ever see every dollar invested passively. There will always be a market for individual companies. People and companies buy other companies for other reasons than to invest for retirement. If every invested dollar were actually indexed in a cap-weighted index, one company could not purchase 51% of a micro-cap company without buying 51% of Exxon, Microsoft, and GE, too.

  13. Thanks for the clarification Mike.

    In terms of if *everyone* bought and held passively, how would the index fund know what price to put on a stock if everyone was passive? That’s what I’m saying.

    An index tracker as I understand it follows the index — i.e. the aggregate of all decisions on the value of all the listed companies by all active investors/decision makers (and passive buyers).

    The value of an index tracker is you get this average decision making very cheaply, as you know. It’s not that there’s some other way to price stocks that an index fund follows (as you know, too ;) ).

    It’s a moot point because it will never happen — and if I was literally the last active investor left in the world I’m sure I’d make a fortune in weeks — but perhaps interesting theoretically. Although maybe I should discuss on my own blog rather than bothering you with it. ;)

    Apols if I’m still not making myself clear. Perhaps it’s one for me to ponder alone.

  14. “It’s a moot point because it will never happen — and if I was literally the last active investor left in the world I’m sure I’d make a fortune in weeks.”

    Agreed on both accounts.

    As for the thought experiment: I can’t really imagine how things would look if literally everybody were investing exclusively via buy & hold indexing. (Would there even be such a thing as stock prices?) But as long as companies earn profits, and as long as investors have a way to own a share of those profits, it seems that investing would be profitable.

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