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[Shaw] We (technicians) really don't have the answers, but our craft (technical analysis)
allows us to ask questions and establish mindsets to prepare for possible future market events.
[Mark Twain] "History doesn't repeat itself, it rhymes". One should always remember that similarities may exist between various episodes, but each experience is different to some extent.
[Federal Reserve Bank of New York] "Technical analysis, the prediction of price movements based on past price movements, has been shown to generate statistically significant profits despite its incompatibility with most economists' notions of efficient markets..." (Osler and Chang, Staff Report No. 4, 1995).
[Hussman] One of the key elements of a sound investment approach is the recognition that market action conveys information. The best indicators of oncoming economic conditions are not statistics such as employment, GDP or industrial production, but market action reflected through risk spreads (the difference in yields between risky corporate bonds and default-free Treasuries), stock prices, currency markets, yield curves, and other forward-looking indicators. That said, investors put themselves in jeopardy when they rely on any indicator or model without a firm understanding of why it should be useful, and the mechanism behind it. Investment decisions made without this understanding are not based on analysis, but on superstition.
[Edwards and Magee] "The market price reflects not only the differing fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers, but it also reflects their needs and resources - in total, factors which defy analysis and for which no statistics are obtainable. These are nevertheless all synthesized, weighted and finally expressed in the one precise figure at which a buyer and seller get together and make a deal. The resulting price is the only figure that counts. It is futile to assign an intrinsic value to a stock certificate. One share of US Steel, for example, was worth $261 in the early fall of 1929, but you could buy it for only $22 in June 1932. By March 1937 it was selling for $126 and just one year later for $38. This sort of thing, this wide divergence between presumed value and intrinsic value, is not the exception, it is the rule, it is going on all the time. The fact is that the real value of US Steel is determined at any give time solely, definitely and inexorably by supply and demand, which are accurately reflected in the transactions consummated on the floor of the exchange".
[Dolefin] "It is crucial to keep in mind that Technical Analysis is not an exact science. Rather, TA deals with probability distributions and as such leaves room for unexpected counterproductive outcomes. This means that a strict and rigorous discipline is a must in the practical use of technical analysis. The advantage of TA in contrast to the fundamental approach is that the decision of maintaining or abandoning an active scenario depends on rather exact criteria that can improve or deteriorate decisively with every single price change. It is not necessary to wait for the outcome of fundamental figures that are already out-of-date at the time of their release".
[Bill Miller] "There was some interesting work by a scientist named Blake Lebaron, who was affiliated with the Santa Fe Institute. About ten years ago, he studied a number of technical trading rules. Most market professionals, value investors and finance professors think that technical trading doesn't work. If it did work, then there should be a lot of technical traders who are making a lot of money, but it is very difficult to find many of these people. Blake found that there were some technical trading rules (not very many) that worked. The most powerful of these was Simple Moving Averages. He published this in a very well-known paper. About two or three years ago, a few academics decided to re-look at Lebaron's work in light of new developments in statistics since his time. They wanted to test his methodology using the latest statistical tools. Lo and behold, his methodology and data all checked out! They decided to update his study to today. When they looked at the more recent data, however, they discovered that his technique stopped working about a month after he published it. They went on to test roughly 1,100 technical trading rules and discovered that not one of them produced any excess returns. Markets are remarkably efficient".

[Shaw] Success in the stock market comes by minimizing risk. But, unfortunately, many look at the market from the viewpoint of reward only, sometimes taking unnecessary risk to achieve it. Buying a stock with apparent strong fundamentals and little regard for the stock's technical position can easily result in a quick loss. Many stocks can "top-out" when, as the saying goes, "business couldn't be better". On the other hand, undue risk is also taken when making a commitment strictly on technical grounds. Many good-looking stocks have fallen out of so-called base formations due to an unexpected poor earnings report. Therefore it seems logical that a combination of both types of securities analysis should result in better decision making and the results that follow. Since technical analysis is primarily a timing tool, it could be said that fundamental analysis represents the "what" input, while technical analysis is the "when". (Warren Buffet had noted as early as in 1966: "The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right", oded)

Cutting losses short is crucial for long-term investment success. We have often referred to a simple philosophy whereby we look at our decision making as an exercise that can result in only one of five eventual outcomes. We can experience an unchanged position, a large profit, large loss, small profit, or a small loss. If we can possibly eliminate one of these outcomes, obviously the large loss, then we are merely left with the other four. Over a number of years the small profits, losses and unchanged positions will "offset" each other. Therefore we are left with the enjoyment of occasionally booking the large profit. Many technical methods can be employed as long-term disciplines to guard against the large loss. We are sure that other analytical inputs can be loss-inhibiting procedures as well, but the author believes the technical approach seems to lend itself quite readily to such an application.

Technical analysis is based upon the study of supply and demand, or the price movements within the general stock (or other) market's framework. Although the market is, of course, concerned with day-to-day business developments and worldwide news events, it is primarily concerned with future expectations. In this regard, the market is therefore looked at as more of a barometer than a thermometer. Specifically, it has not been uncommon to witness a stock rising in a viable uptrend when current news concerning the company is not all that positive. By the same token, one can witness a stock initiate a major downtrend while earnings are most favorable. To carry our thesis a step further, it would be most uncommon to witness a stock begin a major upside just before earnings start to deteriorate. The reverse oddity would occur if a stock commenced a major downtrend just before earnings began to show substantial recovery.

The technical study of price in evaluating the force of supply and demand does not immediately presents the reason why a trends exists. Since the market is a discounting mechanism, those reasons are unlikely to clearly emerge until many months, even years, later (Historically, the equity market tends to lead, improving in advance of the economy. Over the past 80 years, the Dow Jones Index has bottomed from 3 to 9 months ahead of an economic recovery. The average lead time for the Dow to turn up before the end of recessions has been 5.2 months).

Let us review what we consider to be the three basic and necessary assumptions regarding technical analysis:

Assumption 1: In Price there is Knowledge
The market and/or an individual stock acts like a barometer rather than a thermometer. Events are usually discounted in advance with movements likely the result of "informed" (not to be confused with an insider) buyers and sellers at work. We should never forget, as we explore the technical implications of market analysis, that the price formations or patterns (as they are called by some) that evolve due to supply/demand behavior are, for the most part, the result of fundamentalists, speculators, technicians, or whomever, putting their money to work based upon their established convictions. Market (and stock) tend to move to extremes in a psychological sense. On one end, you have "greed", which is normally associated with a top (nobody left to buy), while on the other extreme you have "fear" (nobody left to sell). One technical theory that we have supported concerns the "five-leg" pattern associated with a major trend, up or down. As the discounting mechanism matures, and more believers emerge to support a major trend, eventually the above extremes are reached. Figure 1 attempts to portray the discounting scheme. At first, as the stock begins to climb, the advance is fraught with skeptics abounding. We call this the disbelief phase (Leg 1). Profit taking develops (Leg 2), which in turn is followed by another upturn (Leg 3). By now future fundamental improvement may be more widely accepted (function of stock price?). We call this the belief leg. Another correction occurs (Leg 4) which is then followed by the "everyone's-got-to-own-it" stage (greed - Leg 5). A major bear trend develops most often with the opposite psychological implications. The stock tops out when the fundamentals look good, and begins a serious break which is not recognized by most as a new bear market (disbelief). After a brief rally, a renewed trend of deterioration commences, breaking the prior lows, and possibly accompanied by the first tangible signs of fundamental (earnings) deterioration (belief). The belief phase is finally a call to action - a recognition of risk and a reversal of the immobilizing "deer frozen in the headlight" disbelief phase. As the "belief" spreads, more and more investor participants begin to take serious action to preserve capital, and remaining positions are sold. Recognized losses are offset by profit taking anywhere that gains remain in place, putting all equities at risk of absolute price decline (including those that have heretofore outperformed). Usually, this stage will be expressed in media views like, "this is the worst bear market in a generation". This belief phase brings the structural bear market a step closer to its ultimate low. But there is one final, third, phase on the way down. That is the counterpart to the third and final phase on the way up, the "greed" phase, for the structural bull trend - after another short interim rally, the stock breaks down again, instituting the fear syndrome (Leg 5). The common experience is that of capitulation, when "the baby is thrown out with the bath water" in a final fury of selling (margin calls could very well play a role in such a trend, where stock is sold to meet equity requirements). The fear phase generally incorporates the final low (the first segment of the bear trend) and allows the initiation of the second segment - the "repair" years.

Assumption 2: Accumulation precedes uptrends & Distribution precedes downtrends
This assumption should not be too difficult to understand or accept as it deals with basic stock market dynamics or the law of supply and demand. First, we should define the terms that are used. We know there is a buyer for every seller of stock. But one of these forces is usually stronger or more influential - especially in the long run. For instance, if 50,000 shares of stock were to change hands on a downtick trade, especially with a concession representing a large spread from the last sale, we would consider that the seller was a stronger influence that the buyer. For, if a buyer (or buyers) were all that anxious to purchase the stock, it would be logical to expect that the trade would have taken place with little or no concession of price at all. In periods of a more vibrant market atmosphere, a trade would, in all likelihood, occur on an uptick. A major concession in price on a large block trade is usually looked upon as evidence of distribution, and it can be a sign of the stock moving from strong to weak hands. Accumulation by definition occurs when a stock moves from weak to strong hands or, more importantly when supply is eliminated from the marketplace. Such a trade could take place on an uptick in price. Our second assumption reads: before a stock experience a markup phase, whether it be minor or major, a period of accumulation usually will take place. Conversely, before a stock enters into a major or minor downtrend, a period of distribution usually will be the preliminary occurrence. Accumulation or distribution can occur within neutral trading trends. Accumulation is often referred to as the building of a "base", while a trend of distribution is also call a "top". Obviously an uptrend in prices denotes on-balance buying, while a downtrend is indicative of extreme supply. The ability to analyze accumulation or distribution within neutral price patterns is a price technical challenge. It can allow a technician to anticipate a move, rather than wait to react to a "breakout".

Assumption 3: The Bigger the Base, the Higher in Space...
This third assumption is tied into the first two discussed. It is an observation that can be readily made by any student willing to expend the time and effort. It deals with the scope and extent of market movements in relation to each other. As an example, in most cases, a short phase of stock price consolidation - or backing and filling - will be followed by a relative short-term movement, up or down, in the stock's price. On the other hand, a larger consolidation phase can lead to a greater stock price move. Figure 2 should aid in the understanding of this assumption. In Example A, the minor downtrend movement in price was followed by a short-term consolidation phase before the stock began to move up once again. In Example B, however, the downside adjustment was somewhat more severe than in the former case and thus the consolidation pattern was slightly longer in perspective. Example C is an extreme, reflecting a major downward trend. Simply stated, when the bulldozer, crane, steel ball, and wrecker visited this scene, it took longer for the masons, plumbers, carpenters, and electricians to accomplish their rebuilding process (see also end note *, oded); the consolidation pattern was of longer duration. Assumption 3 therefore states: Usually, movements in the market tend to have a relationship to each other - "the bigger the base, the higher in space; the bigger the top, the bigger the drop; and the bigger the drop, the longer the need for repair".

* Why does it take so long to rebuilt the damage? Arnold Van den Berg of Century Management explains the fundamental basis of Shaw's observations, as follows: Rebuilding takes so long because debt has to be liquidated and paid off, companies have to be restored and the excess capacity that was built up, has to be used up. So it takes many years, when you have bubbles, to bring things back.

Smoke and Mirrors? Charting and Technical Analysis
Both the anecdotal and the empirical evidence seem to suggest that investors often are irrational, at least based upon the economic definition of rationality. Consolidating all of the irrationalities that have been attributed to financial markets, we have created five groupings:
1) Market participants over react to new information.
2) Market participants are slow learners.
3) Investors change their minds frequently and often irrationally, causing significant shifts in demand and supply, causing prices to move.
4) There are a group of investors who lead markets, and finding out when and what they are buying and selling can provide a useful leading indicator of future price movements.
5) There are external forces that govern up and down movements in markets that override fundamentals and investor preferences.

If we were to summarize the assumptions that underlie technical analysis, we would list the following:
1) Market value is determined solely by the interaction of supply and demand.
2) Supply and demand are governed by numerous factors, both rational and irrational. The market continually and automatically weighs all these factors.
3) Disregarding minor fluctuations in the market, stock prices tend to move in trends that persist for an appreciable length of time.
4) Changes in trend are caused by shifts in demand and supply. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself. This is at the core of technical analysis. Charts, the believers argue, send advance warning of shifts in demand and supply in the form of price and volume patterns.

Charting and Technical Analysis, Damodaran
The Basis for Price Patterns: 1. Investors are not always rational in the way they set expectations. These irrationalities may lead to expectations being set too low for some assets at some times and too high for other assets at other times. Thus, the next piece of information is more likely to contain good news for the first asset and bad news for the second. 2. Price changes themselves may provide information to markets. Thus, the fact that a stock has gone up strongly the last four days may be viewed as good news by investors, making it more likely that the price will go up today then down".

An Evolutionary Approach to Technical Trading and Capital Market Efficiency, Rode, Parikh, Friedman and Kane, 1995
"Because investors are prevented from making optimal decisions they must use heuristic rules to guide their decision making. This does not mean that their decision making is random or that it is doomed to failure. In many cases, humans using heuristic rules can perform quite well. This is the foundation of the theory: technical trading rules represent efficient heuristic rules which can be used to make reasonably good investing decisions. The object of technical analysis is to predict a complex time series with one which is easier to calculate and forecast. This is exactly the essence of simplifying heuristic behavior: substitution of the less complex for the intractable. Thus technical trading represents a "rational" choice for boundedly rational investors. Technical trading can allow investors to make reasonably well-informed decisions with relatively small information processing costs. Various work has been done on the predictive power of technical analysis (e.g., Neftci, 1991; Blume, Easeley, and O'Hara, 1994) and the results have generally been supportive of the technical rule approach. It is clearly conceded that technical analysis doesn't not produce optimal results".
Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation, Lo, Mamaysky and Wang, 2000
Technical analysis, also known as "charting", has been part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of technical analysis - the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition using non parametric kernel regression, and apply this method to a large number of U.S. stocks from 1962 to 1996 to evaluate the effectiveness to technical analysis. By comparing the unconditional empirical distribution of daily stock returns to the conditional distribution - conditioned on specific technical indicators such as head-and-shoulders or double bottoms - we find that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value".
Does Intraday Technical Analysis in the U'S' Equity Market Have Value?, Marshall, Cahan and Cahan, 2006
This paper investigates whether intraday technical analysis is profitable in the U.S. equity market. Surveys of market participants indicate that they place more emphasis on technical analysis (and less on fundamental analysis) the shorter the time horizon; however, the technical analysis literature to date has focused on long-term technical trading rules. We find, using two bootstrap methodologies, that none of the 7,846 popular technical trading rules we test are profitable after data snooping bias is taken into account. There is no evidence that the market is inefficient over this time horizon. (see 2008 extended study)
How to reconcile Market Efficiency and Technical Analysis, Ilinskaia and Ilinski, 1999
"Weak form of the Efficiency Market Hypothesis says that the all relevant information came from historical data is encoded in the current price and, hence, the only ingredient which is able to influence the future prices is a new information. The information is unpredictable and random. This excludes predictions of future market movements from historical data, i.e. makes the technical analysis out of law. However the technical analysis is widely used by traders and speculators who steadily refuse to consider the market as a "fair game" and survive with such believe. In the paper we make a conjecture that TA and EMH correspond to different time regimes".
The Mechanisms of Market Inefficiency: An Introduction to the New Finance, STOUT, 2004
"During the 1970s and early 1980s, the Efficient Capital Market Hypothesis (ECMH) became one of the most widely-accepted and influential ideas in finance economics. More recently, however, the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This Article argues that the weaknesses of efficient market theory are, and were, apparent from a careful inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of market phenomena inconsistent with the ECHM can be explained using market models that modify these three assumptions. In illustration, this Article explores three important strands of today's finance literature: (1) the expanding body of work on asset pricing when investors have heterogeneous expectations; (2) recent theoretical and empirical scholarship on how and why arbitrage may move certain types of publicly available information into price more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in behavioral finance, which examines what happens to prices when market participants do not all share rational expectations. Taken together, these three bodies of work show signs of providing the essential framework on which can be built a new and more powerful working model of securities markets".
The Value of Technical Analysis, Roberts, 2002
Even though there is little academic research that supports the usefulness of technical analysis, its use remains widespread in financial markets. One explanation previously offered is the ability of technical methods to identify periods of high volatility. The results indicate that highly risk-averse agents could significantly benefit from technical strategies.
In Defense of Technical Analysis: Discussion, SORENSEN, 1985
"This paper has shown that past prices, when combined with other valuable information, can indeed be helpful in achieving unusual profit. However, it is the nonprice information that creates the opportunity. The past prices serve only to permit its efficient exploitation".
Partial Revelation of Information in Experimental Asset Markets, COPELAND and FRIEDMAN, 1991
"The logical basis for technical analysis is that shifts in asset supply or demand are not instantaneous but rather take some time to complete themselves. Technical indicators are intended to detect such shifts while they are still underway".
Foreign Exchange Rate Forecasting Techniques: Implications for Business and Policy, GOODMAN, 1978
"On average, the economics-oriented services do rather poorly over the relatively short-time horizon considered in this study. All the technically-oriented services do remarkably well. The average performance of the poorest technically-oriented services is far better than the average performance of the best economics-oriented services".
Technical Analysis in the Foreign Exchange Market: A Layman's Guide, NEELY, 1997
"The weight of the evidence now suggests that excess returns have been available to technical foreign exchange traders over long periods. Risk is hard to define and measure, however, and this difficulty has obscured the degree of inefficiency in the foreign exchange market. There is no guarantee, of course, that technical rules will continue to generate excess returns in the future; the excess returns may be bid away by market participants. Indeed, this may already be occurring".
Naive Trading Rules in Financial Markets and Wiener-Kolmogorov Prediction Theory: A Study of "Technical Analysis", NEFTCI, 1991
"Even if the rules are well defined, technical analysis can only work if the processes driving the market are nonlinear".
Exploring the Fuzzy Nature of Technical Patterns of U.S Stock Market, Dong and Zhou
"Technical analysis has been a part of financial practice for many decades. One of the most challenging areas in technical analysis is the automatic detection of technical patterns that are similar in the eyes of expert investors. In this paper, we propose a fuzzy logic based approach for technical analysis. By introducing the inter & intra fuzzification into an automatic pattern detection and analysis process, we incorporate human cognitive uncertainty into the technical analysis domain".
[Cutler et al.] Several studies of asset pricing have challenged the view that stock prices movements are wholly attributable to the arrival of news. The apparent absence of fundamental economic news coincident with the dramatic stock market movements of late 1987 is particularly difficult to reconcile with the standard view - that fluctuations in asset pricing are attributable to changes in fundamental values. Our results suggest the difficulty of explaining as much as half of the variance in aggregate stock prices on the basis of publicly available news bearing on fundamental values. Volatility may reflect changes that take place in average assessments of given sets of information regarding fundamental values as investors re-examine existing data or present new arguments. Small changes in the supply of or demand for securities can have large effects on prices. If many investors accept market prices as indicators of value and so do not trade on the basis of their own assessment of values, market values will be more susceptible to those who trade on the basis of their own opinions.
Stock trade patterns could predict financial earthquakes, MIT News, 2003
Large-scale events in the stock market adhere to distinct patterns. The patterns found by the scientists are "power laws", which describe mathematical relationships between the frequency of large and small events. In short, the scientists have shown that stock markets have a mathematical elegance frequently found in natural systems. "We have found that the artificial world of the financial markets follows a pattern similar to one found in our natural world. Trading on the stock market has a lot of randomness, but at the end of the day you find that a pattern emerges that matches power-law patterns found empirically in data from systems as diverse as earthquakes and human language. The scientists show that--for the market as a whole and for an individual stock--the daily volume of stocks traded, number of trades and price fluctuations follow power laws. For example, the number of days when a particular stock price moves by 1 percent will be eight times the number of days when that stock moves by 2 percent, which will in turn be eight times the number of days when that stock moves by 4 percent, which will in turn be eight times the number of days that stock moves by 8 percent, and so on". see the Nature article
המונופול על המידע, איתן אבריאל, דה-מרקר, 29/3/2004
"הבנקים הגדולים, למשל, יודעים טוב יותר מאחרים מה קורה בשוק, מכיוון ששטף הפעולות שהם מבצעים מול הלקוחות שלהם, מול הבנקים הזרים ומול הבנקים המקומיים מספק להם מידע עודף על הלך הרוחות הכללי, וגם על קיומם של מוכרים או קונים גדולים העשויים להשפיע על שער הדולר בכיוון זה או אחר. ככל שהבנק גדול יותר והיקף הפעילות שהוא מבצע גדול יותר - כך המידע שבידיו רב יותר, ולכן סיכוייו לסיים את יום המחר ברווח טובים יותר. כך ברור שכל שחקן ... סובל מנחיתות מידע, שתבוא במקרים רבים על חשבונו".