Market Technician No63

The last issue of the Market Technician went to press in the midst ofunprecedented financial turmoil. Old and respected institutionswere disappearing from the financial landscape at such an alarmingrate that some questioned whether we might not be witnessing asystematic collapse of the international financial order as we knowit. But governments around the world stepped in to underpin thebanks. However, no sooner had they had shored up the financialsector when the real economy started to buckle. The authorities arenow competing with each other to bring in the largest fiscalpackages in order to try and ward off an economic depression.

It was encouraging to see a good delegation of STA members atthe IFTA conference in Paris in November. A criticism of previousIFTA gatherings has been that they have tended to invite the samespeakers. But this years hosts, Afate, made a big effort to ring thechanges. The theme was research and analysis of financial marketswhich brought together academics and market practitioners. And,perhaps not surprisingly, this gave rise to some spiriteddiscussions. In fairness to the academics presenting papers at thisconference, they all accepted that market behaviour is totallyinconsistent with random-walk theory. But some traders found theacademics statistical analysis of historical data completelydivorced from the realities of the market and revealed a lack ofunderstanding about the underlying rationale of technicalanalysis. For example, a central bank had apparently sent out aquestionnaire asking technical analysts to come up with an end-year forecast without realising that technical analysis is essentiallya dynamic process rather than a static modelling system. For theirpart, academics were frustrated by the lack of standardisation oftechnical analysis. For example, patterns such as head andshoulders can be interpreted completely differently by differentanalysts. As scientists, academics are looking for ways to formalisethe subject so that they can measure its results but the lack ofstandardisation makes it difficult for them to do this inconventional academic terms. Looking ahead, academics are tryingto develop genetic algorithms that evolve patterns or rules that arenot currently used by technical analysts.

Tony Plummer gave an excellent talk on The logic of non-rationalbehaviour in financial markets in which he examined how themarket works as a system. As well as looking at what drives group

behaviour, he put the recent turbulence within an historicalperspective. The chart below shows how 1-day percentage changestend to cluster around a centre of gravity of relatively small moves inthe middle of the diagram. Over the past 62 years two main eventshave been outside this inner core October 1987 and October 2008.In other words, if looked at from sufficiently wide perspective,seemingly random movements assume an order or pattern. As acorollary, it is clearly possible to identify unusual events.

Overall, the Paris conference provided a forum for some veryinteresting discussions and was a useful step in developing abetter understanding of how academics and market practitionerscan work together.

The education committee under John Camerons direction havejust completed another foundation course. The course for thediploma will begin this month. The autumn Diploma exam resultedin one Distinction, 19 passes and 9 fails.

IN THIS ISSUE2 STA diploma results

3 Obituaries

4 Market forecasts for 2009 J. Nebenzahl

6 Charting the rise of technical analysis K. Edgeley

8 2009 Market perspectives T. Parker

10 Perpectives on technical analysis J. Hanahodzid

FOR YOUR DIARY10th February How to use the lesser known Tom De Mark

OscillatorsSpeaker: Trevor Neil

10th March Technical analysis art or scienceSpeaker: Tim Parker

15th April Speaker: Julien Nebanzahl

N.B. Unless otherwise stated, the monthly meetings will takeplace at the British Bankers Association, Pinners Hall, 105 -108 OldBroad Street, London EC2N 1EX at 6.00 p.m.

JANUARY 2009 www.sta-uk.org

MARKET TECHNICIANNo. 63

THE JOURNAL OF THE STA

COPY DEADLINE FOR THE NEXT ISSUE MARCH 2009 PUBLICATION OF THE NEXT ISSUE APRIL 2009

DJ Industrial Average: Jan 1946 to Nov 20081-day percentage changes

Issue 63 January 2009 MARKET TECHNICIAN2

CHAIRMAN

Deborah Owen: [email protected]

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The Barbican library contains our collection. Michael buys new books for itwhere appropriate. Any suggestions for new books should be made to him.

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John Cameron: [email protected]

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Please keep the articles coming in the success of the Journal depends onits authors, and we would like to thank all those who have supported uswith their high standard of work. The aim is to make the Journal a valuableshowcase for members research as well as to inform and entertainreaders.

The Society is not responsible for any material published in The MarketTechnician and publication of any material or expression of opinions doesnot necessarily imply that the Society agrees with them. The Society is notauthorised to conduct investment business and does not provideinvestment advice or recommendations.

Articles are published without responsibility on the part of the Society, theeditor or authors for loss occasioned by any person acting or refrainingfrom action as a result of any view expressed therein.

Distinction

C. Bain

Pass

A Al Haddad

N Al-Rantisi

T Babooa

D Binnington

C Chevalier

P Colas

D Grover

M Harniman

J Hawbrook

N Holt

S Kelly

C Manian

C Matthews

A Myers

H Rashdan

J Remington-Hobbs

N Suiffet

C Viketos

D Williams

NetworkingWHO TO CONTACT ON YOUR COMMITTEE

STA diploma resultsAUTUMN 2008

STA Diploma Course 2009The STA is again holding its Diploma course in TechnicalAnalysis at the London School of Economics in Aldwych.

All teaching is by STA members.

The course runs from: 14 January 2 April 2009

It prepares students for the Diploma examination in April 2009.The Course consists of 11 Wednesday evenings and is followedby a full Exam Preparation Day (including Report writing), onThursday 2 April 2009. The sessions are from 6.00pm to 9.00pmand the Exam Preparation Day, which includes lunch, runs from9.30am to 5.00pm. The Exam itself lasts three hours and will beheld Wednesday 22nd April 2009.

It is possible to attend individual lectures.

If you would like further information please contact Katie Abberton on

0845 003 9549

MARKET TECHNICIAN Issue 63 January 2009 3

Obituaries

Franoise Skelley 1963 2008

On rare occasions in our personal and professional lives, we meetcertain people who are unique, who make a lasting impression. Itmay be because of their fierce intelligence, their strength ofcharacter, passion for life, loyalty, or their complete sense of fun.Franoise Skelley was such a person, and she had all of thesequalities in abundance.

Fran started her career in technical analysis in the late 1980s, whenshe and her husband Steven were running a TA consultancy.However, it wasnt until she joined Credit Suisse in 1992 that shereally came to international prominence. Here she built a worldrenowned team and created many innovative technical products.

Full of energy and never afraid to state her views, Fran waspassionate about technical analysis and always looking to learnnew techniques. She was, though, equally focused on the correctand disciplined application of the core basics, and her approach tomarket analysis was rigorous and thorough, professionalism at itspeak. But her real joy was in calling market tops and bottoms,which she did on a regular basis.

Fran had a close association with the STA, where she was a memberof the forward planning and grandfathering committees, and wasan active and enthusiastic supporter of the annual dinners andconferences, where she became a recognised speaker. She also feltstrongly about IFTA, attending many of its conferences and washerself a speaker at the London IFTA conference in 2002. She wasalso a member of the American Association of ProfessionalTechnical Analysts. Fran was made a Fellow of the UK Society ofTechnical Analysts in 2005.

When speaking to friends and colleagues, words and phrases thatrepeatedly cropped up when describing Fran were: wonderful,intelligent, fun, loyal, independent, strong, passionate, forceof nature, didnt suffer fools, unafraid of anyone or anything. Shehad that rare ability to light up and enliven any event, whether aprofessional business meeting or a social gathering. For those thatworked with her, she was an inspirational colleague and a loyal andtrusted friend.

Fran was diagnosed with cancer in early 2007 and passed away inAugust 2008, after a brave fight, at the tragically young age of 45.Her strength of character, practicality and lack of self-pity duringthis period was incredible to behold, not just to family and friends,but also to the doctors and nurses. We extend our thoughts,sympathies and prayers to her family, with whom we share greatsadness at this loss.

David Sneddon and Anne Whitby

Ian S. Notley 1936-2008

Ian passed away in May of 2008 after a bout with cancer. I first metIan in the 1970s when he spoke in New York City. One could only beimpressed with his knowledge of the subject under discussion andhis erudite manner of presentation. I became a dedicated followerand learned much from Ian over the years.

He did a great service to the industry by presenting his cyclicalmaterial with style and confidence. His delivery did as much toconvince audiences as did the integrity of his data and histhorough knowledge of past market cycles. Ian always stuck to hisguns, and his resolve was based upon history, market and politicalhistory. I recall his presentation in Canada in 1989 during which hesaid that the economy and the markets were about to turn up.Many were very dubious, citing the fundamental problems of theday. Ian remained resolute and his forecast proved to be accurate. Iam certain that we all have similar stories to tell.

He had moved from Australia to Canada in the early 1970s, workingwith several firms in Toronto. In 1987, he moved to Connecticut andformed Yelton Fiscal, his own advisory group. He supported ourcraft during his entire career, being one of the founders of theCanadian Society of Technical Analysts (CSTA) and of theInternational Federation of Technical Analysts (IFTA). We allremember the Walkabout, Ians introductory session at IFTAconferences. In 1993, he was awarded a Fellowship of the Society ofTechnical Analysts and was given an award for Cycle Wave Analysisby the MTA in New York in 1997. In 2002, he was presented with theA.J Frost award by the CSTA. In 2006, the MTA honoured him againwith an annual award in recognition of innovative work.

Ian said that A man lives on through his protgs and Iancertainly developed a following of dedicated and knowledgeableprofessionals who remain students of the markets. His work andhis service is continuing under the guidance of Jonathan Arter whospent nearly twenty years working with Ian and who recentlyconducted the always well received Walkabout at the IFTAconference in Paris.

Ian personally altered my life when he introduced me to an Arabwho subsequently hired me. This led to my marriage and 14 yearsin the Gulf. My wife and I always looked forward to his visits to ourvilla and our discussions of history and culture. Surya and I and Iansmany Arab friends miss him, as well as all of those who knew himworldwide.

Bill Sarubbi


This presentation will examine the 2009 outlook for the foreignexchange, bond and commodity markets together with the majorstock indices.

FOREX 2009Chart 1 shows the monthly Euro/dollar cross rate. The analysisdisplays a double top at $1.6, which is also the top of a long termchannel. The logical correction is very violent and seems to becyclical. The first quote of the Euro/dollar (January 1999) is $1.17;which is also the pivot of the 1999-2008 downside and upsideswings. The most favoured scenario is, therefore, a fall of theEuro/dollar during 2009 with $1.17 the major target. Any brief rallybelow $1.4910 will confirm this forecast (selling area) but a breakup above this threshold level would trigger a new wave of buying,probably take the rate to a high of around $1.64 (alternativescenario). Once the $1.17 level is reached, the Euro/dollar shouldresume its secular uptrend (2010-2012).

BONDS 2009The Eurozone bond contract, the Bund, has been moving broadlysideways since establishing a major top at 124.60. The market seems

to be tracing out a flat and somewhat complex correction which islikely to continue over the coming months until the 118.50 level isbreached. This technical signal will trigger a huge rally toward newhighs, above 124.60 and could occur within the next three to sixmonths.

COMMODITIES 2009Oil (shown on Chart 3) is about to reach the 38.2% fibonacci ratioof $52. This level could trigger an intermediate bounce but the fallfrom $150 has been so strong that 50% is a more likely retracementtarget. Oil should bounce from the $35/37.50 area, probablyhelped by momentum supports (such as the 52-wk displayedhere). This reversal will nevertheless take some time as bottoms incommodity markets are commonly rounded (whereas tops are V-Top patterns as seen at the $150 peak). From this support area, oilshould rally back up to $100 in the course of 2009 and probablyhigher in 2010, with the potential to make new all-time highs.

Gold (chart 4) has been the strongest commodity during thefinancial turmoil. A 38.2% ratio should complete the correction ofthe previous bullish Elliott cycle and, from here, some reboundshould occur. But the current complex correction (ABC/X) allowsfor a longer base formation than that of oil. Under this centralscenario, gold should move sideways during 2009, possiblybottoming at $635, the 50% ratio. The two boundaries ($725 and$635) are clearly long term entry prices for the on-going secularbullish movement.

EQUITY INDICES 2009Chart 5 shows the S&P500 implied volatility. Markets have clearlyentered a new highly-volatile territory. This should last another twoto three years with the lows unlikely to fall below 30. In the shortterm, it is very difficult to evaluate the possible paths of a crashgiven the high volatility.

Market forecasts for 2009

The article is a summary of a presentation given at the November 2008 IFTA conference. By Julien Nebenzahl

Chart 1Chart 3

Chart 2


With a 50% fall in global equities in less than 18 months, it iscommon sense to say that we are closer to the end of thecorrection process than the beginning.

In cyclical terms, the most important event is the failure of the USpresidential cycle to trace out its usual pattern in 2006, as was thecase in 1986 and the subsequent consequences of that episode arewell known (see chart 6 of the STOXX600). Despite this majorinterruption in the four-year cyle, one can assume that the cycleswill soon re-synchonize, as they have done in previous years -

especially if we understand the credit bubble as the main cause ofthis cycle disturbance. The four-year cycle points to a low in 2010;the 10-year (or business cycle) is expected to occur in 2012.

We can, therefore, have an intermediate rally before the 2010 and2012 cyclical bottoms (given that both of them may or may notcreate new lows). The monthly chart of the STOXX600 (Chart 7)shows a bullish channel broken this autumn. This indicates that thetrend is over but it leaves room for some recovery before a newcorrection gets underway. Once the current bottom is in place -and this could be either October 2008 or February 2009 (for thereasons discussed above, it is very difficult to evaluate the exacttiming) - the favoured scenario is a fast rally toward 38.2% or even50%, therefore a +33/50% rise from the lows.

Update on December 23rd:

FOREX 2009The sharp correction in December has not challenged theEuro/dollar bearish scenario of $1.17 in 2009 because the$1.491/1.5 level has not been broken. However, volatility shoulddecrease in the first quarter.

BONDS 2009The outlook for bonds has changed dramatically: the upperthreshold of the Bund has been realised much sooner thanexpected. Bond markets will remain strong in early 2009 and thenpeak before the end of the year. This correction could be an issue forfinancial markets.

COMMODITIES 2009Oil is now on the support (50% ratio) and gold is still in the ABC/Xcomplex correction.

EQUITY INDICES 2009Markets are in the process of forming a base but no strong signalhas appeared so far. It seems that the beginning of the year will stillcreate anxiety before hope.

Julien Nebenzahl is the founder and President of DayByDay, the leadingindependent European technical analysis research house. He waschairman of the French society of Technical Analysis (AFATE) from 2004to 2007 and is co-author of L'analyse technique, theories et methodes.

Chart 4

Chart 7

Chart 6

Chart 5


Technical analysis along with behavioural finance (with which itshares many beliefs) is gaining more popular acceptance. Volatilityin asset prices since the 2000 stock market peak commends a moreactive investment stance over a buy-and-hold strategy. Technicalanalysis is well placed to provide guidance in these troubled times.

The random-walk theorist and the technical analyst have beenprickly adversaries for more than 30 years. Burton Malkiels bestselling bookA Random Walk Down Wall Street was first published in1973 after a 20-year bull market; a golden age of growth, lowinflation and minimal unemployment. The book suggests thatmarkets fluctuate with no set pattern around an intrinsic fair value. Ifthe theory holds, prices will reflect all available information and anyresidual excess return will be random; the best strategy in the stockmarket in such an environment is one of buy-and-hold. The booksuggests no excess return can be generated by the use of technicalor fundamental analysis. Certainly, in the years preceding 1973, buy-and-hold seemed to be the best course of action for equities, but inthe 10 years thereafter it was significantly less profitable.

The crowd drives the trendThe rational investor, Homo Economicus, beloved in the ivorytowers of academia, bases his decisions on the maximisation ofwealth and utility. However, he is an elusive creature once he stepson to Wall Street and his progress is far from random. The advancesand recognition of behavioural finance, with its basis in cognitiveand emotional biases, do not explicitly commend technicalanalysis, but the technical and behavioural approaches share manybeliefs. Traditional economics proposes that the rational investorwill learn from past mistakes, but a psychological approach wouldargue against this. Psychologists and technical analysts suggestthat past behaviour is the best predictor of future behaviour;cognitive biases cause sentiment to fluctuate cyclically fromextreme optimism to extreme pessimism.

Kondratieff, Schumpeter and Kitchin, among others, haveidentified repetitive cyclical rhythms in economic activity. It is the

interaction of cycles of different length that give the appearance ofrandomness but, in reality, this interaction is far more predictable.The cyclical rotation out of stocks and into commodities in the1970s may be before the memory of many currently in the marketplace, but again, after a 20-year bull run in equities, we have seen asimilar rotation since the 2000 stock market peak. Politicians maymake claims to reduce boom and bust, but attempts to smooth outeconomic activity are often in vain, as we are now discovering.

The argument of what drives asset returns is one of the logicalagainst the psychological. The rational investor may exist inisolation, but when he enters the market place he becomes one ofthe crowd and is governed by the group mentality. This herdingbehaviour is often driven by expectations based on prior priceaction; in this respect the individual can become influenced by thesentiment of the crowd. The market reaction to a news release isbased on how the outcome differs from the pre-announcementconsensus forecast. Crowds can sometimes reflect better the sum ofthe individual members knowledge but can also behave irrationallywhen trends extend; hence the old Wall Street adage right duringtrends, but wrong at both ends. As Charles Dow said the marketreduces to a bloodless verdict all knowledge bearing on finance. Inthis respect, technical analysis agrees with Famas Efficient MarketHypothesis in that prices discount everything, reflecting shifts insupply and demand; where it differs is in emphasizing the potentialfor crowd psychology to drive trend activity.

The trends are in the distribution tailsBiases prevail in almost all market behaviour; these can range fromoverconfidence in a price forecast to the rejection of data oranalysis that contradicts ones current trading position. Anexpectations bias can develop when relying on a past correlationbetween two securities to continue indefinitely. Optimism andconfidence dominate decision making and investors tend tooverestimate their knowledge, underestimate risk and exaggeratetheir ability to control their emotions.

A key argument against the random walk theory is extreme pricemovement. Prices do find a long-run equilibrium, albeit a risingone in stocks linked to economic growth, but there are also periodsof serial correlation. How often do moves of three, four or morestandard deviations from the mean occur? Certainly more than anormal distribution would allow. Market returns do not follow anormal path, the distribution being more leptokurtic, with fattertails at the distribution extremes reflecting the trend activity that atechnical analyst looks for.

Technical toolsThe ability to identify clearly the prevailing phase of the market iscritical to successful analysis. A range-bound market of pricefluctuations around a stationary mean provides tradingopportunities if one can identify when prices will revert to themean. By using a bounded oscillator such as the Relative StrengthIndex, it is possible to time entry and exit points to trade the range.

Charting the rise of technical analysis

By Kevin Edgeley, CFA, MFTA

Figure 1: Inflation adjusted S&P (source: Haver Analytics)


A trending market provides quicker returns, but oscillators are oftena poor tool in such an environment; they will gravitate to the upper,or overbought, area in a bull trend and the lower or oversold area ina down trend. The more traditional tool for trading a trend is amoving average system which will maintain directional positions asthe trend develops, but the problem remains - which is the bestmoving average? The significance of a break above or below amoving average is often over-emphasized. Contrary to popularopinion, the optimal average length varies across time and acrossasset class. The identification and measurement of trend strength isthe key determinant in investment selection; an indicator such asWilders Average Directional Movement Index (ADX) can be used tomeasure the relative trend performance of different assets but notethat this indicator measures the strength of a trend, not its direction.Many funds and managed programs use variations on thesethemes for price direction and market timing purposes.

Complementary analysisThe technical and fundamental approaches are not necessarilycontradictory. Fundamental analysis looks at the cause ofeconomic change supply and demand, productivity, industrialdevelopment technical analysis looks at the effect. Thesefundamental drivers impact on the market consensus and therebyon price. Price can and does vary from a fundamental fair value.The difference can often be one of value against momentum. Infundamental terms, a stock may look cheap and worthy of a buyrecommendation but technically, the momentum of a price trendmay make the stock cheaper still as the move enters the fat tail ofthe distribution. The net result may be a buy at the same level as afundamental strategy buys against the trend on the way down,while a technical strategy buys with the trend on the way back up.

Technical analysts have often been accused, probably rightly inmany cases, of a lack of rigour in testing their beliefs. There have

been a number of empirical tests on the validity of chart patterns,with varying results as these subjective patterns are difficult toquantify. Others have found persistent serial correlation in prices -the so-called momentum effect. Many academics, however, remainsceptical of technical analysis due to its inconsistency withtraditional financial theory. Blind adherence to a moving averagebreakout or a particular chart pattern as a signal for a price movedoes not endear technicians to the broader market. However, inthe same way a fundamental analyst would not rely purely on alow P/E ratio for recommending a stock purchase, sound technicalanalysis relies on a mix of different indicators to generate a traderecommendation. Technicians make no claims to get the marketright every time, but more and more empirical research onbehavioural principles reinforces the case for technical analysis toplay a more prominent part in the investment process.

Professional fundamental analysts vastly outnumber those using atechnical approach, but the technical contingent is growing and issupported by regional societies in the same way as the CFA. Manyregional chapters run an education syllabus; in the UK this leads tothe STA Diploma, and on further study to the IFTA Master ofFinancial Technical Analysis. This education process aims toprovide more rigorous support for technical methods.

The current market environment is supportive of further growth inthe use of technical methods. In the 1970s, the US stock marketchanged phase from trend to range and, although there wereperiods of serial correlation within this range, these trends wereshort term and fluctuated around a fairly stationary long termmean. This period led to a number of innovations in the technicalworld and it is likely that the current market conditions willengender further expansion in the use of technical analysis.

This article first appeared in Professional Investor (Autumn 2008)

Figure 2: FTSE 100 and Trend Strength (source: Updata)


2009 market perspectives

The article is a summary of a presentation given at the November 2008 IFTA conference. By Tim Parker

This article is a re-run of a short presentation I made to theInternational Federation of Technical Analysts in Paris in earlyNovember, when the world seemed to be falling apart. The analysisI used was based on mainstream Dow Theory, using many longerterm charts for perspective while making some important inter-market observations.

By November 2008 returns in global equity markets had postedtheir worst year since the 1970s. The US equity markets fell 43% in1931, and in 2008 to date were already down 40%, and appeared tobe heading for their second worst year after 1931 in 140 years. Inaddition, volatility was exploding (7 days in October saw falls of 4%or more), hedge funds and others were deleveraging fast, andforced selling was beginning to emerge everywhere; downgradesto corporate profits had hardly even begun, credit spreads wererapidly widening, and so on...

The charts, however, were more encouraging:1. S&P 500 Index: On the monthly bar chart the coincidence ofsupport from the 1982 uptrend and the 2002 low (a 100%retracement of the 2002-07 rally) were too significant to ignore.Also the long term RSI was becoming extravagantly oversold. Areaction at just below 750 was to be expected.

2. The VIX: blew out to historic highs by end October. The key use ofthis measure is to look for a lower high on the indicator coincident

with a new low on the S&P 500. This was to be seen in lateNovember.

3. The TED Spread (the spread between 3-month interbank ratesand the 3-month US Treasury Bill yield). This market is at the core ofthe global financial crisis (rather than equities), so must bewatched. By 3rd November it had fallen 38% from the highs.

4. Spot Gold (in US$): On 6th November this chart was telling usthat a supposed key beneficiary of de-leveraging was not workingthat well, despite US$ strength.

5. Japanese Yen Trade-Weighted Index: This de-leveraging beneficiary,on the other hand, worked well... but was already 11% off its highs,suggesting a cooling off in the panic to unwind the carry trade.


6. US 10-Year Treasury Note Yield: I pointed out that a one-yearbasing process may have been underway... in fact this was nevercompleted and, instead, yields collapsed to record lows. Again, thisis not necessarily bearish for equities in comparative yield terms.

7. US$ High Yield Corporate Bond Index: at extended levels, andmay also have been topping out.

8. Asian Equities: steepened downtrends were just broken. Was thisthe first sign of imminent basing?

9. Taiwan TAIEX index monthly chart. The long term chart of thisequity market showed a reaction at significant 18-year uptrendsupport.

10. China: back to basics... the Shanghai Composite index hadretraced 100% of the bubble and was now approaching lots ofsupport at the prior 8-year range.

11. DJ EuroStoxx 600 Pan European index: this was showing a longterm oversold condition at the 20-year uptrend...

12. Defensive sectors were testing the top of multi-year relativeranges: such as the ratio of the Food & Bevs sector against the DJEuroStoxx 50 index.

13. Another defensive sector at 10-year relative highs was Health Care.

ConclusionAll was looking bleak in early November, and by Christmas it is stilla very fraught environment. However, the longer term charts arenot all that bad, and we wouldnt be surprised to see a better 2009in markets than generally anticipated.

Tim Parker is Managing Director of PH Partners Ltdwww.phanalysis.com


IntroductionEver since the emergence of modern finance theory, the followersof technical analysis have found themselves marginalized by thefinancial establishment and held at bay by fortress walls built onmisunderstanding and contempt; misunderstanding, since thetechnical jargon of head-and-shoulders, wedges, and pennantsdoes not resonate with minds steeped in physics and statistics;contempt, for the fervent adherents of modern finance reject themere possibility of patterns in market prices. Such a segregativestate of affairs hints at the striking dichotomy which permeates thefinancial world. On the one hand, academics tend to embrace theefficient markets hypothesis which, roughly speaking, stipulatesthat markets are unpredictable, in the sense that there is no way toforecast future prices based on previous ones and thereby make aprofit. The efficient markets hypothesis was shaped in the writingsof Eugene Fama and Paul Samuelson in the 1960s, and despite therecent proposals of alternative hypotheses, it remains deeplyingrained in the culture of academic finance.

This stands in sharp contrast with technical analysis, whichattempts to divine markets direction based on past prices. Oftenand quite controversially this is done by searching with the nakedeye for certain patterns in price histories that are believed toembody the prime mover of all market action: crowd psychology.For example, a sequence of successively higher highs and lowerlows which traces the so-called triangle bottom pattern in theprice data is usually interpreted by technicians as a manifestationof strengthening confidence punctuated by subsiding terror, andhence as the presage of an uptrend. Perhaps surprisingly,technicians in some cases do appear to make consistent profitsthat cannot be attributed to chance alone.

In the light of this dichotomy, the rift between academics andtechnicians is not quick to heal, but may require the twocommunities to take a careful look at the other. In this article wepresent our insights from one exploration of technical analysis,spanning past, present, and future. First, to place technical analysisin context, we conduct a historical study of its evolution throughtime and across cultures. Second, we deal with the current lack offormalisation of technical analysis: there is no complete agreementon what technical analysis is, with many texts only partiallyoverlapping on the methodologies to be employed. Consequently,our second main endeavour is to understand fully what present-day technical analysis consists of, and to this end we conductinterviews with its current leading practitioners. Finally, weconsider the future of technical analysis, which in our view willmove away from ambiguous heuristics towards formally definedindicators and dynamic strategies, capturing the ever-changingnature of financial markets. In the rest of this article we discussthese three perspectives in turn, each the subject of a forthcomingbook co-authored with Andrew Lo.

The historical context of technical analysisThat human nature will never change and technical analysis

therefore never become obsolete is often heard from seasonedtechnicians. But if fear and greed have always been the maindrivers of supply and demand in the markets, then technicalanalysis that measures supply/demand imbalances should havespread its web of roots deep in the realms of history and widelyacross civilizations. Historical evidence suggests that this indeed isthe case. Arguably as old as the markets themselves, technicalanalysis dates back to at least the ancient Babylon of the 7th centuryB.C. This evidence comes from a set of price diaries that surviveduntil our time,1 where the prices of the same six commodities suchas barley, dates, sesame, and wool were carefully charted,continuously through centuries, with the purpose of predictingthem. In fact, just like contemporary technical analysts do, thediary keepers would adjust the frequency at which they recordedthe market quotations according to the level of market volatility.

More recently, technical analysis was used in the 17th century at theAmsterdam Exchange where business was conducted in a way thatis remarkably similar to that of current exchanges. In Confusin deConfusiones (1688), one of the oldest books ever written on stockexchange business, Joseph de la Vega provides a vivid account ofthe dynamics of this Exchange and observes that on this point weare all alike when the prices rise, we think they will run away fromus, suggesting that people at that time were naturally inclined tomake inferences about future prices based on past ones.

From the 18th century, the evidence that technical analysis wasused in Japan comes from the writings of the legendary traderMunehisa Homma, who in his book The Fountain of Gold describeshow market psychology can help predict prices; for example,when all are bearish, he suggests that there is a cause for pricesto rise.2 Homma also documents the candlesticks chartingtechnique, which is used to this day, especially in Japan.

Skipping one century ahead, to late imperial China, the similaritiesbetween Chinese merchant manuals and present-day technicalanalysis texts manifest themselves in the emphasis of both on thecyclicality of markets and the role it plays in market timing. Thestatement from Essential Business, one such manual, that whengoods become extremely expensive, then they must becomeinexpensive again3 is as fully understandable now in the contextof trend reversals as it was then.

The foundations of the present-day technical analysis were laiddown in the early 1900s by Charles Dow. In the January 4th, 1902edition of The Wall Street Journal, Dow proposed his famousdefinition of a trend as a sequence of successive highs and lows bysaying that it is a bull period as long as the average of one highpoint exceeds that of previous high points. However, even thismost recent form of technical analysis has never been formalised,but continues now as always to flourish on the fringes of theestablishment and pass from one generation to the next throughodd apprenticeships and confabulations, remaining to this day amost colorful part of the financial folklore.

Perspectives on technical analysisBy Jasmina Hasanhodzic


Insights from the interviews with leading techniciansGiven the lack of standardisation of technical analysis, learningabout it from books is a daunting task: the contradictory adviceand loose and frequent use of qualifiers such as often andprobably throws the uninitiated into ambivalence and confusion.Learning about technical analysis from its leading practitioners ismore inviting; after all, that is how this intricate craft survived tillour time not through books, but through the word of mouth.

If a single word could summarise the interviews we conducted, itwould be diverse, as it captures both the intriguing beauty of thiscraft and the troubles that plague it. Spanning a striking variety ofstyles in their practice of technical analysis, our interviewees rangefrom short-term traders (Raschke, Weinstein) to educators (Murphy,Acampora), long-term investors (Desmond, Deemer), artisttechnicians (McAvity), highly eclectic technicians (Dudack), historians(Shaw), long-term market theme writers (Farrell), and those who insiston being labelled market rather than technical analysts (Birinyi).

Diverse, too, are their interpretations of technical analysis, a tellingillustration of which is provided by their responses to the questiondoes the lack of hard and fast rules in technical analysis everbother you, which varied from thats exactly what bothers me tobut there are hard and fast rules in technical analysis. Theinterviewees do agree however on one point, and that is thesignificance of the role intuition plays in their decision making. AsMurphy puts it, Im not sure I could explain to you how I do what Ido. I look at many things in a short interval of time and come to aconclusion. That elusive skill may explain why these practitionersdo not have a problem with sharing their knowledge, the toolsthey develop, or the strategies they pioneer. There is no single rightway to put it all together. Everyone does it in slightly andsometimes widely different ways. Some technicians operate best incomplete isolation from the outside world Linda Raschke, whodoes not watch TV or read The Wall Street Journal, is a primeexample others prefer to complement their technical per -spectives with fundamental, economic, and political ones.

The palpable heterogeneity among leading technicians thatemerges from our interviews yields a potential explanation for thelack of impact that technical analysis has had on the broaderfinancial community. Without a unified, standardised, and broadlyrecognised body of knowledge in which every practicingtechnician must be conversant, it is difficult to see how technicalanalysis can spread. The advent of the Chartered MarketTechnician program by the Market Technicians Association is a stepin the right direction but, as our interviews underscore, there is stilla considerable amount of art and subjectivity in the practice oftechnical analysis.

Towards a science of technical analysisFor too long languishing in the murky waters of part art-partscience, technical analysis is finally starting to develop a morerigorous approach. Big strides, indeed, have been made towardsthe standardisation of technical analysis in recent years, such as byAronson (2007) and Kirkpatrick and Dahlquist (2006). The impetusfor statistically evaluating technical analysis naturally comes fromacademia, with studies yielding evidence of its validity in wide-ranging areas, such as moving averages (Brock, Lakonishok, andLeBaron, 1992), genetic algorithms to discover optimal tradingrules (Neely, Weller, and Dittmar, 1997), and the Dow Theory (Brown,Goetzmann, and Kumar, 1998), to name a few.

In their quest to quantify technical analysis, academics haveturned, too, to the most controversial of its techniques: patterns.Finding patterns in price charts is a subjective endeavour thatrelies on the natural smoothing filter of the human eye; a mainchallenge therefore in quantifying the patterns lies in modellingthe way in which eyes smooth the data they view. The pioneeringworks by Chang and Osler (1994, 1999) and Lo, Mamaysky, andWang (2000), as well as the recent extension of the latter by theauthor (Hasanhodzic, 2007), take on this challenge by smoothingthe data using statistical filtering techniques, such as kernelregression and neural networks. They then develop algorithms toidentify automatically technical patterns in that data, and finallyevaluate the information content of the patterns thus found.4

These works, too, find proof of the validity of technical analysis.

The observation that human nature never changes, and thatconsequently technical indicators designed to measure thereflection of human nature in market prices never change either, isa notable argument in favour of technical analysis, but one that atthe same time underscores its main shortcoming: technical analysishas not kept up with technological advances. Of course, chartingand data collecting have become automated, but most popularpatterns and heuristics of today were developed in the pre-computing age when calculating a simple moving average was aformidable task. For example, a 10-day moving average becamepopular because it was easy to compute one could divide by tensimply by moving the decimal place to the left not because it wasstatistically optimal, and it remains commonly used to this day.

Suboptimal parametrisation is only a symptom of a chronic diseaseafflicting technical analysis: its static nature cannot account for theever-changing character of financial markets. In the past, whenexecution was manual and costly, and financial systems far lessconnected and complex, static used to be a prerequisite forimplementability, now it is a condition for failure. As marketsevolve and trading strategies become more sophisticated, theneed for new, dynamic indicators becomes apparent. Never hasthis need been more urgent than now, when in the light of theevents of last years August, one can no longer deny that hedgefunds have become a paramount force: it is not the feeling of thecrowd but the action of a single gigantic hedge fund thatprecipitated the crisis continuing to this day. This is echoed bymany of our interviewees, including Walter Deemer who findsingenious ways of tracing the hedge-fund activity indirectly, viacertain mutual funds: I am convinced that these 6 or 7 billiondollars of assets in Rydex funds reflect the general hedge-fundtrading activity which is the driving force in the market, he notes.

Directly tracking hedge-fund activity is of course what one wouldwant, but this is problematic if not infeasible for, shrouded insecrecy, hedge funds are notorious for their inaccessibility andinfrequent reporting. A possible way to circumvent this problem isjointly proposed by the author (Hasanhodzic and Lo, 2007), andconsists of replicating hedge funds in a transparent and publicallyavailable format. Starting from the empirical observation that alarge portion of hedge-fund returns can be obtained by passiveexposure to certain common risk factors such as those capturedby stocks, bonds, currency, commodity, and credit markets weshow how hedge-fund returns can be expressed in terms ofreturns realized in those markets, via a linear regression model.Based on this idea, a number of prominent asset-managementfirms have recently launched mutual funds that aim to replicate

12 Issue 63 January 2009 MARKET TECHNICIAN

hedge-fund factor exposures. Unlike hedge-fund returns, thereturns of these funds are public and updated daily, and can beused as an indicator of the aggregate performance of the hedge-fund sector. Moreover, assets flowing in and out of these mutualfunds are publically available, which raises the possibility of usingthem to gauge the investors sentiment shifts.

ConclusionIn this article we presented some of our perspectives on technicalanalysis spanning past, present, and future. Our historicalexploration reveals that technical analysis was a force throughoutcenturies and across cultures. Our interviews with the present-daymasters of technical analysis help us understand what technicalanalysis is, and armed with that understanding we can movetowards the future, which in our view consists of standardisation anddevelopment of new indicators to measure fast-changing marketenvironments. Although the fortress walls separating techniciansfrom the adherents of modern finance still stand tall, they are notinsurmountable, and we hope that the growing volume of in-depthexaminations of technical analysis will awaken the sceptics and openthe door for the dialogue between the two communities to begin.

1 As documented by Slotsky (1997).2 As quoted by Nison (1994).3 As quoted by Lufrano (1997).4 It is important here to distinguish between evaluatingprofitability of technical trading rules and evaluating theinformation content of technical analysis; the former necessitatesthe modelling of the trading implementation and riskmanagement, whereas the latter detects supply/demandimbalances regardless of whether or not one can profitably act onthat information.

References

Aaronson, D., 2007, Evidence-Based Technical Analysis. Hoboken, NJ:John Wiley & Sons.

Brock, W., Lakonishok, J. and B. LeBaron, 1992, Simple TechnicalTrading Rules and the Stochastic Properties of Stock Returns,Journal of Finance 47, 1731-1764.

Brown, S., Goetzmann, W. and A. Kumar, 1998, The Dow Theory:William Peter Hamiltons Track Record Re-Considered, Journal ofFinance 53, 1311-1333.

Chang, K. and C. Osler, 1994, Evaluating Chart-Based TechnicalAnalysis: The Head-and-Shoulders Pattern in Foreign ExchangeMarkets, working paper, Federal Reserve Bank of New York.

Chang, K. and C. Osler, 1999, Methodical Madness: TechnicalAnalysis and the Irrationality of Exchange-Rate Forecasts,Economic Journal 109, 636-661.

De la Vega, J., 1957, Confusin de Confusiones. Cambridge, MA:Harvard University Printing Office.

Hasanhodzic, J., 2007, Investments Unwrapped: DemystifyingTechnical Analysis and Hedge-Fund Strategies, Ph.D. thesis,Massachusetts Institute of Technology.

Hasanhodzic, J. and A. Lo, 2007, Can Hedge-Fund Returns BeReplicated?: The Linear Case, Journal of Investment Management5, 5-45.

Kirkpatrick, C. and J. Dahlquist, 2006, Technical Analysis: TheComplete Resource for Financial Market Technicians. UpperSaddle River, NJ: FT Press.

Lo, A. and J. Hasanhodzic, 2009, The Heretics of Finance:Conversations with Leading Practitioners of Technical Analysis.New York, NY: Bloomberg Press.

Lo, A. and J. Hasanhodzic, forthcoming, Tales of Future Past: TheFascinating Story of Technical Analysis. New York, NY: BloombergPress.

Lo, A. and J. Hasanhodzic, forthcoming, A Quantitative Approach toTechnical Analysis. New York, NY: Bloomberg Press.

Lo, A., Mamaysky, H. and J. Wang, 2000, Foundations of TechnicalAnalysis: Computational Algorithms, Statistical Inference, andEmpirical Implementation, Journal of Finance 55, 1705-1765.

Lufrano, R., 1997, Honorable Merchants: Commerce and Self-Cultivation in Late Imperial China. Honolulu, HI: University ofHawaii Press.

Nison, S., 1994, Beyond Candlesticks: New Japanese ChartingTechniques Revealed. New York, NY: John Wiley & Sons.

Neely, C., Weber, P. and R. Dittmar, 1997, Is Technical Analysis in theForeign Exchange Market Profitable? A Genetic ProgrammingApproach, Journal of Financial and Quantitative Analysis 32, 405-426.

Slotsky, A., 1997, The Bourse of Babylon. Bethesda, MD: CDL Press.

Jasmina Hasanhodzic, Ph.D. is a research scientist at AlphaSimplexGroup, LLC. The views and opinions expressed in this article are thoseof the author only, and do not necessarily represent the views andopinions of AlphaSimplex Group, MIT, or any of their affiliates andemployees. The author makes no representations or warranty, eitherexpressed or implied, as to the accuracy or completeness of theinformation contained in this article, nor does she recommend thatthis article serve as the basis for any investment decision this articleis for information purposes only. The research summarized in thisarticle was supported by the MIT Presidential Fellowship and the MITLab for Financial Engineering.

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