In the early 1990s, I was introduced to the efficient market hypothesis, which purports that the financial markets are efficient, in terms of information, and outperforming them on a consistent basis is not possible. Whether this is true or untrue is difficult to say. Besides, it does contain the word “hypothesis” which is synonymous with words such as theory and supposition, indicating that it is anything but a sure thing. Even so, that doesn’t stop investors from searching for the Holy Grail of investing. Is there a key to the future? Is there an indicator that can forecast what the markets will do?
In this post, we’ll look at the EMH and my favorite technical indicator.
Efficient Market Hypothesis
The EMH consists of three parts or forms. They are: Weak, Semi-Strong and Strong. The Weak form suggests that prices on traded assets reflect all past publicly known information. The Semi-Strong form suggests that prices reflect all past publicly known information and change to reflect future information the moment it’s revealed. The Strong form suggests that prices even reflect all ‘hidden” or “insider” information. Hence, proponents of the EMH believe that markets are “efficient” and instantly reflect all information. If this is true, why do technical analysts even exist?
I’ve consistently held the view that technical analysis is a reflection of what has occurred in the past. In short, you have to have data to create the graphs for technical analysis to exist. Although there is no secret key to the future of markets (ironically, if there were a secret key, then I wouldn’t know about it, since it would be a secret…..oh, the irony is thick), I still find technical analysis to be quite interesting. Here’s one of my favorite indicators.
Directional Movement Index (DMI)
The DMI is used to indicate the degree to which the market is trending, if at all. It can be used on the entire market, a single stock or an ETF. I’ve even used it on a mutual fund. It consists of two primary lines. One is +DMI and the other is -DMI. A third line is derived from these which is called the ADX or Average Directional Movement Index.
The DMI was created by Wells Wilder, a mechanical engineer who also created the Relative Strength Index, Average True Range, and the Parabolic SAR. Back to the DMI.
The market is considered to be trending whenever one of the DMI lines (+DMI or -DMI) is above the other, and also above 25 or 30 (on a scale of 1 to 100), depending on the source.
I’ve no doubt that you realize there is a mountain of information for advisors to consider when making investment decisions. As far as technical analysis is concerned, I believe there are some useful tools, but I also believe the key is to use one to confirm another. I’ll conclude with a bit more irony.
Let’s say the DMI were used by every investor. What would happen? If the market was in an uptrend, the DMI would indicate this and investors would jump in which would make the uptrend continue until a bubble was formed. Then, as we’ve seen numerous times, investors would begin to take their profits and the market would head south. In essence, the more people who rely on technical analysis, the more technical analysis will dominate market movement. However, it’s still “data after the fact.”
Thanks for reading and have a great week!