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Why Technical Analysis might work : Insights from Libertarian Economics & Academia

, May 23, 2013, 1 Comments

Technical Analysis has been likened to Astrology and other such forms of arguably false knowledge. Despite all the debate, academic and otherwise, one observes that market participants in highly organized and liquid markets such as Currencies or Exchange Traded Commodities make extensive use of Technical Analysis.

The debaters usually organize themselves into camps, much like religion. Some people make a living out of either promoting or deriding it, without advancing beyond the rookie level in this art, science, or whatever you want to call it.

From an epistemological standpoint, anybody familiar with even an iota of economics knows of the ‘law’ of demand and supply in a market. The ‘efficiency’ of any market depends on its liquidity and level of organization. As mentioned earlier, the extensive use of Technical Analysis in liquid and well organized markets leads us to the logical conclusion that some entities do manage to practice it successfully. Perhaps the best kept secrets are just that – secrets. And the golden rule is probably that there are no golden rules. Some set of rules might work today; They might not work tomorrow. However, some other set of rules might work tomorrow.

Now I shall stand on the shoulders of some giants to make a case in favour of Technical Analysis.

Mark Spitznagel, an investor who has worked with Nassim Nicholas Taleb of ‘The Black Swan’ theory fame swears by the Austrian school of thought.

In his article he says – “To Mises, “What distinguishes the Austrian School and will lend it immortal fame is precisely the fact that it created a theory of economic action and not of economic equilibrium or non-action.”  The Austrian approach to the market process is just that: “The market is a process.”

Technical analysis provides us with a raw insight into the dynamic market process which Spitznagel speaks of : demand and supply in action.

In a treatise on the market process here, we read “Every day thousands of airplanes take off from airports, each one bound for a different destination. Getting them all in the air and back on the ground on time and without colliding with each other is an incredibly complex task, and the air traffic control system is a marvel of sophisticated organization. But also every day in the Bay area people make thousands of times as many trips in automobiles, with far more individuated points of origin, destinations, and “flight plans.” That system, the coordination of millions of automobile trips, is far too complex for any traffic control system to manage, so we have to let it operate spontaneously within a few specific rules: drive on the right, stop at lights, yield when making a left turn. There are accidents, to be sure, and traffic congestion–much of which could be alleviated if the roads themselves were built and operated according to market principles–but the point is that it would be simply impossible to plan and consciously coordinate all those automobile trips. Contrary to our initial impression, then, it is precisely the less complex systems that can be planned and the more complex systems that must develop spontaneously.”

These ad hoc rules which the piece talks of can be thought of as Technical Analysis. We don’t need theories. We need to tinker and find rules which work. Of course, they will most probably stop working someday, and then a new set of rules need to be discovered.

Attempts have been made to study Technical Analysis scientifically. This academic paper titled “Head and Shoulders Above the Rest? The Performance of Institutional Portfolio Managers Who Use Technical Analysis”. relies on institutional portfolio managers’ statements about whether and how intensely they use technical analysis, irrespective of the form in which they implement it. It concludes thatFunds using technical analysis appear to have provided a meaningful advantage to their investors, albeit in an unexpected way.

Professor Andrew Lo of MIT has written a book called “A non random walk down wall street” which establishes some credibility for Technical Analysis. Another attempt at scientifically decoding TA has been made in the book “Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals” by Professor Dave Aronson at Baruch College.

The trick is to believe in the markets as complex adaptive systems, it seems.

About author
Anmol Sharma is a graduate (BE - Electronics & Instrumentation Engineering), a post-graduate (MSc - Economics) from the Birla Institute of Technology & Science and holds a Diploma in Mathematics from the London School of Economics & Political Science. Anmol has worked with JP Morgan, the National Council of Applied Economic Research, Carleton University (Canada) and Indian Overseas Bank in a wide variety of research roles. ...more ...more