Thursday, May 22, 2008

Are Financial Economists Seeing the Light on Technical Analysis?

Readers might be familiar with the following quotation from Burton Malkiel (A Random Walk Down Wall Street, 1996, p. 154):

“technical strategies are usually amusing, often comforting, but of no real value”

Proponents of "low cost index funds" typically believe this is true as do the majority of mainstream economists it would seem. The efficient market hypothesis argues that changes in market prices are purely random resulting from the arrival of previously unknown information to the market and that, therefore, there is no way to exploit past prices and volume data to predict changes in market prices. Then why do the majority of participants in foreign exchange markets as well as many in other markets use various variants of technical analysis to varying degrees? This question is addressed in the following paper:

Lukas Menkhoff and Mark P. Taylor, The obstinate passion of foreign exchange professionals: technical analysis, Journal of Economic Literature, Vol. XLV (December 2007), pp. 936–972.

The Journal of Economic Literature is one of the three or four most prestigious academic journals in economics and Mark Taylor is a top international macro-economist.

I'll leave it to the authors to explain, by drawing the following from their conclusion (pp966-967):

"A reading of the literature on the nature and use of technical analysis in the foreign exchange market allows us to draw up a set of stylized facts concerning its nature and use, and also to distinguish a number of arguments that have typically been adduced to explain its continued use.

Indeed, first and foremost among these stylized facts lies the continued and widespread use of technical analysis in the foreign exchange market. Research conducted in most of the major foreign exchange markets during the last decade or so reveals clearly that the use of technical analysis is an important and persistent phenomenon which is highly influential in the decision making of foreign exchange professionals. A similar situation emerges with respect to the profitability of technical analysis. It is beyond question that, for major flexible exchange rates and over longer time periods, the use of technical analysis may be used to provide very high returns. What is disputed, however, is whether the realization of these profits has to be bought at the cost of taking large risks and whether the profits can fully compensate for this additional risk.

A contribution that we have sought to make in this paper is in relating the available empirical evidence to several positions that have been developed in order to explain the continued use of technical analysis.

The first of these—interpreting the use of technical analysis as an indication of not-fully rational behavior—is difficult to reconcile with the fact that virtually all professionals in the market rely on this tool at least to a small degree. Moreover, there is no hard evidence showing that chartists are characterized by temporarily suboptimal behavior, or underestimate the risk involved or accept technical analysis as a marketing instrument.

The second position, relating profitability to foreign exchange interventions by the monetary authorities, is a little more satisfying in the sense that it suggests a more solid rationale for the use of technical analysis by rational agents. Also, some stylized facts concerning the profitability of technical analysis —namely that it tends to be more profitable during periods of official intervention —fit well with this position. There is, however, more recent evidence that suggests that it may be large exchange rate movements themselves that may be leading both intervention and technical analysis profitability or, equivalently, that the influence of technical analysis, by driving the exchange rate away from the level consistent with the fundamentals, may generate a rationale for official intervention, rather than vice versa, through the coordination channel of intervention effectiveness.

The third position, namely that technical analysis is simply an instrument in the processing and assimilation of market information, can also reconcile the importance of order flows and technical analysis to some degree. The main problem with this position, however, is that it does not explain the reason behind sluggish adjustment to news, preferences for round figures in order placement, etc.

Overall, therefore, perhaps the most satisfying explanation concerning the continued use of technical analysis seems to be position four, whereby technical analysis is seen as an instrument informing traders about nonfundamental price determinants. These forces are more important in the shorter-run, so for a full understanding of exchange rate dynamics, professionals need a combination of several tools, in particular both technical and fundamental analysis. This position also fits well with the stylized fact on the higher profitability of technical analysis in flexible exchange rate markets, as there is some indication that these markets may be characterized by a degree of volatility that is hard to explain by fundamentals alone (Robert P. Flood and Rose 1995).

This still leaves open, however, the question of risk-adjusted profitability. If technical analysis has some rationale in the sense of being able to generate profitable trading rules, why does the market process not assimilate or arbitrage these profit opportunities away? The answer may be the same as with fundamental analysis: in well functioning markets one would expect that profit opportunities will be exploited up to an extent where agents feel appropriately compensated for their risk. To take open positions is inherently risky, whether the decision is based on fundamental or technical considerations.

What is perhaps most striking from our reading of the literature, however, is that technical analysis remains a passionate obsession of many foreign exchange market professionals; it is clearly an intrinsic part of this market. For academic researchers, this means that technical analysis must be understood and integrated into economic reasoning at both the macroeconomic and the microstructural levels. For market practitioners, it means that technical trading strategies should be constantly evaluated as potentially important tools in the search for excess returns. "

In other words, technical analysis works and produces significant profits because market prices convey information that is not embodied in the known fundamentals, but it is an open question as to whether exploiting those profit opportunities means taking on more apparent risk, which the majority of market participants are unwilling to do. Even if the market is more or less efficient, someone has to move the market towards the equilibrium and many participants in the foreign exchange markets are actively trying to avoid risk by hedging away their foreign exchange liabilities rather than maximize their profitability.

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