The Logic Behind Technical Analysis

Copyright 2006 Geoff Gannon
Let me first say that I do not now engage in technical analysis;
nor, have I ever engaged in technical analysis I do not believe
doing so would be a productive use of my time
Having said that, I do not claim technical analysis has no
predictive value In fact, I suspect it does have some
predictive value The Efficient Market Hypothesis is flawed It
is based upon the (unwritten) premise that data determines
market prices As Graham so clearly put it in “Security
Analysis”:
“the influence of what we call analytical factors over the
market price is both partial and indirect – partial, because it
frequently competes with purely speculative factors which
influence the price in the opposite direction; and indirect,
because it acts through the intermediary of people’s sentiments
and decisions In other words, the market is not a weighing
machine, on which the value of each issue is recorded by an
exact and impersonal mechanism, in accordance with its specific
qualities Rather should we say that the market is a voting
machine, whereon countless individuals register choices which
are the product partly of reason and partly of emotion”
I’ve seen a lot of people cite this quote, without bothering to
notice what’s really being said Graham had a very broad mind,
much broader than say someone like Buffett That’s both a
blessing and a curse At several points in Security Analysis
(and to a lesser extent in his other works), Graham can not help
but explore an interesting topic more deeply than is strictly
necessary for his primary purpose In this case, Graham could
have said what many have since interpreted him as saying: in the
short run, stock prices often get out of whack; in the long run,
they are governed by the intrinsic value of the underlying
business Of course, Graham didn’t say that Instead he chose to
describe the stock market in a way that should have been of
great interest to economists as well as investors
Data affects prices indirectly The market is a lot like a fun
house mirror The resulting reflection is caused in part by the
original data, but that does not mean the reflection is an
accurate representation of the original data To take this
metaphor a step further, the Efficient Market Hypothesis is
based on the idea that the original image acts on the mirror to
create the reflection It does not recognize the unpleasant
truth that one can interpret the same process in a very
different way One could say it is the mirror that acts on the
original image to create the reflection In fact, that is often
how we interpret the process We say an object is reflected in a
mirror We rarely use the active “an object reflects in a
mirror”
For some reason, when we talk about the market we like to use
inappropriate metaphors We talk about wealth being destroyed
when prices fall Yet, no one talks of wealth being destroyed
when the price of some product falls When the market rises, we
talk about buyers, as if there wasn’t a seller on the other side
of the trade Above all else, we talk about “the market” not as
a mere aggregation of trades, but as some sort of object all its
own
The Efficient Market Hypothesis does not recognize the true
importance of interpretation Saying that data (publicly
available information) acts on market prices omits the key step
After all, the same data is available to every blackjack player
Casinos just don’t like the way a card counter interprets that
data
The Efficient Market Hypothesis is not the only argument against
technical analysis There is also empirical evidence that
questions the utility of technical analysis However, empirical
evidence alone is not sufficient to prove technical analysis has
no predictive power If most knuckleball pitchers had limited
success, the knuckleball might be an inherently ineffective
pitch, or there might be a better way to throw it The same is
true of technical analysis
The adjective “random” is a very strange word Although it is
rarely the definition given, the most appropriate definition for
random would have to be “having no discernible pattern” The
word discernible can not be omitted If it is, we will take too
high a view of science and statistics There’s a great
introduction to economics written by Carl Menger which begins:
“All things are subject to the law of cause and effect This
great principle knows no exception, and we would search in vain
in the realm of experience for an example to the contrary Human
progress has no tendency to cast it in doubt, but rather the
effect of confirming it and of always further widening knowledge
of the scope of its validity”
All things are subject to the law of cause and effect;
therefore, nothing is truly random A caused event must have a
pattern – though that pattern needn’t be discernible Even if
one argued there is such a thing as an uncaused event, who would
argue that stock price movements are uncaused? We know that they
are caused by buying and selling Stock prices are the effects
of purposeful human actions Several sciences study the causes
of purposeful human action; so, it would be hard to argue any
human action is uncaused Furthermore, each of our own internal
mental experiences suggests that our purposeful actions have
very definite causes We also know that the actions of some
market participants are based in part on price movements Many
investors will admit as much They may be lying But, there is
plenty of evidence to suggest they aren’t
If the actions of investors cause price movements, and past
price movements are a partial cause of the actions of investors,
then past price movements must partially cause future price
movements
Technical analysis is logically valid Not only is it possible
that some form of technical analysis might have predictive
power; I would argue it necessarily follows from the above
assumptions that some form of technical analysis must have
predictive power
So, why don’t I use technical analysis? I believe fundamental
analysis is a far more powerful too In fact, I believe
fundamental analysis is so much more powerful that one ought not
to spend any time on technical analysis that could instead be
spent on fundamental analysis I also believe there is more than
enough fundamental analysis to keep an investor occupied; so, he
shouldn’t devote any time to technical analysis Personally, I
feel I am much better suited to fundamental analysis than I am
to technical analysis Of course, there is no reason why this
argument should hold any weight with you I also believe there
is sufficient empirical evidence to support the idea that
fundamental analysis is a far more powerful tool than technical
analysis
Even though I believe there must be some form of technical
analysis that does have predictive power, the mental model of
investing which I have constructed does not allow for such a
form of technical analysis In other words: logically, there
must be an effective form of technical analysis, but
practically, I pretend there isn’t
Why? Because I believe that’s the most useful model One should
adopt the most useful model not the most honest model I’m
willing to pretend technical analysis does not work, even though
I know some form of it must work
Really, this isn’t all that strange In science, I’m willing to
pretend there are random events, even though I know there must
not be random events In math, I’m willing to pretend zero is a
number, even though I know it must not be a number A model with
random events is useful In most circumstances, a refusal to
allow for random events would be harmful rather than helpful
The model with random events is simpler and more workable The
situation is much the same with zero It isn’t a number To
include zero as a number, you would have to put aside the
principles of arithmetic So, we don’t do that In school, you
were taught that zero is a number, but that there are certain
things you must never do with zero You accepted that, because
it was a simple, workable model
I propose you do much the same in the case of technical
analysis You should recognize the logical validity of technical
analysis, but create a mental model of investing in which
technical analysis has no utility whatsoever

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