“Do you think that the inclusion of astrology in technical analysis undermines the credibility of the craft?”

The answers that some leading technicians give to this question, posed by Andrew W. Lo of the MIT Sloan School of Management and Jasmina Hasanhodzic of AlphaSimplex Group LLC, reveal an impressively broad-minded attitude:

• “Could astrology in some offhand way be beneficial or instructive? I’m going to say yes.”
• “It depends on the type of astrology you’re talking about.”
• “I’ve seen some people make some very good calls using astrology.”
• “Astrology is bad for technical analysis only in the eyes of closed minds.”

By comparison with the stargazers, conventional security analysts command little respect from the chartists. Commenting on whether technical analysis might be more effective in forecasting market direction when combined with fundamental analysis, technician Robert Prechter likens the question to asking, “Is food more effective when used on its own or when combined with arsenic?” Countering the criticism that technical analysis relies on the past to predict the future, Alan Shaw points out that fundamental analysts’ use of balance sheets and income statements is similarly backward looking. This argument glosses over the fact that fundamental analysts’ actual practice is to derive their valuations from companies’ projected financial statements.

Not even fellow technicians are exempt from the reproaches of Lo and Hasanhodzic’s interviewees. Prechter derides technicians who deviate from the price-is-all-that-matters principle by discussing the fundamentals (e.g., the trade deficit, unemployment, and statements by the Fed chairman) “as if any of that makes a whit of difference.” Shaw condemns what he regards as erroneous technical analysis: “Listen to many of the people on the cartoon network—CNBC—and what you’ll hear is stupidity.”

Readers of The Heretics of Finance: Conversations with Leading Practitioners of Technical Analysis must excuse the defensive tone of certain passages. The technicians featured in the book come across as sincere in their belief that the patterns of past price movements contain useful information about future price movements. Stan Weinstein flatly states, “If you follow the system, it’s impossible to have a big loss.” The chartists tirelessly refine and apply their time-honored techniques, only to reap the scorn of academicians who maintain that markets are highly efficient.

Suffering the disdain of finance professors, however, is an improvement over being regarded as “low-level criminals,” in Anthony Tabell’s words. In the 1920s, the point and figure chart was used to detect collusive stock manipulation (“pools”), presumably in an attempt to benefit from this unsavory, albeit not yet illegal, activity. According to Tabell, the technical analysts’ shady reputation persisted into the 1950s.

Nowadays, technicians come under fire mainly for promulgating trading rules that lack empirical validation. They tend to dismiss this criticism as unfair or irrelevant, offering such defenses as the following:

• “I doubt that many of the theories have been—or can be—back-tested.”
• “Few things in life are perfectly black or white.”
• “Technical analysis is an art.”

Not all the interviewees in The Heretics of Finance are so casual about statistical proof. Laszlo Birinyi contends that the absence of hard and fast rules and proven theories is problematic. “It allows you to pick a stand and then find things that support your stand,” he argues. Although the authors include him among the technicians, Birinyi bluntly states, “The truth is technical analysis doesn’t work in the market.” His own approach to trading involves exhaustive empirical testing, often with the result of debunking venerable technical rules. Birinyi notes that anyone who relied on the advance/decline ratio would have stayed out of the stock market from 1957 to 2002.

These controversies make for highly interesting reading, which is aided by excellent redaction of lengthy interviews that could have proved unwieldy to other editors. The fact that the raw material consists of extemporaneous speech excuses a few redundant modifiers (e.g., “particularly unique,” “total gestalt”). The homophonic confusion “neither fish nor foul,” however, cannot be excused on that basis. Curiously, the book’s introduction states that the authors interviewed 14 leading technical analysts, yet the table of contents and the acknowledgments list only 13.

Lo and Hasanhodzic must be commended for undertaking this ambitious project. The Market Technicians Association has more than 3,000 members in 70 countries. Serious research on such a prominent feature of the financial markets is worthwhile whether or not one finds technical analysis helpful in making investment decisions.

As it happens, the authors’ thoughtful introduction summarizes a rigorous study that suggested technical methods are more useful than many academicians believe.¹ The study developed precise mathematical definitions of 10 classic indicators, including the head and shoulders and the double bottom. Using a quantitative technique well suited to estimating nonlinear curves (nonparametric kernel regression), the researchers found that for NASDAQ stocks, all 10 patterns are statistically significant. This finding implies that the indicators contain incremental information regarding future returns. Lo and Hasanhodzic comment:

While 'incremental information' does not necessarily imply that technical analysis can be used to generate profitable trading strategies—as most technicians would argue—these findings do raise the possibility that technical indicators can add value to the investment process.¹

They conclude by expressing the hope that their book will launch a productive dialogue between academicians and technical analysts. That remains to be seen, but The Heretics of Finance makes an intriguing case for bringing the parties together.

—M.S.F.