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:
- How well has it performed in the past?
- Why has it worked?
- 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.
“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.