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The usefulness of technical analysis

How efficient are the TA investors?


Xuancheng Li

ABSTRACT In this paper, I first outline the definition of Technical analysis and briefly illustrate the assumptions of it. Then I will move on to balance the pros and cons of TA and give the empirical evidence. In conclusion, in my point of view, TA is relatively less efficient than the fundamental strategies which been introduced by Graham Dodd in his book Security Analysis.

Introduction Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.(Murphy 1999). Where market action refers to price, volume and open interest. In contrast to fundamental analysis, technical analysis does not focus on the value of the company or a commodity. Technicians are likely to pay attention to the movement of price in the market. Therefore, there are some assumptions that followed by the TA investors. Firstly, market action discounts everything, for example, anything that cam affect price is already reflected in the market. Investors who follow this strategy are likely to estimate the demand and supply of one or many commodities and determine its/ their prices. The second assumption is that TA investors assume history repeats itself, that means the price pattern retain usefulness over time. The importance of Technical Analysis Firstly, technical analysis investors have used a wide range of tools and philosophies that include moving average and candlestick charting. Therefore they only need to focus on the past price and relevant statistics, this can reduce the time consumption, which is a crucial element in investing. Secondly, in contrast to fundamental investors, technical analyst are less dependent on financial statements, which include things like cash flow, balance sheet and income statement. This is also a key advantage of TA investors that save them an enormous amount of time and money where fundamental investors have to pay for. Thirdly, in some markets such as foreign exchange market, technical analysis investors are more popular because the movement of currencies is likely to examine by investors by investigating on their patterns. As most of the technical analyst are rule-based, they are more likely to make profits in such markets because the charts will reflect the information on the market efficiently that will further prevent them from making a loss. The criticisms of Technical analysis

It appears there are some of weaknesses of TA analysts, as its assumptions cannot be held. Firstly, under the EMH weak form assumptions, the market has the ability to adjust itself from all information that available in the market. Therefore, technical analysis techniques will not be able to consistently produce excess returns. In the semi-strong form efficiency, both of TA and fundamental analysis are difficult to make an excess returns. The vast majority of academics believe in at least the soft form (Fama 1970) efficiency; therefore the investors who follow this strategy will not stand in such assumptions. Secondly, do prices actually move in trends? There is some trends collection: up, down, or sideways (flat) or some combination. This mainly comes from Dow Theory which illustrate that there are three phases in trends: An accumulation phase where investors in the know are actively buying (selling) stocks against general opinion of the market; subsequently, the market catches on these investors and a rapid changes in price make it up to phase 2; lastly, the astute investors begin to distribute their holdings to the market which is phase3. There are some doubts that whether the trends exist. In my point of view, consider the rapid growth of globalization, the trends are less likely to be found by the investors because the market is completed different from the past as it include many factors that did not exist in the past. For example, many hi-tech companies went IPO last month in NASDAQ such as GROUPON and Zynga, which are two big heads in the Internet companies. However these kinds of companies only experience 10-15 years and it is difficult to find the trend behind them, as there is a lack of information in this industry. Therefore, the price trends are more difficult to follow nowadays. Thirdly, the history is less likely to repeat itself in terms of any kind of patterns. Technical analysis investors always consider the charts pattern to analysis market movement and understand trends. Although some of the charts have been used for 100 years, they are become less important as I illustrate above. A recent paper by Kim Man Lui which he used an evolutionary approach to discover association relationship between patterns within time series data. The results show that there is evidence of relationship between some of the index composite stocks, however, there is no evidence for a relationship between some index composite others. Therefore, with the market become highly correlated

between U.S. Europe and rest of the world, the history will not likely to repeat itself as it happened in the past. Lastly, high transaction will be a significant cost to investors who follow TA. Follow a paper by Wing-Keung Wong, which focus on how rewarding technical analysis is. The paper did find some positive results about Technical analysis such single moving averages is the best result followed by dual moving average. But the transaction costs are not included in the article. The common rate of commission is about 1% per trade, for some large institutional investors such like mutual funds pay about 0.5% or less. I have been trading shared for two years via HSBC and they charge the commission at 2.5% and also a sum of taxes to pay both in bulling and selling shares. Therefore if I follow the technical analysis, I will expect the return of my portfolio will above at least 3%, which makes me more difficult to use this strategy. Fundamental analysis? I have been following this particular strategy by examining the financial statements and financial environment for 2 years and I have made some return on my portfolio. By regarding to the book: Security Analysis by Graham Dodd, he encouraged investors try not to be speculators who buy and sell shares in a relatively short run such like 2 weeks or even several months. Once you turned to be a speculator, you would be driven by the profits rather than focus on fundamental so they are likely to miss opportunities in the market. Both Mr. Buffett and Mr. Graham conceded the risks as one of the most important rule under their investing philosophies. The phrase margin of safety also becomes the most popular strategy by fundamental investors; they aims not to lose money rather than some TA investors try to maximize their portfolios. Conclusion This paper balances the pros and cons of technical analysis and the evidence behind this strategy. I am strongly disagreeing with the strategies that most TA adapted. The history will not repeat by itself as more participants join in the global financial markets, more inventions

such as Internet industry has been expanding during the last 10 years. Therefore the initial assumptions cannot be held and so as the strategy. I have used the fundamental analysis for 2 years and it did produce excess return for me, so I would consider fundamental analysis is more important than technical analysis. However, maybe the best strategy is to combine these two philosophies and it seems more efficient as some mutual investors had adapted it. Reference 1. What Mr. Buffett Learned from Graham and Dodd by Richard M. Rockwood: http://www.focusinvestor.com/BuffettandGraham.pdf 2. L. Menkhoff. The use of technical analysis by fund managers: International Evidence. Journal of Banking and Finance, 34:25732586, 2010. 3. L. Menkhoff and U. Schmidt. the use of trading strategies by fund Managers: some first survey evidence. Applied Economics, 37:1719 1730, 2005. 4. The Efficient Market Hypothesis and Its Critics by Burton G. Malkiel, Princeton
University CEPS Working Paper No. 91 April 2003 5. HOW REWARDING IS TECHNICAL ANALYSIS? EVIDENCE FROM SINGAPORE STOCK MARKET Wing-Keung Wong Department of Economics National University of Singapore