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Article from current issue of Businessweek...
JW
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http://www.businessweek.com/2000/00_16/b3677113.htm
This Alchemy May Yield Real Gold
Technical analysts--the Street's soothsayers--get a vote of
confidence from MIT rocket scientists
Technical analysts don't get no respect. Academic economists
consider their game--predicting stock prices by studying
charts--on a par with examining the entrails of a freshly
slaughtered goat. Conventional economic wisdom says that
stock prices already reflect all relevant information, so
past movements are no clue to future ones. Even if stock
prices are a little predictable, say most economists, you
won't get anywhere by poring over charts for such
technical-analyst arcana as ''rising bottoms,'' ''double
tops,'' and ''head-and-shoulders formations.'' Burton G.
Malkiel, author of A Random Walk Down Wall Street, writes
that ''under scientific scrutiny, chart reading must share a
pedestal with alchemy.''
But technical analysts--also known as chartists--may yet get
the last laugh. A paper written by three authors from the
Massachusetts Institute of Technology, and recently
published by the prestigious National Bureau of Economic
Research, concludes that ''certain technical patterns do
provide incremental information, especially for Nasdaq
stocks.'' In language that's bold for academics, the paper
goes on to say that ''while this does not necessarily imply
that technical analysis can be used to generate 'excess'
trading profits, it does raise the possibility that
technical analysis can add value to the investment
process.''
Technical analysis might actually add value? Predictably,
technical analysts are overjoyed by the partial endorsement.
''I'm, like, flabbergasted,'' says Ralph J. Acampora, the
director of technical research at Prudential Securities Inc.
The chartists are particularly pleased that the project was
led by Andrew W. Lo, director of MIT's Laboratory for
Financial Engineering, who taught many of the finance rocket
scientists now working on Wall Street. Says Acampora: ''This
gives the field an awful lot of credibility.''
The paper, by Lo, graduate student Harry Mamaysky, and
finance professor Jiang Wang
(http://www.nber.org/papers/w7613), is tough slogging unless
you happen to be on intimate terms with kernel regression
estimators and the Kolmogorov-Smirnov test. But its basic
strategy is simple. First, the authors wrote a computer
program that automated the process of finding 10 of the
chartists' favorite patterns. Then they turned the program
loose on daily stock returns for hundreds of companies on
the New York Stock Exchange, American Stock Exchange, and
Nasdaq from 1962 to 1996. Out of more than 800,000
observations of raw data, the program turned up about 2,500
head-and-shoulders patterns (three peaks, the middle one
being the highest), about 2,100 triangle tops (a pattern
with progressively lower peaks and rising bottoms), and so
on.
STARTLING RESULTS. The next step was to see how stocks
performed in the period after a pattern was completed. If
technical analysis were hogwash, the authors should have
spotted no regularities at all--just random ups and downs.
The results were startling. The most bullish signal, the
inverse head-and-shoulders pattern, produced an average 4%
increase in the price of a stock on the third day after the
pattern's completion. The most bearish signal, broadening
bottoms, produced an average 6.2% decrease (charts). The
authors also looked at other statistical measures such as
standard deviation and skew and found that they also were
significantly different from those of a randomly chosen day
in the market.
The reason for waiting until the third day after a pattern's
completion to peek at the stock performance was that in
practice, it sometimes takes a day or so to recognize that a
pattern has formed and to act on it. Plus, the authors
figured it would be more impressive to skeptics if a stock
was still moving as long as three days after a pattern's
completion. While the paper reports only the one-day change,
Lo says the authors got similarly impressive results when
they looked at five- and 10-day returns.
INTUITIVE INPUT. So, is this bankable? The authors don't
offer an opinion. The problem is that there's no agreed-upon
definition of what it means to ''beat the market,'' because
of the trade-off between risks and rewards. If you earn an
above-average return, but take on above-average risks in
doing so, doubters will argue that your risk-adjusted return
was no better than average. For instance, if a
chartist-trading strategy were highly correlated with
movements in the overall market, it would expose an investor
to extra market risk. Rather than get into a protracted
debate about what constitutes beating the market, the MIT
group decided to focus on what they could clearly prove. The
paper demonstrates that technical patterns do contain
genuine information about what is going to happen next in
the market.
To be sure, real-life technical analysis isn't as pure as
the MIT research. Flesh-and-blood chartists operate heavily
on intuition. They often don't agree on whether a particular
pattern exists or even what it signals if it does exist.
They'll frequently walk both sides of the street, predicting
that stocks will fall in the short term but rise in the long
term, or vice versa, without precisely defining long or
short. ''You scratch three technical analysts, you'll get
four opinions,'' says Mike Epstein, the Boston-based
director of quantitative trading for NDB Capital Markets.
There is, for example, no consensus among technical analysts
about where today's gyrating stock market is headed in the
coming days. In the middle of the Nasdaq Composite Index's
roller-coaster ride on Apr. 4, Acampora said, ''I don't
think it's over for the Nasdaq necessarily,'' but added that
''if they can blow out some more of these stocks, you'll get
to the capitulation phase,'' in which stocks touch bottom
and rebound. Epstein said, ''I'm looking for a trading rally
very shortly, maybe even right here,'' but warned that he
might well change his mind the next minute.
PROFITABLE PATTERNS. Despite the theatrics surrounding
technical analysis, Lo thinks it works because it provides
insight into some of the key forces that determine prices,
such as the warring forces of fear and greed. Since markets
are made up of real people, not economic automatons,
psychological concepts used by technical analysts such as
''resistance levels,'' ''support levels,'' ''overbought,''
''oversold,'' and ''momentum'' can have real meaning. Lo
says that technical analysts ''have been doing informally
and intuitively what academic economists do''--namely,
measuring the forces of supply and demand.
Ultimately, Lo hopes to use computers to detect new patterns
that are better indicators of the stock market than the ones
handed down from generation to generation of technical
analysts. He acknowledges that any pattern will eventually
be arbitraged away, but believes that ''the arbitrage itself
can create new ones....There might be two heads and three
shoulders--some pretty bizarre Quasimodo figures.'' As Lo
sees it, the trick is to develop tools that find exploitable
patterns before others do.
Lo says he and his co-authors have been approached about
commercializing their work, but they aren't looking to go
into technical analysis full-time. ''We actually like being
academics a lot,'' he says. On the other hand, Lo isn't
completely immune to the lure of money. He said he's still
curious about whether technical analysis really can beat the
market after adjusting for risk--a question that his latest
paper doesn't attempt to answer. If he and his colleagues
discover that it can, he says, ''We might never publish that
paper.'' Now, there's a professor with a good head on his
shoulders.
By Peter Coy in New York
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