Capitalistic Musings | Page 8

is defined thus in "The Econometrics of Financial
Markets", a 1997 textbook authored by John Campbell, Andrew Lo,
and Craig MacKinlay:
"An approach to investment management based on the belief that
historical price series, trading volume, and other market statistics
exhibit regularities - often ... in the form of geometric patterns ... that
can be profitably exploited to extrapolate future price movements."
A less fanciful definition may be the one offered by Edwards and
Magee in "Technical Analysis of Stock Trends":
"The science of recording, usually in graphic form, the actual history of
trading (price changes, volume of transactions, etc.) in a certain stock
or in 'the averages' and then deducing from that pictured history the
probable future trend."
Fundamental analysis is about the study of key statistics from the
financial statements of firms as well as background information about
the company's products, business plan, management, industry, the
economy, and the marketplace.
Economists, since the 1960's, sought to rebuff technical analysis.
Markets, they say, are efficient and "walk" randomly. Prices reflect all
the information known to market players - including all the information
pertaining to the future. Technical analysis has often been compared to

voodoo, alchemy, and astrology - for instance by Burton Malkiel in his
seminal work, "A Random Walk Down Wall Street."
The paradox is that technicians are more orthodox than the most devout
academic. They adhere to the strong version of market efficiency. The
market is so efficient, they say, that nothing can be gleaned from
fundamental analysis. All fundamental insights, information, and
analyses are already reflected in the price. This is why one can deduce
future prices from past and present ones.
Jack Schwager, sums it up in his book "Schwager on Futures:
Technical Analysis", quoted by Stockcharts.com, :
"One way of viewing it is that markets may witness extended periods of
random fluctuation, interspersed with shorter periods of nonrandom
behavior. The goal of the chartist is to identify those periods (i.e. major
trends)."
Not so, retort the fundamentalists. The fair value of a security or a
market can be derived from available information using mathematical
models - but is rarely reflected in prices. This is the weak version of the
market efficiency hypothesis.
The mathematically convenient idealization of the efficient market,
though, has been debunked in numerous studies. These are efficiently
summarized in Craig McKinlay and Andrew Lo's tome "A Non-random
Walk Down Wall Street" published in 1999.
Not all markets are strongly efficient. Most of them sport weak or
"semi-strong" efficiency. In some markets, a filter model - one that
dictates the timing of sales and purchases - could prove useful. This is
especially true when the equilibrium price of a share - or of the market
as a whole - changes as a result of externalities.
Substantive news, change in management, an oil shock, a terrorist
attack, an accounting scandal, an FDA approval, a major contract, or a
natural, or man-made disaster - all cause share prices and market
indices to break the boundaries of the price band that they have
occupied. Technical analysts identify these boundaries and trace
breakthroughs and their outcomes in terms of prices.
Technical analysis may be nothing more than a self-fulfilling prophecy,
though. The more devotees it has, the stronger it affects the shares or
markets it analyses. Investors move in herds and are inclined to seek
patterns in the often bewildering marketplace. As opposed to the

assumptions underlying the classic theory of portfolio analysis -
investors do remember past prices. They hesitate before they cross
certain numerical thresholds.
But this herd mentality is also the Achilles heel of technical analysis. If
everyone were to follow its guidance - it would have been rendered
useless. If everyone were to buy and sell at the same time - based on
the same technical advice - price advantages would have been
arbitraged away instantaneously. Technical analysis is about privileged
information to the privileged few - though not too few, lest prices are
not swayed.
Studies cited in Edwin Elton and Martin Gruber's "Modern Portfolio
Theory and Investment Analysis" and elsewhere show that a filter
model - trading with technical analysis - is preferable to a "buy and
hold" strategy but inferior to trading at random. Trading against
recommendations issued by a technical analysis model and with them -
yielded the same results. Fama-Blum discovered that the advantage
proffered by such models is identical to transaction costs.
The proponents of technical analysis claim that rather than forming
investor psychology - it reflects their risk aversion at different price
levels. Moreover, the borders between the two forms of analysis -
technical and fundamental - are less sharply demarcated nowadays.
"Fundamentalists" insert past prices and volume data in their models -
and "technicians" incorporate arcana such as the dividend stream and
past earnings in theirs.