Why Technical Analysis is Nonsense

Whenever I ('The Prince') hear bloggers or financial “professionals” reading charts and talking about breakouts, support, momentum, resistance, chart patterns, or any number of goofy names for the shapes that charts make, I immediately begin to smile. I do admit that there is useful information to be gleaned from charts such as the number of buyers and sellers or the volume of a stock. Screens of stocks that are near their 52-week lows or 52-week highs can be useful for finding stocks that are good values or overvalued. However, the Prince does not buy into technical stock trading or the day trading that many technical traders partake in.

The truth is most institutional investors and real Wall Street professionals know that technical trading is absolutely hogwash. Now, I’m not the first person to attack technical trading, and I won’t be the last, but hopefully what follows will be educational or at least thought-provoking. The Prince doesn’t believe he is offering any new arguments against technical analysis but he is offering new evidence that may be more compelling when combined with old arguments against technical analysis.

First, a few disclaimers so I don’t hurt too many feelings or egos in the blogosphere. There are many intelligent people online who prescribe to technical trading strategies. My intention with this blog post is not to belittle them, as many of them may even make quite a bit of money. Yet, ultimately those that do perform well on a “risk adjusted basis” are the exception to the rule.

Those that do perform well are deceiving themselves when they think that their prowess in reading charts is leading to their out-performance. In the end, their returns are nothing more than throwing darts at a board and getting lucky, but thinking they have a sure way to always hit a bulls-eye (in the language of day traders have their “winners outnumber your losers”).

Now, there are plenty of con-artists on the Internet selling get “rich quick," ”easy money,” and “guaranteed profits” technical trading schemes like how to trade penny stocks, or use my “stock-trading robot.” This post is not directed at them because The Prince doesn’t think they deserve his attention.

This article is for all investors that vehemently believe in the power of technical analysis but don’t realize that on a risk-adjusted and tax-adjusted (ah…this is very important), they are not outperforming the market. It is meant to educate investors about the tenets of technical analysis, and then make a case for why it is not taken seriously, or even practiced by Wall Street professionals.

No Bid for Technical Trading in the Institutional Investor Marketplace

Let’s start this argument with an applicable example that I think will get any amateur investor who believes in technical analysis some pause. Not too long ago, The Prince was working on a Primebrokerage sales team for a large Wall Street bank. Let’s just say that this Wall Street investment bank has the number one franchise on Wall Street for Primebrokerage. For those who don’t know what Primebrokerage is, let me give you a little introduction.

It is one of the hottest businesses on Wall Street with the juiciest margins and the highest top-line growth. Basically, it is the business of servicing hedge funds which essentially means lending stock for short sales and cash for leverage to hedge funds. This is a very sticky business because if a hedge fund is Primed at a bank they are more likely to trade through that bank’s desks. They are also more likely to use that bank’s investment banking services if they do private deals. Banks that have built successful Primebrokerage practices have seen their businesses flourish.

I spent two summers working in a Primebrokerage division before I entered investment banking. During my time working on the capital introductions team and the sales team I got to see inside some of the largest hedge fund launches of the past few years. The Prince got to work on launches that were so secret and so large they went by code names and only the most worthy investors were allowed to invest. The Prince is talking about multi-billion dollar launches by guys with amazing pedigree (i.e. ex-SAC, ex-Goldman Sach Prop Desk, ex-Maverick, etc.) and successful track record managing large amounts of money.

In other words, The Prince got to see how real experiences hedge managers launched their businesses and brought in large amounts of institutional capital (corporate pension funds, endowments, state pension funds, high net work individuals, etc.). During these two summers he got to see the offering documents and marketing materials for over 500 of largest most respected hedge fund firms on the Street. His firm was a Primebroker for roughly 90 of the firms on Alpha Magazine’s Hedge Fund 100, as ranked by Assets Under Management or AUM.

Needless to say, The Prince became very familiar with hedge fund industry dynamics, the strategies employed by most hedge funds, fee structures, compensations structures, hedge fund power dynamics, what it takes to start a successful fund, the pedigrees of a-list hedge fund managers, and the desires of institutional investors. Do you know how many funds The Prince ran across that professed to use technical analysis to make investments? Zero. That’s right, not one fund. There simply is no bid for this baloney strategy from institutional investors. Most successful hedge fund investors are fundamental investors and The Prince will always believe in fundamental value and contrarian investing.

So if the most sophisticated instructional investors don’t believe in it why should you as an individual investors subscribe to technical analysis? Do we every see Steve Cohen, James Simons (click here for a great Bloomberg profile of Simons, RenTec is one of the best kept secrets from the public eye in the hedge fund industry), or the like coming out and claiming to use technical analysis. Of course not. Now some people may be under the illusion that quantitative or statistical arbitrage funds use technical analysis but they are not readying charts. They are analyzing enormous amounts of data to try to find market inefficiencies and then exploit these inefficiencies.

Do you think Renaissance Technologies keeps hundreds of PhDs in hard sciences on staff to read charts? Of course not. Quantitative firms prescribe to a scientific-based investment strategy that couldn’t be further from reading the tea leaves of charts using technical analysis. The Renaissance Medallion Fund, which redeemed all outside investors a few years ago before jacking up fees to 4% management and 40% incentive fee, did not return an average of 35% per annum after fees since 1989 and rise to become the most consistently successful hedge fund in the industry by using technical analysis. So why would you use technical analysis?

What is Technical Analysis?

If the anecdotal arguments above don’t make you question technical analysis’ worth we can go further. With the previous anecdotal evidence in mind, let’s look at the basics of technical analysis. Technical analysis is the forecasting of future price movements based on an examination of past price movements, and does not result in absolute predictions about the future. Defenders of technical analysis claim it can help investors anticipate what is “likely” to happen to prices over time. It makes use of a wide variety of charts that show price over time, and can be applied to stocks, indices, commodities, futures or any tradable instrument where the price is driven by supply and demand. The reference price for the technical analysts can be any combination of the open, high, low, or close for a given security for a specific period of time, as some technical analysts include volume or open interest figures with their study of price action.

Let’s look at the tenets of technical analysis as original presented by the grandfather of technical analysis, Charles Dow, the founder of Dow Jones. Dow developed a series of principles for understanding and analyzing market behavior. The first principle is that price movements are not totally random. The second major tenet is that price discounts everything and finally that what is more important than why.

Pictured at right: Charles Dow - “Grandfather of Technical Analysis” (Library of Congress Prints & Photographs Division. LC-USZC2-5907)

When a technical trader says that ‘price discounts everything,’ he or she means something like the strong or semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. And, because all information is already reflected in the price, it represents the fair value, and should form the basis for all analysis. The market price reflects the sum knowledge of all investors. Technical analysis utilizes the information captured by the price to interpret what the market is saying about an asset.

Most technical analysis practitioners agree that prices trend. However, some also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. Their objective is to identify the periods when nonrandom behavior is occurring, and profit from it while not participating when random fluctuation is occurring.

When Dow claimed that “what” is more Important than “why,” he was acknowledging that a technical analyst knows the price of everything, but the value of nothing. Technical analysts are are only concerned with what is the current price, and what is the history of the price movement. The price of a tradable asset is nothing more than a reflection of the battle between supply and demand for the asset.

The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach. Technical traders believe it is best to concentrate on what, and not pay attention to why. This is in direct contrast to most fundamental traders (i.e. most successful hedge fund managers and institutional money managers of other stripes) who are concerned with why the price is what it is. For technical traders the why portion of the equation is too broad and many times the fundamental reasons given are seem suspect.

In summary, many technical traders see technical analysis’ focus on price as its greatest trait since the objective is to predict the future price by focusing on price movements. Price movements do precede fundamental changes, and by focusing on price, technical traders are focusing on the future. Technical analysis’ focus on supply, demand, and price action acknowledges that there is information to be gleaned from market information about future price movements, and it can help identify support and resistance levels which can help analysts find out when supply or demand is becoming stronger. It may also help with the timing of a proper entry point for a trader, as they also maintain that even fundamental investors can benefit from a price chart because it provides a pictorial price history which is valuable information to a trader. Such information can include a stock’s volatility, reactions to events, historical volume, and the relative strength of the stock to the market. While these are all good points, The Prince doesn’t believe that technical analysis can lead to long-term risk adjusted, and tax adjusted out-performance.

Classic Weaknesses of Technical Analysis

The most important weakness is that analysts reading charts can be biased. This is the case with fundamental analysis. Technical analysis is subjective, and our personal biases can be reflected in our trading decisions. If an analyst is feeling bullish this may bias his or her reading of the chart.

Technical traders are also critiqued for being too late in identifying trends. All too often we see technical traders marking up charts showing price movements when they were unable to predict the trend before it started. As a result, many technical traders miss out on trends because they start riding them too late.

Technical analysis is also chronically open to interpretation. For example, two technical traders can look at a chart and tell two different stories and see two different patterns. The chart's interpretations are in the eye of the beholder. Not all signals and patterns work. Sometimes a “sell signal” will work, and sometimes it won’t. And, it may work on one particular stock but not on another.

Even though many principles of technical analysis claim to be universal, all are idiosyncratic. For most technical analysis tools, two followers of a theory may see different results. Technical analysis was developed for short-term traders. There is little value in assisting investment decisions, if any, for institutional money managers.

While these classic weaknesses of technical analysis are convincing to The Prince, The Prince is more convinced by the attitude of success hedge fund managers and institutional investors towards the use of technical analysis. If a portfolio manager calls or meets with an institutional investor and tells them they are going to employ technical analysis, the institutional investor is going to laugh or hang up. That’s all the convincing The Prince needs of the bankruptcy of technical analysis as an investing strategy. Technical analysis is an art, and not a science, and The Prince believes in science.

Comments

[Pj568]

What is the right method? Technical analysis has the same flaws just like any other type of analysis, no more, no less. All financial analysis contains a multitude of assumptions, most of which will be incorrect. You can see that no correct method exists just by comparing the the values assigned by the various analysts to the market value. Look at last year, today or next year and you'll find wide descrepancies. You'll find parties making and losing money using any method selected. Just like all methods you can get the past correct more often than the future. You can tell that private equity and public companies are definitely not immune to failures either by looking at their acquisition track record.

2008 Jan 07 09:23 AM

[The Silver Analyst]

So the big boys don't use technical analysis? Going by the subprime mess and the various other big mistakes they have rode up and down (dot com bust?), whatever they are using it ain't much better!

2008 Jan 07 10:24 AM

[kkin365]

If anyone has a sure-fire system to make money, you can rest assured that that someone will not disclose it to anyone else. So, in the final analysis, it is the result that counts. I think Barron's has the right approach -- ask no question about technique, just the facts.

2008 Jan 07 10:29 AM

[Pj568]

Quoting the authors website " I am a senior at a prestigious college (i.e. think Williams, Harvard, Princeton, Amherst) awaiting the start of my first full-time job as an investment banking analyst at a prestigious bank (i.e. think Morgan Stanley or Goldman Sachs). I will be commenting on finance news and events. I will also share some trading ideas that I have in my portfolio and the rationales behind the themes that motivate my trading ideas.............I think it is time for me to venture out on my own with a blog to share my point of view and selected parts of my life with the world. So essentially, I have no real qualifications to write finance commentary but it should be interesting nonetheless."

2008 Jan 07 11:00 AM

[ratsharp]

hey prrince.. i was told the same thing at any fin course i was taught.. the profs didnt even try to disprove that tech analysis doesnt work ..coz the assumptions were that its has already been tested. The funny part is if you look for papers on tech analysis , there is one as recent as 2001 by a strong practicioner of quantitative strategies who mentions that there are some that work( without mentioneing which one obviously). The market ineffiiencies that you talk about which are being exploited by "quants" are simply a stastical and in many ways a reasonable interpretation of almost 7000 technical strategies.. hardcoded and then parametrized. I could write more, but then I would spill the bean , and then I would have to kill you.

2008 Jan 07 12:54 PM

[Michael Covel]

In my book Trend Following I make the distinction between predictive and reactive technical analysis (no small distinction). Reactive technical analysis or if you call it systems trading or if you call it trend following is all about the use of the scientific method.

2008 Jan 07 06:14 PM

[Nelbender]

Prince, Interesting Article, but, You are away WRONG!! You obviously have a lot to learn. I don't blame you for working for a Investment Banker, don't try Trading on you own, with that attitude. Percentage wise, I'll put up my Portfolio, against any Fundamentalist. Needless to say, I am a Technical Chartist, and obviously there is a lot more to reading the Charts of any Stock, than you have time to comprehend. I make from 60% to 100% returns on my Money, each Year. I'll even blow your mind more, I trade on $1.00 to $5.00 stocks, doing that.

There is a lot of Hogwash put out by Analysis. Don't believe everything that you hear. By the way that all these Big Fund Managers have goofed this last year, maybe they too, should hire some Technical People. Fundamentalist thinking will get you in trouble, quick!! Charts, with the FIBORONIC Factor System, applied there on, will enlighten you quick, if you have someone to show you how. However, with your attitude, I wouldn't attempt it. You are away off Base.

2008 Jan 07 10:51 PM

[Nelbender]

By the way, you say that Technical Chartist can't predict the future? Ask a Fundamentalist what is going to happen when the Nasdaq nears the 2398 area. Up and out of here, is what the Chart says!!

2008 Jan 07 10:59 PM

[davenport47]

The false expectation that TA ought to be a scientifically accurate system for predicting stock prices may indeed kill you in the real world. First, you should get a fundamental idea or make an observation (such as the bursting of the housing bubble) and then, and only then, use charting as a tool in trying to deal with how that idea may play out in the stocks.

My own use of TA (as a tool) is to note when a price trend has reversed. A trend reversal may be called "a change in fundamentals" as well as "a bearish chart pattern" or whatever you like. A chart is simply another way of tracking what's going on with the stock price. Why the stock price is rising or falling is important, so I disagree with those who think TA should be used in a vacuum. I didn't bail out of my short positions, for example, when the Dow went over 14K. How come? Because I decided that the market had become "irrationally exuberant"! That's was an intuitive observation, given my real-world knowledge at the time. Later, I "called" the top of the rally on Oct. 11 using TA methods.

I also rode out all the calls for bottoms in the homebuilders because the textbook TA *coincided* with what I knew of unwinding bubble markets---that they fall far more, and have far greater consequences, than anyone first realizes. I listened seriously to Yale economist Robert Schiller, who knows far more than I about FA in housing markets.

The mistake that people make is to attack the straw man of pure TA, as if one should expect it to provide something NO system of trading or investing can provide---which is scientific predictability. Malkiel, in A Random Walk Down Wall Street, quotes studies that show neither TA nor FA does better than chance in predicting stock prices over the short or intermediate term. And I suspect---though I am not certain---this is true. But some combination of the two, along with one's own insight---not to mention good money management---may be the ticket. It has been so for me since I began studying these matters seriously.

On the issue of hired technical analysts, major brokerages such as Merrill Lynch and Goldman have them. You can verify this any day on CNBC when a guest is introduced as a chief technical analyst for Merrill Lynch, etc. So I have no idea about the information here. Perhaps there is an investment culture that eschews the idea of TA. That's fine with me, for one needs people on the other side of a trade made using TA.

One disadvantage of TA is that you usually miss part of a move by waiting for confirmation. Yet that's how Jesse Livermore made his millions. "Never anticipate" was a motto of his. This means that you usually load up only when a price breakout or breakdown is confirmed. And if you get a failed signal, you get out quickly to minimize your losses. Sometimes one's intuition overrides textbook confirmation.

Also, when someone refers disparagingly to TA as "an art" not a science, I wonder why that's a problem. TA is a tool that should be used in conjunction with one's knowledge and experience.

2008 Jan 07 11:14 PM

[Yafit]

I was a sell-side fundamental analyst (tier-1 clients), and a portfolio manager before that. To summarize your logic, it is basically:
1. hedge funds provide amazing returns
2. hedge funds don't use TA.

My summarized answer:
1. hedge funds use extensive leverage so when the markets rise (and they have done so year after year in the last few years) then the hedge funds have multiple return as the market.
2. tier1 hedge funds are extremely large, and can't use TA to manage such portfolios even if they wanted.
3. pointing to the successful hedge-funds and saying "see, they don't use TA" is exactly like pointing to the most successful traders and saying "see, they don't use fundamental".
4. smaller hedge funds do intra-day trading and they DO use variations of TA (in addition to statistics etc), but certainly NO fundamentals.

my 2cents.

p.s. see gstock.com - you might be surprised.

2008 Jan 08 02:24 AM

[turtletrader]

This is Bull$hit. "sometimes entries work and sometimes they dont"? cant the same be said for fundamental analysis? did fundamental analysis make some internet stocks look like bargains when they were off 20%?

2008 Jan 08 02:13 PM

[davidjohnhall]

Me thinks the prince has become a frog!

Basing your own ideas on what fund managers are doing is no better than a technical trader basing his ideas on Charle's Dow's thoughts of past and current (not future) price action. I might be a little crazy here, but I'll take the opinion of Chalres Dow for now.

That's Chalres Dow of...Dow Jones.

Truth is, most (if not all) retail traders aren't having lunch with hedge fund managers and hardly ever get the right story from the buy side driven news and analyst recomendation. But they sure can tell when price is taking a swan dive...or riding up on strength.

As for those stocks that are trading sideways...we'll leave those for the fundamental value traders to accumulate in their bases. And we'll meet you at the breakout!

Buy the rumor sell the news. Isn't that what they say? Based on what I've just read I will be shorting your opinion.

2008 Jan 08 02:21 PM

[Peter Davis]

With all due respect, that's about the dumbest thing I've ever heard. Fundamental analysis can be very effective, but so can technical analysis. I wonder what the institutional investors who have shunned TA are saying now as they're taking a bath from myriad bad investments.

I know of many technicians who have been wildly successful and would put their records up against anyones. While the author may not find TA to be useful, that doesn't mean it is empirically invalid.

Th fundamentalists can try to bottom fish all they want and continue trying to buy value only to watch "cheap" get "far cheaper". The method I employ called for a retest of August lows in the S&P over a month and a half ago. It reasserted that forecast when the market rallied into Dec. 10th. As I write this, we're about 6 points above that low. No fundamental analysis went into this forecast.

It is my opinion that any method can be valid, provided that it is traded with discipline and consistency. It's been my experience that those who speak in absolutes are the most dangerous ones, because they fail to see alternative opinions. On the other hand, this technician doesn't mind, because such foolishness makes for great trades.

2008 Jan 08 03:26 PM

[John Forman]

Firstly, why does "The Prince" refer to himself in the 3rd person?

Secondly, "anecdotal evidence" doesn't convince me of anything.

Thirdly, has the author actually been in a meeting or on a phone call where a money manager talked about using technical analysis and got laughed at?

I'm well aquainted with the type of financial theory taught at the university level. It is almost exclusively oriented toward institutions (large portfolio management) and of little practical use for individuals. Second, there have been some very serious changes in the views among leading academics regarding technical analysis (sometimes referred to as Behavioral Finance) which has yet to really filter down to the classroom.

2008 Jan 08 06:42 PM

[calven]

Technical Analysis is hogwash because you obviously haven't taken the time to learn how to use it. If you assume that technical analysis can be used independently of everything you are hogwash yourself. Technical analysis, when used with a few other methods listed below is extremely valuable. Particularly volume and price movement - VOLUME moves stocks. There are other important factors like price ranges and support and resistance....

1) Find Stocks with strong fundamentals (valuation)
2) Identify catalysts (or lack thereof) for the company/sector IE competitive advantage, increasing product demand, cyclical factors, rising prices
3) USE TECHNICAL ANALYSIS TO IDENTIFY A PROPER ENTRY POINT (USUALLY MULTIPLE ENTRY POINTS IE SCALING A POSITION) AT KEY SUPPORT LEVELS

If you don't use technical analysis in relation to "scaling" into a position you are missing out on a lot of upside and better entry points. As far as I am concerned your article leads me to believe 1) You have never tried TA or worse 2) You have tried using it independently of fundamental analysis.

I would respectfully recommend taking down this ridiculous article until you fully explore TA for yourself...and for heaven sakes, realize it is only part of the puzzle. It should account for roughly 1/3 of your trading decision.

2008 Jan 08 07:50 PM

[turtletrader]

I think this author has stirred up an old debate and has offered nothing new to chew on. I personally manage a rather sizable fund that uses nothing but technical analysis, pattern recognition, and other forms of trend following. While I dont care whether the company I trade makes ipods or sewing machines, we do make sure the company is of a certain size and of ample liquidity before trading. and that is only because our system has proven that comanies of that certain size and liquidity outperform.

best of lucking reading the tea leaves and scratching your head when your cheap stock is now in a fire sale.

2008 Jan 09 01:08 PM

[NoFate]

There are at a minimum several benefits of TA:

1) At the very least provides a framework in an otherwise context free environment.

2) Certainly the more macro signals are powerful ...lower highs and lower lows, double bottoms, etc. Ignore these things at great peril.

3) It is hard to prove support and resistance levels, etc. because TA is trumped by the economy, news and earnings ...often slicing through TA levels like butter. But these levels also often hold when other forces are not moving the market.

4) Many people know TA and therefore some predictions become self fulfilling prophesies.

I too come at investing from an academic background ...Economics degree and MBA ...and I regret listening to many of my professors (who meant well). TA is an attempt to determine the impact of psychology on the market, which is a severly understudied phenomena.

During my studies all I heard was "random walk" ...which is probably accurate for the very short term ...but tell me the NASDAQ took a random walk from 5200 to 1200 at the beginning of the century. What a load of crap.

Not just in investing, but in life ...always be skeptical, but also always be open to new ideas.

2008 Jan 09 01:48 PM

[ritholtz]

This was the funniest post I have ever read.

Not only are you an inexperienced child, but you completely mischaracterize what the usage and value fo TA is.

Even funnier, you have the nerve to call yourself Prince of Wall Street -- that's hysterical!

Come back after you have spent some time and money learning to trade. As of right now, you are just another loudmouth, a minister with no portfolio . . .

2008 Jan 10 03:26 PM

[DD123454]

Great, a 22 year old soon to be graduate of a prestigious college that daddy paid for is going to let us in on the secrets of high finance. And how did he find out and get his swelled head--he talked to some people and they told him. Two things stand out: one, he doesn't know anything really about TA (or money management or anything else, except maybe where to get the best croissant in Cambridge or Providence) and, two, he is unlikely to learn. All great fortunes have been made with TA, even those parading under the mask of FA. Why? Because no matter what your reason for establishing a position, only fools hold it beyond the point where it violates a price point (support, resistance, etc.) Those who use FA talking points to get them into a position might as well use the stars or the phases of the moon; those who ignore TA warnings for adjusting stops, setting targets, harvesting profits, will soon have blown up accounts and useless war stories. Even Soros who sometimes analyzed markets via FA in the end relied on a form of TA to increase, decrease or get out of the markets.

2008 Jan 10 03:53 PM

[NO DooDahs]

@ the Prince: please, don't go changing! Your trades will doubtless provide much profit for others. Could you disclose them, please?

@ Seeking Alpha: I am once again reminded why I rarely visit here.

2008 Jan 13 01:44 PM