April 10, 2009
As the days of easy profits in one way markets comes to an end, fundamental analysis is once again in vogue among managers and analysts. All this is emphasized by a recent report at Bloomberg on how certain Japanese hedge funds were able to beat the horrendous markets of last year by doing away with technical analysis, and holding old fashioned meetings with company management. This is a trend that is going to intensify and strengthen with the passage of time, but technical analysis will maintain its popularity among traders as a predictive method, due to the large infrastructure that exists to support its use.
Technical analysis (and its more sophisticated cousin, quantitative analysis), both are predicated on the notion that markets discount all available information to market participants. Markets indeed discount most, if not all of the information available, but the problem arises out of the weightings attached to each piece of data can alter the outcome of these studies massively. The market discounts rumours, unrevised data, high and low frequency information with equal avidity, and weighs them depending on the mood and attitude of the day. Thus, the picture painted by the markets is similar to a cubist painting, rather than a clear descriptive one depicting the situation as it is. It is clear that the discounting mechanism of the markets is a deeply flawed one, but that dfoesn’t mean that there’s a better method, medium for pricing assets.
Technical analysis assumes that historical prices offer guidance on future price movements. Instead, most scientists believe that stock prices possess the Markov Property. In other words, all one needs to know to guess the future price is the price of today, with everything before that completely irrelevant to future price action. Indeed, experience tells us the same too: how many times has the trader seen breakouts occur without absolutely no hint on the previous price action?
Technical and quantitative analysis both discount fat tails of the probability distribution as improbable. On the other hand, experience clearly shows that spikes and collapses are the most common feature of the markets, with periods of calm being the exception. These periods usually emerge as a result of non-market influences, such as government action, or central bank expansion of the money supply.
The predictive power of technical analysis is as limited as that of astrology. It’s effectiveness is as limited as that of gambling strategies in the long term. Confidence and success are the greatest rewards of trading. But confidence and success are the enemies of technical analyst, since he believes that success and failure come in strings.