In fact, Burton Malkiel, author of A Random Walk Down Wall Street, said that technical analysis “shared a pedestal with alchemy.”

IS PRICE MOVEMENT RANDOM?

Looking back, it was the rise in popularity of modern finance theory in the 1960s that left technicians out in the cold. As academics embraced the theory of efficient markets and random prices little room was left for the study of charts, price and price behavior. However, in recent years, the chill in the academic community toward technical analysis is thawing as academics highlight flaws in efficient markets and random price theories.

IT'S OLD

Technical analysis may actually be the oldest form of market analysis.

After all, the Japanese were drawing prices on charts (in candlestick form) hundreds of years ago. In the 1700s in Osaka, a legendary rice trader built his fortune using this method of charting analysis.  In the United States, technical analysis can be traced back to the 1880s. The so-called "tape readers" of that time were in actuality implementing a form of price study. That early form of price analysis actually preceded traditional “fundamental” analysis as that was before annual reports, price/earnings ratios and other fundamental measures were commonly available.

GAINING RESPECT

Those who study and most importantly make money using technical analysis perhaps may say “their loss” when it comes to the academic world’s snub of technical methods. But, for those like Dangerfield who are looking for a little respect, there are signs the Profs in the ivory towers may be starting to come around.

Several years ago, the Market Technician’s Association (MTA) honored Professor Andrew Lo, from the MIT Sloan School of Management with their Recognition Award for his work toward advancing interest and research on technical analysis within academia. I had the pleasure of chatting with Professor Lo.

Lo pointed to the “cultural” gap between traditional financial analysis and technical analysis and admitted: “it is changing, but most of the academic community is skeptical of technical analysis.” I asked him why he thought this was the case. “There is a cultural bias that academics developed long ago against technical analysis. The language of technical analysis is filled with jargon, just as quantitative analysis, but the two groups never figured out how to talk to each other,” Lo said.  He pointed to an old saying: ‘progress in academics occurs funeral by funeral’ –“a certain amount of time will have to pass” before technical analysis may be fully embraced by the academic world.

However, Lo tells colleagues: “You can’t criticize it until you understand it.” He has conducted research and written papers on technical analysis (see box at bottom) in an effort to expand awareness in academia.

Lo was first attracted to technical analysis because “my mode of learning is visual. I find pictures and graphs easier to digest than numbers. The whole notion of charting seemed so odd and interesting.” He calls his interest in technical analysis a hobby and notes he has employed certain methods in his own investing.

WILL HISTORY SET THE RECORD STRAIGHT

Lo points to many areas of behavioral finance and notes that much of those roots emerge from technical analysis. Also, he highlighted Dow Theory and said: “technicians could argue that Dow Theory is based on behavior and over-reaction.” Currently, in his work, Lo is conducting historical research tracing some of these ideas back to antiquity.

IT'S ALL ABOUT PATTERNS

“Any time there are numbers, humans tend to find patterns. Pattern recognition goes back to the Babylonian times when they were tracking the stars and seasons and reading information in patterns and stars for agricultural purposes. This is where we think the origins of technical analysis lie—in that patterns contain information that can be used for planning the future.”

In Lo’s view, technical analysis is simply “the ability to use patterns in data to be able to make statements about the past and use them as guidelines for making investments for the future.” In general, the three (or four) main disciplines of financial market analysis: fundamental, technical, quantitative and behavioral are all focused on the same behavior and data. “Each one captures a somewhat different aspect of a reality we all share.”

However, Lo does believe that technicians and the field in general could benefit from application of the principles of scientific inquiry, such as hypothesis testing, controlled experimentation and the principles of statistical inference. “These are the tools any scientific discipline can use. Once technical analysts develop a deeper appreciation for these then they will be able to leverage their insights in ways they never could before,” he said.

EVOLVE OR DIE

Lo does have a warning for those in the technical field.

As individual traders are well aware the financial markets have undergone significant structural changes in recent years including the massive shift to the screen, cheaper cost of access, the implementation of automated trading, the impact of algorithmic systems, decimalization, and last but not least the mindboggling sums of speculative money that are now flowing through the financial markets chasing trends and profits, often switching gears on a nano-second’s notice.

“In my view, technical analysts can play a very important role by providing oversight and creative energy in designing automated trading systems. But, that boat is already leaving. It is important for technicians to take their place in this new world order.”

He believes that the “basics of technical analysis have not been altered by technology—and they should have been.” Lo says there is “too much low hanging fruit” out there in relation to technical analysis and technology and new advances are needed such as “coming up with technical indicators that are too subtle for the human eye to pick up on.”

YOUR EDGE

Professor Lo is optimistic for the individual trader in today’s new order of financial markets. “Look at the various options for trading cheaply and quickly. Make use of technology to develop your own trading signals and patterns.” In today’s technology laden world where cell phones, IPods, DVD players are now the norm, technical traders need to “invest more time in learning the technology [relating to trading] or get left behind,” Lo warns. If one does so there are great rewards such as “being able to integrate trading rules with execution strategies on automated platforms.”

He professes great respect for master technicians noting: “they are people who have developed a great deal of intuition about the markets. Technical analysis is a very dynamic, organic, creative process,” he said.

But, “for technical analysts to keep up with advances in technology they are going to have to change their way of thinking. A fundamental paradigm shift is needed. Technology must play an important role in defining and expanding the field. If technical analysts doesn’t evolve and innovate they’ll become obsolete and left behind,” Lo concluded.
 

This story previously appeared in SFO magazine.