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 transactions, 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 tool. 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 accurate 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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