Your Trading Charts Work Better in Study When Markets Get Frothy

To critics, technical analysis is snake oil, purporting to find order in markets when none exists. New research says using charts as the basis for trading decisions actually works -- when investors are at their least rational.

In a study titled “Sentiment and the Effectiveness of Technical Analysis,” researchers found that hedge funds that leaned on technical analysis beat their peers by an average of 5.3 percent per year during stretches when investor optimism was elevated. One reason: price momentum overwhelms influences like earnings and the economy in times of market euphoria.

The study, to be published in the Journal of Financial and Quantitative Analysis, is part of a debate dating back to Nobel laureate Eugene Fama’s efficient market hypothesis, which questioned whether useful information about future prices could be divined from the past. According to David Smith, one of the authors of the study, insights can be drawn from charts when investors are acting irrationally.

“If you can take the emotion and behavioral impediments and simply use numbers on things like moving averages, Bollinger bands and other types of technical analysis, it may save people from their own impulses,” Smith, a professor of finance at Albany’s School of Business and Center for Institutional Investment Management, said in an interview.

Technical Returns

Smith, along with Hofstra professors Edward Zychowicz and Na Wang, and State University of New York at Albany professor Ying Wang, tracked the performance of more than 5,000 hedge funds from 1994 to 2010. The group then compared the results of funds that identify themselves as users of technical analysis against those that don’t use price and volume charts as trading cues.

Funds using technical tools returned an average 0.39 percent during months in which the Baker-Wurgler index of market sentiment was above the median, the study shows. Non-technical funds averaged a loss of 0.06 percent during that time. When sentiment was depressed, the opposite was true: technical funds trailed their peers by 0.2 percentage points.

The findings suggest speculation during bull markets drives prices beyond intrinsic values, Smith said. Because not all market participants have the ability to bet against stocks through short-selling, high stock multiples often last longer than low ones.

Valuation gaps during market euphoria are an opportunity for technical analysts, as corporate earnings and economic outlooks are “imprecise” signals when investors are excited and stock prices deviate from fundamental value. That’s when moving averages and momentum strategies can provide better guidance, the authors write.

“Insofar as markets exhibit stronger trends in high sentiment periods, technical analysis techniques such as moving average and momentum strategies are informative because they are primarily designed to detect price trends,” the authors wrote. “In contrast, other signals such as earnings and economic outlook are likely to be imprecise.”

‘Random Walk’

The study shows randomness doesn’t always rule markets, said Burton Malkiel, chief investment officer of Wealthfront Inc. and professor emeritus at Princeton University. Malkiel, whose “A Random Walk Down Wall Street” advocates buying and holding broad index funds as a practical interpretation of the efficient market hypothesis, says there’s one big catch.

“The market is not a perfect random walk,” Malkiel said in a phone interview. “From time to time there is a bit of momentum in the stock market and when people use technical analysis usually what they’ve done is loaded up on this momentum factor. The problem is it’s very undependable and can stop on a dime. Nobody can time the market.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE