by Rick Ferri
Technical analysis reminds me of searching for gold at the end of a rainbow. Children of all ages are mesmerized by the story, yet no one to date has found a pot of gold. Itās not because gold isnāt there ā it most certainly exists in the mind of every child. The problem is the rainbow; itās circular, there is no end to it.
Technical analysis of the stock market is similar. A fortune awaits anyone who can analyze a price chart and accurately determine if there is a pot of gold hidden at the end. It sounds like a worthy endeavor. Unfortunately, successful technical analysis is easier believed than achieved.
Jiali Fang, Yafeng Qin and Ben Jacobsen, all from Massey University in New Zealand, recently analyzed 93 different ways investors use technical indicators in an attempt to predict the stock market as measured by the S&P 500. They documented their results in a paper titled, Technical Market Indicators: An Overview.
Their research was robust because it looked at price predictability from three angles: the total returns of each indicator relative to a buy-and-hold market; how each indicator performed during different phases in the economic cycle; and how each indicator performed based on changing market sentiment and strength.
The sample frequencies varied across the 93 indicators, with one annual indicator, 28 monthly indicators, 18 weekly indicators, and 46 daily indicators that anticipate different terms of market trends. The annual indicator (NYSE seat prices) starts in 1820 and the oldest monthly, weekly and daily indicators started in 1918, 1932 and 1938, respectively. The oldest market indicator has nearly 200 years of history and the 93 indicators have an average sample length of 54 years.
Economic cycle data was derived from the National Bureau of Economic Research (NBER).
Sentiment indicators attempt to predict market movements based on tracking the bullish or bearish psychology of the market using a composite of factors such as investor surveys and short sales data. Market strength indicators measure the breadth of market movements using an assortment of measures such as weekly highs versus lows. A full list is provided in the report.
Despite laboriously searching for an indicator that led to a pot of gold, no gold was found. None of the 93 indicators showed predictability for future stock returns. This conclusion consistently holds even when predictability was enhanced with the known states of the business cycle and sentiment regimes.
āOur preliminary analysis shows that at a conservative 10% significance level, 30 out of 93 indicators show possible predictability. However, only 10 of these remain significant after we conduct sub-sample robustness checks. Since some indicators exhibit sign-switching predictability in the sub-sample test, we employ rolling window regressions to take a closer look at the stability of indication. This further reduces the number of possible predictive indicators to eight. We then conduct economic significance tests to account for risk and transaction costs and none of the technical trading strategies beats the naĆÆve buy and hold strategy in terms of either the Sharpe ratio or Jensenās Ī±.ā
The paper concludes on an optimistic note for those who do believe there is a pot of gold waiting at the end of price charts. The researchers readily admit they may have missed a rainbow that has an end, āWith previous mixed findings on price-based technical indicators, it is still not easy to provide a simple positive or negative answer to the broad question of whether or not technical analysis is useful. Our results, at least, make the answer not inconclusive with evidence from the family of market indicators missing.ā Can you handle the truth?
Copyright Ā© Rick Ferri
