A Good Reason to believe in Technical Analysis

The validity of technical analysis is still an unresolved issue with adherents and opponents on both sides. I may normally be expected to believe in the efficiency hypothesis given the fact that I am a U.S trained finance professor and academic world of finance puts its considerable weight in favor of this hypothesis with only a few exceptions. There is really no room for the technical analysis within the strict context of the efficiency hypothesis. All the information that technician or fundamentalist can hope to utilize for guessing the future course of stock prices is already reflected in the current price. The deviation of tomorrow’s price from today’s price is governed by pure chance. Stock prices and returns obey a normal distribution just like an unbiased coin thrown for heads and tails. The claims of technical analysis is then no more valid then the claims of astrology. This is what efficiency hypothesis says. 

Indeed I was one of the sympathizers of the efficiency hypothesis initially. Science, however, is based on facts and observations. Rather than taking sides on the basis of what others say, I decided to investigate this issue myself. I started testing numerous technical indicators using actual stock data (stochastic, MACD, moving averages, etc) to see if their performance were indeed better than a simple “buy and hold” strategy. The results were mixed. The aforementioned indicators seemed to perform well for a certain period of time, but then turning into a futile exercise with no gains but a lot of commission costs. A common feature in most of them was the fact that they were simply trend following. Consequently, they were a bit late in signaling the buy and sell signals. This is an important shortcoming since the best daily gains are usually realized in the very early phases of an uptrend.

Then, I got acquainted with Japanese candlesticks through the book of Steve Nison, which is kind of a bible in this subject. At the first glance, candlesticks are a very unlikely candidate for an excellent technical indicator. After all we are talking about a method used by 18.century rice traders in Japan. Patterns only use opening, closing, high and low prices as inputs. No math, no formulas.

Despite this simplicity, their timing at the turning points of stock prices was much better than other trend following indicators. Candlestick patterns generate buy and sell signals just at the point when the trend is changing direction. Somehow they succeed to feel the pulse of the market better than the other indicators. One only needs to browse through the Chapter 7 of a book called Japanese Charting Explained written by Gregory L.Morris to find quantitative evidence of candlestick superiority over other technical indicators. Morris tests the performance of 68 different candlestick patterns on 2277 stocks from NYSE, AMEX and NASDAQ. He uses two different testing periods. The first period is the particularly volatile period from April 30, 2002 to December 31, 2004 with 675 market trading days. The second period is a much longer one spanning from November 29, 1991 to December 31, 2004 with 3300 market trading days. After showing the performance of each candlestick pattern on the basis of percentage of wins and average per cent gain, he then compares the candlestick performance with 14 widely utilized technical indicators (MACD, ROC, CCI, Stochastic, etc.). The results are an eye opener. Candlesticks do definitely perform better than all other indicators in the short term and assess the direction of prices better than others within a horizon of 5 days.

So far, so good, however there is a major problem. How is a small investor expected to tackle with all the intricacies of recognizing and identifying the patterns correctly? This is not a superficial problem. There are hundreds of different patterns to memorize. There are also some subtle questions such as if a very thin body (a small difference between opening and closing prices) is compatible with a Doji formation (a cross-like formation) or what we really mean when we talk about a long body?

The solution came from an unexpected source, the internet. Indonesian Bulls (www.indonesianbulls.com), which is just a branch of a group of sites  dealing with the stock exchanges for different countries, generates buy, sell, buy if, and sell if signals on daily and weekly basis for all the stocks in the Jakarta stock market also providing a commentary. The site works with an automated system based on digital recognition of Japanese candlestick patterns. The site generates a cautionary buy if (or sell if) signal based on patterns before giving a definite buy and sell signal and defines a certain market based confirmation criteria to transform a buy if (or sell if) to a definite buy (or sell) signal thus showing due respect for the market dynamics of that day. The site also reports a two year history for all the stocks which transparently shows the results of trading, assuming that the trades are done by a small investor whose decisions are entirely based on site’s definite buy and sell signals. The reported results also allow a -0.2% slippage per trade to cover the commission costs and the possibility of missing the suggested buy or sell price, which is a reasonable assumption.

The site also has a stock ranking system ranging from five stars to one star. Apparently the stars reflect the conformity of the stock in question to the algorithm used to generate the signals. For example, a five star stock called Charoen Pi Ord (CPIN.JK) on December 12, 2010 was traded at 1880 IDR. This stock was traded at a price of 97 IDR two years ago, on January 13, 2009.  The price of the stock increased almost 19 times since then. It was evidently a golden opportunity for a “buy and hold” strategy. However, even this spectacular performance looks quite modest, when it is compared with an investor’s performance that is assumed to trade under the guidance of the aforementioned site. A small investor following the site’s buy and sell signals would be able to increase an initial investment of 100 IDR to 7288 IDR in just two years. It means that 1 IDR invested in this stock is now worth 72.88 IDR and it shows an almost four times better performance than a simple “buy and hold” strategy, a theoretically impossible case according to the efficiency hypothesis.

Now be ready for the good news. The site operates in 34 countries including U.S.A, most of Europe, China, Japan, India, Australia, Russia, South America and others, apparently based on the same buy and signal system and with similar success stories. The samples below from different countries clearly show how signals generated by candlestick patterns can beat “buy and hold” strategy all over the world (by January 01, 2011): 

Symbol        Stock Name                                    Country           Buy & Hold (2yr.)         Candlesticks (2yr.)

GGAL.BA        GP FIN GALICIA                       Argentina              7.60 times                 16.00 times

MEO.AX          MEO AUSTRALIA                      Australia               2.23 times                 49.87 times      

KBCA.BR       KBC ANCORA                            Belgium                0.82 times                 13.68 times

TEKA4.SA      TEKA PR                                     Brazil                      3.76 times                 17.88 times        

600111.SS    RARE-EARTH  A                          China                      7.76 times                 30.49 times

AVL                 AVALON VENTURES LTD        Canada (TSX)      19.88 times               12.33 times

NOT                NORONT RESOURCES LTD    Canada (CDNX)  1.96 times                 107.34 times

GES.CO         GREENTECH ENERGY               Denmark               0.85 times                 10.45 times

RNO.PA         RENAULT                                    France                   2.50 times                 13.45 times

IFX.DE            INFINEON TECHNOL N           Germany               7.46 times                  49.40 times

8200.HK        SAU SAN TONG                          Hong Kong          2.32 times                  125.85 times

RAJA.JK         RUKUN RAHARJA                     Indonesia             5.37 times                  43.69 times

F.MI                 FIAT                                              Italy                        2.84 times                  10.35 times

8515               AIFUL                                           Japan                    0.41 times                   46.38 times

003190.KS    RNL BIO                                      Korea                     3.10 times                   34.04 times

AIG.MX            AMER INTL GROUP                  Mexico                   1.71 times                   10.60 times

ALMAL             Al-Mal Investment Co KSCC   Middle East          2.70 times                    28.30 times

TOM2.AS         TOMTOM N.V.                            Netherlands         2.39 times                    30.53 times

GOGL.OL        GOLDEN OCEAN                     Norway                  2.01 times                    39.05 times

MTX                  METOREX LIMITED                  South Africa          2.56 times                    23.54 times

MTS.MC           MITTAL STEEL                          Spain                     1.77 times                    10.16 times

EG0.SI             JES INTERNATIONAL HOLD    Singapore              2.91 times                    33.32 times

PETRO.ST      PETROGRAND                          Sweden                  0.41 times                    26.70 times

XTAN.SW         XSTRATA                                   Switzerland            3.43 times                    13.39 times

2358.TW          MAG TECH                                Taiwan                    3.92 times                    33.72 times

MAKTK             Makina Takim                           Turkey                      20.41 times                 139.04 times

BKIR                 Bank of Ireland                         U.K.                          1.42 times                   168.11 times

APP                  AMERICAN APPAREL INC     U.S. (AMEX)             0.53 times                   51.12 times

MGM                 MGM MIRAGE INC                   U.S. (NYSE)            1.28 times                    32.57 times

PWER              POWER ONE INC                     U.S. (NASDAQ)       8.16 times                    108.16 times

PCFG               PACIFIC GOLD CP                    U.S. (OTCBB)          4.13 times                     538.69 times

So what is the main point that needs to be highlighted? First, the efficiency hypothesis despite its theoretical elegance is incompatible with empirical facts. A simple “buy and hold” strategy can easily be beaten by a good technical system even after allowing for commissions.  Second, there are friendly sites among the internet which can help the small investor to achieve much better results than a “buy and hold” strategy. So, there is no reason to be confined to the dull world of the efficiency hypothesis whose death warrant about technical analysis does not receive any support from the real world of the markets.