22 INVESTING WITH VOLUME ANALYSIS

that weren’t fundamental. And they couldn’t prosecute him

because he wasn’t regulated, he wasn’t part of a brokerage
company. The SEC came out in 1949 with a rule that all
research on Wall Street, and here’s the quote, “...has to be
rooted in sound fundamental principles.” Magee didn’t
have an MTA (Market Technician’s Association) at the time
to speak for him, didn’t have one. So from that date forward
the whole establishment says—research is all fundamental.
And as a consequence the universities started to teach their
students all these fundamental things, it was the law of the
land—you had to do the fundamentals.

Market Analysis in Today’s Efficient

Markets
The end result was a strong shift to an almost exclusively funda-
mental approach toward investing—one that mostly continues to this
day. Every year, billions of dollars are spent on investment research
for a unique interpretation of Graham’s idea of value. Cowles’s ideas
have gained so much respect that now many of his colleagues believe
that markets cannot be beaten at all by anyone. Consequently, they
advocate investing solely in market indexes.
Even the great Benjamin Graham said at a Donaldson & Lufkin
seminar in 1976, the year of his death:
I am no longer an advocate of elaborate techniques of security
analysis in order to find superior value opportunities. This was
a rewarding activity, say, 40 years ago, when our textbook Gra-
ham and Dodd was first published. But the situation has
changed a great deal since then. In the old days, any well-
trained security analyst could do a good professional job of
selecting undervalued issues through detailed studies. But in
the light of the enormous amount of research now being car-
ried on, I doubt whether in most cases such extensive efforts
will generate sufficient superior selections to justify their
cost. To that very limited extent, I’m on the side of the effi-
cient market school of thought.
CHAPTER 2 • THE HISTORY OF TECHNICAL ANALYSIS 23

Yet, market regulation now has caused the pendulum to swing

back toward the market conditions of before 1930. In October 2000,
the SEC passed fair-disclosure rules. These regulations were
intended to keep valuable insider information from reaching the gen-
eral investing public unfairly or irregularly.
But the regulations instead have caused companies to withhold
too much information from the public, in fear of violating the rules.
As a result, less information is disseminated. An article published by
the Association for Investment Management and Research (AIMR;
now the CFA Institute) states, “Companies can hide behind (Regula-
tion FD) when their fundamentals are deteriorating.” One CFA Insti-
tute respondent commented, “In the past, company management
could send signals indicating trends likely to impact results.” Another
member wrote, “Now there are complete surprises, which result in
more short-term volatility.”
Yet another member commented, “…lack of information has
resulted in more surprise announcements of revisions,” a change that
“increases the risk perception of the entire market, thereby driving
down valuations.”
In the same article, CFA Institute Senior Vice President Patricia
D. Walters, CFA, said
Clearly, many of our members feel that too many companies
are taking an excessively conservative stance and misinter-
preting the new regulation to mean that they should have no
one-to-one or small-group communication with anyone at all.
We don’t believe that that is either the intent or the wording
of the regulation. Regulation FD only prohibits selective dis-
closure or private communication of material, non-public
information. Significantly, CFA Institute’s survey of portfolio
managers shows that, since the regulations “the volume of
substantive information released by the public companies
they research has decreased.”
In addition, the methods by which the exchanges operate have
changed as well. In an effort to increase competitive pricing, the
exchanges have dropped the bid-ask spreads on securities from one-
eighth to a penny. The role of the specialist on the exchange is to keep
24 INVESTING WITH VOLUME ANALYSIS

an orderly market. When spreads were large, specialists had plenty of

room to operate and to profit from the spread.
However, there is little room when the gap is one cent. Conse-
quently, the specialists attempt to profit by facilitating large block
trades and by taking advantage of their prime view of the order flow.
But what happens when the order flow becomes one-sided, as in the
“flash crash” of May 6, 2010? The uniquely advantaged floor brokers
are no longer compensated to absorb the risk of potential losses of
stepping in order to stabilize the market.
As the crash unfolded, orders left the exchange and were routed
to digital exchanges. These exchanges pride themselves on fast execu-
tion. Filling orders at lightning speed is great, but when the orders
are all one sided, what happens next is a disorderly market, as demon-
strated by the dramatic dive and no-less-dramatic rebound that
occurred that day, which temporarily vaporized $1 trillion in wealth.

Contrasting the Ages

It’s important to understand the difference between the market
of Charles Dow and William Peter Hamilton and today’s markets. In
Dow’s time, the companies that comprised the market were under-
regulated. This resulted in information being held closely, resulting in
an uninformed public. Today, the markets are over-regulated, result-
ing in information being closely held for fear of punishment.
Before, the exchanges were under regulated, resulting in bizarre
runs and disorderly markets. Today’s tight regulations and tight
spreads also have resulted in the risk of disorderly markets, as evi-
denced by the flash crash.

Setting the Record Straight—Dow Theory

Strikes Back
According to Graham, the markets were inefficient in Dow’s time,
resulting in many opportunities for value investing. Modern markets,
according to Graham, are efficient, resulting in fewer opportunities to
invest in misvalued stocks. Few dispute that today’s markets are at risk
CHAPTER 2 • THE HISTORY OF TECHNICAL ANALYSIS 25

of sudden disorder. If you are to accept Graham’s view that few value
opportunities remain, the result is that today you have an ideal climate
for employing a technical risk-management approach to the markets.
But what about Cowles’s claim that technical analysis did not
work for Hamilton?
It took several decades, but Yale finally got it right. In 1998,
Stephen J. Brown of the New York University Stern School of Busi-
ness and William N. Goetzmann and Alok Kumar from the Yale
School of Management conducted their own in-depth study on
Cowles’s evaluation of Hamilton’s work. They concluded, “a review of
the evidence against William Peter Hamilton’s timing abilities sug-
gests just the opposite—his application of the Dow Theory appears to
have yielded positive risk-adjusted returns.”
The researchers also noted other points of interest. First, the
index Cowles created was a different set of stocks from the invest-
ments chosen for Hamilton’s portfolio. If Cowles had given Hamilton
the benefit of investing in the same instruments as he had chosen for
his own portfolio, then the annual rates of return would have been
essentially identical, 10.73 percent versus 10.75 percent.
The study’s second issue with Cowles’s work proves that when
comparing a fully invested portfolio to an actively managed portfolio
neglects the factor of risk. According to Cowles, Hamilton would be
long only 55 percent of the time, out of the market 29 percent of the
time, and short the market 16 percent of the time. Therefore, the risk
incurred between the two portfolios would not be the same. On a
risk-adjusted basis, “the Hamilton portfolio has a higher Sharpe Ratio
(0.559 compared with 0.456) and a positive Jensen’s Measure of 4.04
percent—more than 400 basis points per year. This high Jensen’s
Measure is due to a beta of 0.326 with respect to the S&P 500 index,”
according to Brown, Goetzmann, and Kumar. In translation, Hamil-
ton’s portfolio took significantly less risk in producing its returns.
In addition to these points made by the researchers, note that the
study was done and ended in the midst of a strong bull market. This
greatly benefited Cowles’s fully invested portfolio. The researchers
26 INVESTING WITH VOLUME ANALYSIS

point out that Hamilton decisively beat Cowles until the market
became excessively bullish in 1926 (see Figure 2.1).

(Source: The Dow Theory: William Peter Hamilton’s Track Record Reconsidered, William N.
Goetzmann [Yale School of Management] and Stephen J. Brown [Leonard Stern School of
Business, NYU].)

Figure 2.1 Dow theory versus Cowles’ stock index.

Given these successful bear calls and the lower risk assumed in
Hamilton’s portfolio, one can wonder what would happen in a secular
bear market, such as from 1929 to 1947. According to the researchers,
“Hamilton appears to have been extremely successful in his bear
calls.” Armed with this knowledge, who would you want managing
your portfolio today, Hamilton or Cowles?