This Alchemy May Yield Real Gold
Technical analysts don't get no respect. Academic economists consider their game--predicting stock prices by studying charts--on a par with examining the entrails of a freshly slaughtered goat. Conventional economic wisdom says that stock prices already reflect all relevant information, so past movements are no clue to future ones. Even if stock prices are a little predictable, say most economists, you won't get anywhere by poring over charts for such technical-analyst arcana as "rising bottoms," "double tops," and "head-and-shoulders formations." Burton G. Malkiel, author of A Random Walk Down Wall Street, writes that "under scientific scrutiny, chart reading must share a pedestal with alchemy."
But technical analysts--also known as chartists--may yet get the last laugh. A paper written by three authors from the Massachusetts Institute of Technology, and recently published by the prestigious National Bureau of Economic Research, concludes that "certain technical patterns do provide incremental information, especially for Nasdaq stocks." In language that's bold for academics, the paper goes on to say that "while this does not necessarily imply that technical analysis can be used to generate `excess' trading profits, it does raise the possibility that technical analysis can add value to the investment process."
Technical analysis might actually add value? Predictably, technical analysts are overjoyed by the partial endorsement. "I'm, like, flabbergasted," says Ralph J. Acampora, the director of technical research at Prudential Securities Inc. The chartists are particularly pleased that the project was led by Andrew W. Lo, director of MIT's Laboratory for Financial Engineering, who taught many of the finance rocket scientists now working on Wall Street. Says Acampora: "This gives the field an awful lot of credibility."
The paper, by Lo, graduate student Harry Mamaysky, and finance professor Jiang Wang (http://www.nber.org/papers/w7613), is tough slogging unless you happen to be on intimate terms with kernel regression estimators and the Kolmogorov-Smirnov test. But its basic strategy is simple. First, the authors wrote a computer program that automated the process of finding 10 of the chartists' favorite patterns. Then they turned the program loose on daily stock returns for hundreds of companies on the New York Stock Exchange, American Stock Exchange, and Nasdaq from 1962 to 1996. Out of more than 800,000 observations of raw data, the program turned up about 2,500 head-and-shoulders patterns (three peaks, the middle one being the highest), about 2,100 triangle tops (a pattern with progressively lower peaks and rising bottoms), and so on.
STARTLING RESULTS. The next step was to see how stocks performed in the period after a pattern was completed. If technical analysis were hogwash, the authors should have spotted no regularities at all--just random ups and downs.
The results were startling. The most bullish signal, the inverse head-and-shoulders pattern, produced an average 4% increase in the price of a stock on the third day after the pattern's completion. The most bearish signal, broadening bottoms, produced an average 6.2% decrease (charts). The authors also looked at other statistical measures such as standard deviation and skew and found that they also were significantly different from those of a randomly chosen day in the market.
The reason for waiting until the third day after a pattern's completion to peek at the stock performance was that in practice, it sometimes takes a day or so to recognize that a pattern has formed and to act on it. Plus, the authors figured it would be more impressive to skeptics if a stock was still moving as long as three days after a pattern's completion. While the paper reports only the one-day change, Lo says the authors got similarly impressive results when they looked at five- and 10-day returns.
INTUITIVE INPUT. So, is this bankable? The authors don't offer an opinion. The problem is that there's no agreed-upon definition of what it means to "beat the market," because of the trade-off between risks and rewards. If you earn an above-average return, but take on above-average risks in doing so, doubters will argue that your risk-adjusted return was no better than average. For instance, if a chartist-trading strategy were highly correlated with movements in the overall market, it would expose an investor to extra market risk. Rather than get into a protracted debate about what constitutes beating the market, the MIT group decided to focus on what they could clearly prove. The paper demonstrates that technical patterns do contain genuine information about what is going to happen next in the market.
To be sure, real-life technical analysis isn't as pure as the MIT research. Flesh-and-blood chartists operate heavily on intuition. They often don't agree on whether a particular pattern exists or even what it signals if it does exist. They'll frequently walk both sides of the street, predicting that stocks will fall in the short term but rise in the long term, or vice versa, without precisely defining long or short. "You scratch three technical analysts, you'll get four opinions," says Mike Epstein, the Boston-based director of quantitative trading for NDB Capital Markets.
There is, for example, no consensus among technical analysts about where today's gyrating stock market is headed in the coming days. In the middle of the Nasdaq Composite Index's roller-coaster ride on Apr. 4, Acampora said, "I don't think it's over for the Nasdaq necessarily," but added that "if they can blow out some more of these stocks, you'll get to the capitulation phase," in which stocks touch bottom and rebound. Epstein said, "I'm looking for a trading rally very shortly, maybe even right here," but warned that he might well change his mind the next minute.
PROFITABLE PATTERNS. Despite the theatrics surrounding technical analysis, Lo thinks it works because it provides insight into some of the key forces that determine prices, such as the warring forces of fear and greed. Since markets are made up of real people, not economic automatons, psychological concepts used by technical analysts such as "resistance levels," "support levels," "overbought," "oversold," and "momentum" can have real meaning. Lo says that technical analysts "have been doing informally and intuitively what academic economists do"--namely, measuring the forces of supply and demand.
Ultimately, Lo hopes to use computers to detect new patterns that are better indicators of the stock market than the ones handed down from generation to generation of technical analysts. He acknowledges that any pattern will eventually be arbitraged away, but believes that "the arbitrage itself can create new ones....There might be two heads and three shoulders--some pretty bizarre Quasimodo figures." As Lo sees it, the trick is to develop tools that find exploitable patterns before others do.
Lo says he and his co-authors have been approached about commercializing their work, but they aren't looking to go into technical analysis full-time. "We actually like being academics a lot," he says. On the other hand, Lo isn't completely immune to the lure of money. He said he's still curious about whether technical analysis really can beat the market after adjusting for risk--a question that his latest paper doesn't attempt to answer. If he and his colleagues discover that it can, he says, "We might never publish that paper." Now, there's a professor with a good head on his shoulders.