Why Technical Analysis is Nonsense

by: Prince of Wall Street

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.