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<H5>July 23, 2000</H5><br>
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<h5><font color="#ag0000">STRATEGIES</h5></font>
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<H2>The Hidden Language of the Charts</H2>
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<h5>By MARK HURLBERT</h5>
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<p> <img src="http://graphics.nytimes.com/images/f.gif"; align=left alt=F>in ance professors are by their nature a skeptical lot, but their disdain for the forecasting practice known as charting has been especially notable.
<p>
Charting is the branch of technical analysis that tries to
predict price changes in a stock on the basis of certain visual
patterns in a chart of its historical prices or volume data. In
some academic circles, charting is dismissed out of hand.
<p> But according to a new study, much of this scorn may have
resulted from a simple breakdown in communication between the
academics and the chartists. The study was prepared by Andrew W.
Lo, a professor at the Sloan School of Management at the
Massachusetts Institute of Technology; Jiang Wang, a professor of
finance at MIT; and Harry Mamaysky, a graduate student.
<p> In the past, academics didn't comprehend the chartists' argot,
which is filled with terms like "double top" -- the pattern that
is formed after two successive rallies end at more or less the same
price, which is supposed to signal weakness in a stock's share
price.
<p> If academics had only understood what the chartists were talking
about, the study contends, they might have found much with which
they could agree.
<p> Consider the following sentence: "The presence of clearly
identified support and resistance levels, coupled with a one-third
retracement parameter when prices lie between them, suggests the
presence of strong buying and selling opportunities in the near
term." That mouthful is crystal clear to a chartist but is
inscrutable, if not ridiculous, to an academic.
<p> How about this one, written in professor-speak: "The magnitudes
and decay pattern of the first 12 autocorrelations and the
statistical significance of the Box-Pierce Q-statistic suggest the
presence of a high-frequency predictable component in stock
returns."
<p> According to Lo and his co-authors, the two sides' sentences say
essentially the same thing: that past prices contain information
that may be useful in predicting future movements.
<p> Why did it take so long to discover that chartists and finance
professors may at times be basically in agreement? In part, it is
because of the difficulties of translating chartists' visual
pattern recognition into the mathematics on which academics rely.
<p> The professors believe, however, that recent advances make the
translation easier. Because charting patterns can now be expressed
in terms that academics can understand and measure, they say,
researchers can now focus on gauging which charting techniques
actually work.
<p> The authors have done so with five popular but previously
elusive chart patterns, known as head and shoulders, broadening
tops (and the related bottoms), triangles, rectangles and double
tops (and the related bottoms). After defining them mathematically,
the researchers back-tested the patterns' predictive prowess on
price data for 750 stocks over 35 years ending in 1996.
<p> One of their findings is that the patterns predict the future
direction of Nasdaq stocks better than they do exchange-listed
issues. Some that seemed to work well as buy or sell signals for
Nasdaq shares failed utterly when applied to exchange-listed
stocks. More research is needed to determine why that should be so.
<p> Of the five patterns studied, two worked particularly well with
both kinds of stocks in forecasting price weakness: double tops and
the so-called head and shoulders -- a pattern in which a stock
rallies and falls back again three successive times, with the
second of the three rallies (the head) advancing further than
either the first or the third (the shoulders).
<p> Unfortunately, Lo and his colleagues did not calculate the
returns that would have been garnered had investors bought and sold
stocks based on signals from the chart patterns. The results, they
conclude, simply suggest that charting "can add value to the
investment process."
<p> Still, from a team of academics, that's a remarkable
endorsement.
<p>
</i>Mark Hulbert is editor of The Hulbert Financial Digest, a newsletter based in Annandale, Va. His column on investment strategies appears every other week. E-mail: strategy@xxxxxxxxxxxx</i>
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