From the October 2010 issue of Research Magazine • Subscribe!

October 1, 2010

Just Technicalities?

Technical analysts, lumped together with tea-leaf readers and derided by academics, are here to stay.

The late Nobel Prize-winning economist Paul Samuelson, key figure in his profession and author of its biggest-selling textbook, wrote scornfully about "gypsy tea-leaf readers, Wall Street soothsayers and chartist technicians." He referred to technical analysts' efforts to anticipate financial price moves based on charts of earlier market data as "esoteric," and he did not mean that in a good way.

Technical analysis flew in the face of the efficient-markets hypothesis, which dominated late-20th-century academic finance, and which Samuelson helped develop. If markets rapidly assimilate information relevant to prices, as the hypothesis holds, then prices would move in a "random walk" based on unexpected events. Such randomness, in this view, would defeat any efforts to extrapolate the future by charting the past.

The attitude of academic finance theorists toward technical analysis often has been likened to that of astronomers regarding astrology. But whereas astronomy Ph.D.s still show approximately zero interest in horoscopes, technical analysis increasingly has gotten some recognition -- as at least worth discussing, if not embracing -- from the academic world.

One reason for this is that the efficient-markets view is now much-debated itself, with the alternative approach of behavioral finance gaining in attention. Another is that statistical studies of technicians' techniques have produced an ongoing back-and-forth as to whether such methods just might be profitable and under what circumstances.

An interesting question, just starting to be debated, is how behavioral finance relates to technical analysis. As both focus on investor psychology and propose departures from pure market efficiency, the two fields are sometimes seen as compatible or mutually reinforcing. However, some behavioral-finance theorists are among the skeptics of the technical approach, seeing it as itself prone to cognitive and behavioral quirks.

Some technicians, for their part, regard academic skepticism as a benefit, in that it prevents techniques from becoming too widely disseminated to remain effective. Moreover, they claim they are too busy making money in the market to worry about how they are viewed in the ivory tower. One striking aspect of the history of technical analysis is that the discipline retained considerable enthusiasm among financial professionals and the investing public regardless of the views prevailing in theoretical circles.

Technical analysis continues to evolve, with practitioners adding new indicators and patterns and delving into computerized methods (though more than a few tout the virtues of hand-drawn charts). Still, the technicians' craft is an enduring part of the financial landscape, some of its ideas stretching back not just decades but centuries. The tea-leaf readers, soothsayers and technicians that Samuelson derided are here to stay.

Early Intimations

In his 1688 Confusion of Confusions, the world's first book about stocks, Amsterdam trader Joseph de la Vega gave an inkling of the technical focus as he listed three types of factors that made prices fluctuate in Dutch East India Company shares: "conditions in India, European politics, and opinion on the stock exchange itself." The latter category, he suggested, might be so important as to swamp the first two.

In mid-18th-century Japan, a rice merchant named Munehisa Homma (also known by Sokyu Homma and other names) pioneered the use of candlestick charts, with price moves and ranges represented by bars and lines. Homma reputedly garnered vast wealth in a market of rice coupons, an early form of futures contract, and he sketched out a trading style focused on market psychology in a 1755 book titled The Fountain of Gold.

By the late 19th century, technology was making it easier for participants in financial markets in the United States and elsewhere to keep track of prices. The first stock ticker, a reconfigured telegraph machine, was put to use in 1867, and the first telephone was installed on the New York Stock Exchange floor in 1878. Before long, traders and theorists would be sifting through the burgeoning data, looking for patterns.

Charles Dow (1851-1902), who co-founded Dow Jones and was the first editor of the Wall Street Journal, developed a technical approach that came to be known as Dow Theory. He differentiated among various types and phases of market trends, and suggested high trading volume was a good sign a price movement would continue. Having developed the Dow Jones Industrial Average and the Dow Jones Rail Average, Dow discerned that a strong bull market in industrials required the rails to move up as well, usually first.

William Peter Hamilton, who became the Wall Street Journal's editor not long after Dow's death, did much to elaborate upon and popularize his mentor's ideas. His Oct. 25, 1929 editorial "A Turn in the Tide" is cited by technicians for warning of the imminent Crash. Economist Alfred Cowles took a more jaundiced view, concluding in a 1934 study that Hamilton's editorials and Dow Theory had a poor record overall. (In recent years, some academics have reassessed the record in Hamilton's favor.)

Cowles' negative review of Hamilton's record was an early sign of academic skepticism toward technical analysis. Nevertheless, Dow Theory received a growing following of practitioners, and newsletters on the subject began to appear. Meanwhile, other forms of technical analysis were being developed and gaining adherents as well.

Ideas Proliferate

In contrast to Dow's focus on broad market trends, some technicians took an interest in charting individual stocks. Richard Schabaker, an editor at Forbes and the New York Times, was a pioneer of this approach. He died young in 1935 but his methods were developed further by investors John Magee and Robert D. Edwards, the latter Schabaker's brother-in-law. Magee and Edwards' 1948 book Technical Analysis of Stock Trends became a staple of the field and is now in its ninth edition.

Diverse ideas on how to do technical analysis arose and spread in the middle decades of the 20th century. Garfield Drew, initially a bond statistician, monitored stock sentiment through ratios of buying and selling of odd lots. Abraham Cohen, a lawyer by background, refined point-and-figure charting, seeking buy and sell signals in the selective tracking of changes in price direction based on daily highs and lows.

Paul Dysart, who published a newsletter from the 1930s until his death in 1969, developed indices aimed at determining the strength of market price trends based on their correlation with volume increases or declines. George Lindsay, who wrote and advised on markets from the early 1950s into the 1980s, was a onetime commercial artist with a knack for discerning repetitive chart patterns such as "three peaks" and "domed house."

Ralph Elliott, an accountant, proposed that market prices unfold according to discernible patterns of waves and cycles, ranging in duration from minutes to centuries, and he expounded this theory in his books The Wave Principle (1938) and Nature's Law: The Secret of the Universe (1946). Elliott's approach retained some following on Wall Street after his death in 1948, and since the 1970s it has received considerable public attention through the work of market analyst and newsletter publisher Robert Prechter.

By necessity, the pioneers of technical analysis tended to be autodidactic types whose careers had begun in some other area. Over the decades, though, technicians increasingly sought to give their field a more organized and professional demeanor. In the early 1970s, a number of practitioners began holding meetings in New York, forming the Market Technicians Association as a nonprofit professional organization in 1973. In the mid-1980s, the group introduced a Certified Market Technician, or CMT, designation.

Rukeyser's Elves

Public awareness of technical analysis was long boosted by a television show that began running on PBS in 1970. This was Wall Street Week with Louis Rukeyser, which routinely provided a forum for technicians' views of the market. The program conducted interviews with leading technicians. It also had a longtime regular panelist, Robert Nurock, who maintained an index of technical indicators. Rukeyser, with characteristic whimsy, referred to these indicators as "elves" and Nurock as "chief elf."

After personal frictions with Rukeyser, Nurock left the show in 1989. He was replaced with a panel of technicians, also dubbed elves. However, while Nurock's index had won some plaudits as a forecasting tool, the new elves compiled a poor track record. Rukeyser retired the elves in 2001, not long before being pushed into retirement himself. Even so, Wall Street Week had conveyed to the public that technical analysis merited attention.

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On Speaking Terms

For decades, technical analysts and academic finance theorists rarely spoke to each other, or just spoke past each other. The academics readily dismissed the technicians' craft, and the technicians responded with similar disdain.

Today, while the two groups are not exactly close, communication is much more fluid. One sign of this was the 2009 book The Heretics of Finance: Conversations with the Leading Practitioners of Technical Analysis, by Andrew Lo and Jasmina Hasanhodzic.

Lo, a highly regarded MIT professor and director of the university's Laboratory for Financial Engineering, and Hasanhodzic, who completed her Ph.D. under his supervision, interviewed technicians including Ralph Acampora, Laszlo Birinyi and Robert Prechter. The interviews suggest a respectful curiosity on the authors' part, with receptiveness to the possibility the technicians are on to something.

Lo and Hasanhodzic have followed up with a new book The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals, just published by Bloomberg Press.

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