Technical Analysis as an Indicator

Personally I'm very skeptical of technical analysis, but that's just because I am skeptical of easy answers. But try to parse this article over at bloomberg titled "Stock Charts Fail Forecast Test in Complete S&P Miss."

We begin with

Ever since the Standard & Poor's 500 Index peaked in October 2007, six of eight strategies -- which are supposed to make money whether stocks rise or fall -- failed, according to back-testing data compiled by Bloomberg. As the bear market erased $11 trillion from the value of U.S. equities, buy and sell signals from those six technical indicators produced losses of as much as 49 percent, the data show.

Spot something of interest in the wording there? The idea that the techniques used are "supposed to make money whether stocks rise or fail" is, well, a pretty high standard (especially during a 50 percent nose dive in the S&P 500.) Now move to the end of the article where some tables of data are presented:

Indicator                              10/09/2007 - 3/09/2009

Relative Strength Index                                -49.0%
Williams %R                                            -41.7%
Commodity Channel Index                                -38.7%
Parabolic Systems                                      -36.6%
Bollinger Bands                                        -31.5%
Stochastics                                            -24.1%
Directional Movement Indicator                         +24.0%
Moving Average Convergence/Divergence                  +25.9%

S&P 500                                                -56.8%

--------

Indicator                               3/09/2009 - 5/01/2009

Commodity Channel Index                                 -8.3%
Williams %R                                             -8.3%
Bollinger Bands                                         -6.6%
Stochastics                                             -3.3%
Directional Movement Indicator                          -1.9%
Moving Average Convergence/Divergence                   +7.8%
Parabolic Systems                                       +8.2%
Relative Strength Index                                +21.8%

S&P 500                                                +29.7%

--------

Indicator                              10/09/2007 - 5/01/2009

Williams %R                                            -43.1%
Commodity Channel Index                                -40.3%
Parabolic Systems                                      -34.3%
Relative Strength Index                                -34.1%
Bollinger Bands                                        -22.2%
Stochastics                                            -21.8%
Directional Movement Indicator                          +9.0%
Moving Average Convergence/Divergence                  +24.6%

S&P 500                                                -43.9%

Now there is too little detail on exactly how these strategies were back tested (for example how were transaction costs and other deadly sources of drag factored into these calculations?), but if you read that entire article, and compare the general pessimism with the actual results, there seems to me to be a bit of disconnect. What I gather from reading the above data is that during the major downward move, every single indicator strategy outperformed a major index (though some by not much), and further during the recent rebound each of the strategies underperformed the same index. Is it just me or is there some serious cognitive dissonance in this article?



But what I find more interesting is that in the last rally, the technical indicators have done down right miserably. Because my worldview is shaped by believing technical analysis is voodoo, I will hereafter use this as evidence that the markets are returning to "normal." (whatever the hell that means) :)



(The article also contains some great voodoo speak which is a requirement for all technical analysis followers: statements about the validity of the idea but only when it's valid and taken with the proper context! I could have predicted the future if only you'd let me do it from the future!)

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As with diets, the existence of so many technical analysis strategies is evidence that none of them work consistently. If one of them did, everybody would be using that strategy.

By Eric Lund (not verified) on 05 May 2009 #permalink

I would say the difference between diet plans and technical analysis is that if there was one diet that worked, everyone would be doing it, but if there was one technical analysis that worked for some portion of time, then as more started using it, it would become useless.