Thursday, April 7, 2011

Is Technical Analysis Dead?

Something very peculiar is happening with equities.

For more than a year, stocks have not performed according to technical analysis Hoyle. Stock markets have risen on far below average volume. Correlations for virtually all economic sectors and many asset classes hover just below 1.00. And many technical analysis tools have been rendered impotent. Why is this so? Perhaps the answer lies in the nature of the beast: the structure of the market.

Over the past several decades, the structure of the market has changed. In the 1960s and 70s, traditional institutional investors (mutual funds, pensions, insurance companies, and large asset managers) replaced individual investors as the dominant traders of the day. Recently, hedge funds and now high frequency traders (with algorithmic traders in tow) have supplanted traditional institutional investors as the dominant volume drivers in equities. At the same time, products and services such as dark pools, derivatives, and structured products operate outside the traditional norms of equity investing.

Yet, most investors and many in the financial media operate as though there are virtually no effects, no consequences – intended and otherwise – that have occurred in this new environment. All is as it was. Or is it?

As for technical analysis, of all the tools that have worked with a reasonable degree of accuracy, perhaps none have been impacted more by the brave new financial innovation world than sentiment indicators.

Once the bastion of sound investment strategy, the human emotions of greed and fear afforded astute investors and traders with the opportunity to exploit the polar ends of investment human behavior. Ride the greed and fear train for as long as possible then, when things go too far, shift to other side (the contrarian side) of the equation. Not easy to do but highly rewarding if done correctly. However, given the changed world equities operate in today, the question has to be asked, Do such tools work in a world dominated by black box methodologies? A financial world without humans?

When it comes human emotions such as greed and fear, does a hedge fund manager, an algorithmic trader, or a high frequency trader base their decisions on judgment? Do they feel anything? Do they get swept up in the emotional tide of the times? Or is virtually every action taken done based on a set of rules and parameters that do not rely on such human qualities?

And that brings us back to the issue of technical analysis and, specifically, sentiment indicators. Do they still work? Has technical analysis lost a key tool in its toolbox?

Based on the evidence at hand, in the case of sentiment indicators, the answer has to be yes. In the case of volume indicators, the answer is also yes. In the case of momentum indicators, the answer is no.

The one market variable that is least impacted by our financial innovation brave new world is price. And price changes over time, which is what momentum indicators are all about, are tied to the real world of valuation, which is, in turn, tied to the real economy.

Is technical analysis dead? No. But I find it hard to argue for the status quo when so much has changed. Or Keynes once said, “When the facts change, I change my mind. What do you do, sir?”

1 comment:

Ward said...

I definitely look at technical analysis in making investment decisions. Calendar effects as well.

When I do so, though, I look for something that reinforces something fundamental, whether it's spikes every three months that coincide with earnings announcements or inflows that come in line with when payroll runs occur.

The markets have definitely been evolving over the last few years, and that's certain to change some of the rules. I'm not sure most of us know what the new rules are yet, and they may change again before we figure it out...