The Evolution of Technical Analysis, A Lo, J Hasanhodzic

Tags: technical analysis, Jasmina Hasanhodzic, Andrew W. Lo, market prices, indirect evidence, direct evidence, financial practice, Dojima Rice Exchange, market practices, ancient civilizations, efficient markets hypothesis, pool operations, point and figure charts, market data, EMH, Christopher Kurz, technical terms, astrology, Burton Malkiel, Munehisa Homma, Babylonian tablets, United States, BLOOMBERG TERMINALS Andrew W. Lo, John Wiley & Sons, Inc., Copyright Clearance Center, Inc., Andrew W., Permissions Department, Jasmina, Hoboken, New Jersey, Wiley products, prior written permission, United States Copyright Act, market psychology
Content: The Evolution of Technical Analysis FINANCIAL PREDICTION FROM BABYLONIAN TABLETS TO BLOOMBERG TERMINALS Andrew W. Lo Jasmina Hasanhodzic
The Evolution of Technical Analysis Financial Prediction from Babylonian Tablets to Bloomberg Terminals Andrew W. Lo and Jasmina Hasanhodzic
Copyright © 2010 by Andrew W. Lo and Jasmina Hasanhodzic. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Lo, Andrew W. (Andrew Wen-Chuan) The evolution of technical analysis : financial prediction from Babylonian tablets to Bloomberg terminals / Andrew W. Lo and Jasmina Hasanhodzic. p. cm. Includes bibliographical references and index. ISBN 978-1-57660-349-9 (cloth) 1. Technical analysis (Investment analysis)--History. I. Hasanhodzic, Jasmina, 1979- II. Title. HG4529.L62 2010 332.63'2042 -- dc22 2010019276 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1
To our mothers
Contents
Introduction
vii
Chapter 1: Ancient Roots
1
The Beginnings
2
Ancient Babylon
5
Ancient Greece
11
Ancient Rome
15
Negative Attitudes toward Traders
18
Chapter 2: The Middle Ages and the Renaissance
21
Western Europe
22
Technical Analysis
32
Societal Attitudes
39
Chapter 3: Asia
43
Japan
44
China
49
v
vi
CONTENTS
Chapter 4: The New World
59
Wall Street
60
Societal Attitudes
73
Chapter 5: A New Age for Technical Analysis
81
Dow Theory
82
Relative Strength
91
Market Cycles and Waves
92
Chart Patterns
94
Volume of Trading
96
Market Breadth
99
Nontechnical Analysis
99
Chapter 6:
Technical Analysis Today
105
Trends
106
Patterns
109
Strength
111
Cycles
112
Wall Street's Reinterpretation of Technical Analysis 114
Chapter 7: A Brief History of Randomness and
Efficient Markets
131
Prices As Objects of Study
134
The Emergence of Efficient Markets
137
What Is Random?
141
Chapter 8: Academic Approaches to Technical Analysis
149
Theoretical Underpinnings
150
Empirical Evaluation
151
Adaptive Markets and Technical Analysis
161
Notes
167
Bibliography
191
Acknowledgments
199
About the Authors
203
Index
205
Introduction Technical analysis--the forecasting of prices based on patterns in past market data -- is something of a black sheep in modern economics. Some skeptics view it as kissing cousins with sleazy speculation or gambling, while others regard it as a relic that is only slightly more sophisticated than the reading of chicken entrails. Proponents of quantitative analysis, who take physics as the ideal model of how economic science ought to look, view technical analysis as antiquated and contrived in its very foundations. They demand mathematical proofs of its validity and dismiss as exception bias the strong betting averages and impressive bottom lines of successful technicians. We make it no secret, then, that we regard technical analysis as a legitimate and useful discipline, tarred by spurious associations and deserving of further academic study. Some of this skepticism is understandable in light of the historical origins (and occasional abuses) of technical analysis. Many of its methods come down to us from the days before computers and the number-crunching-intensive theories they made possible, and not all of its methods have been thoroughly explored within the quantitative frameworks now available. Many terms and concepts in technical analysis can seem abstruse or outmoded; it is easy to see how a discipline that vii
viii
INTRODUCTION
involves eyeballing charts for patterns with names like "head and shoulders" and "cup with a handle" might seem at first blush more akin to astrology than science. However, many of these are merely heuristics developed in the precomputer age when calculating a simple statistic was a formidable task. For instance, the 10-day moving average became a fixture of technical analysis not because it was optimal, but because it was trivially easy to compute. Indeed, there are many such concepts in "classical" technical analysis that could benefit from quantitative reformulation. Ultimately, however, both technical and quantitative analysis serve similar purposes: They both attempt to predict the future based on models of the past. One is statistical, the other is intuitive. Whereas a quant minimizes a sum of squared residuals to find the best-fitting line given the data, a technician estimates it by looking at the charts, searching for tell-tale patterns, and inferring the thoughts and feelings of other market players. Both approaches have merit. This is not to say that they are equal; clearly, quantitative methods have won hands down, dominating the investment industry because of their demonstrable value-added. But technical analysis is surprisingly resilient and persistent, and in some corners of the financial industry--such as the trading of commodities and currencies--it is still the dominant mode of analysis. This state of affairs suggests that technical analysis may have something to contribute, even to the most sophisticated quant. Fortunately, a slow but sure reconciliation is underway. Though big strides have been made throughout history and in recent years toward developing a more systematic approach to technical analysis, technicians remain ostracized to this day. For evidence, look no further than the Financial Industry Regulatory Authority's official recognition of the Chartered Market Technician designation, which occurred only in 2005. Part of the reason is that technical analysis is often associated with the speculators, bear raiders, and market cornerers of previous eras. As Tony Tabell, a veteran technical analyst and an heir to the technical brokerage business founded by his father Edmund Tabell in the 1930s, explains: It's hard to visualize unless you've talked to people who were involved how difficult this was in the atmosphere of [the] 1930s and 1940s. The entire brokerage business was a basket case.
Introduction
ix
Volume on the NYSE was under a million shares. This was the 1930s, the Great Depression, nobody had any money, and if they did, they were very leery about investing. Furthermore, technical analysis had been associated with the excesses of the 1920s. All of the various Securities Acts were designed to get rid of the manipulative market operations that had characterized the '20s. Since technical work to a great degree (certainly point and figure charts) had been originally conceived as a means of detecting pool operations, confessing that you were involved in technical work at that point was sort of equivalent to confessing that you were some kind of a low-level criminal. I saw some [of ] this, because the remainder of this attitude was still kicking around when I started in the business in the 1950s, but I can imagine how incredible it must have been in the '30s and '40s.1 The efficient markets hypothesis (EMH), formulated in the writings of Samuelson (1965) and Fama (1965a,b; 1970), did not help much.2 According to this theory, there are no patterns in market data that are exploitable through trading strategies. Ever since the advent of modern finance--a theory based on rational expectations and market efficiency -- technical analysis has been dismissed in academic circles as a mathematical impossibility. As Princeton University economist Burton Malkiel concluded in his influential book A Random Walk Down Wall Street (1973), "under scientific scrutiny, chart-reading must share a pedestal with alchemy." As we recount the premature obituaries for technical analysis, it is worth noting as an aside that recent research has not only documented departures from the EMH--in the form of cognitive biases such as overconfidence, overreaction, loss aversion, and herding--but has also included new theoretical underpinnings for technical analysis and the empirical validation of certain technical patterns and indicators. Malkiel's lumping of technical analysis with alchemy is not entirely coincidental, for here we come across another historical reason for the field's questionable reputation--technical analysis was used in conjunction with astrology since the earliest times. The ancient Babylonians would methodically record, often intraday, the prices of various commodities, but they would also assign those same commodities to
x
INTRODUCTION
the astrological regions of Pisces and Taurus, depending on whether they were bullish or bearish. Similarly, in addition to the very logical lists of weights, measures, and exchange rates recorded in medieval merchant manuals, they also often contained lengthy astrological appendixes and advised their readers to buy, sell, or begin anything when they were in the region of Virgo. Yet another example is provided by Christopher Kurz, a sixteenth-century Antwerp trader, who claimed to be able to forecast prices of commodities up to 20 days in advance using his technical Trading System based on back-tested astrological signals. Such close links between technical analysis and astrology are naturally a cause for suspicion and skepticism today. But for our ancestors, astrology was a way of life, applied to wide-ranging areas of human endeavor including warfare and medicine. It was no coincidence that Christopher Kurz doubled as a political astrologer--he is known for having forecasted the extinction of the papacy, among other things -- while Thales of Miletus, one of the Seven Sages of ancient Greece, made meteorological predictions based on movements of the stars and planets. That societies would base their operations in part on astrology sounds absurd today, but interestingly, if we view astrology as a random number generator of the precomputer age, its prevalence becomes more understandable. Then, as now, forecasting--financial and otherwise--was a business of probabilities. Just as computer-generated random numbers are part of today's statistical forecasting models--for example, the commonly used Markov Chain Monte Carlo method for constructing Bayesian forecasts -- astrology may be thought of as a random input in ancient forecasting models. The evolution of technical analysis did not take place in isolation. The growth of markets provided one stimulus for its development. In ancient Babylon, simply writing down Commodity prices on clay tablets was sufficient for tracking market action, but with the advent of financial exchanges, the need for visualizing market data became evident. By the 1830s, price charts emerged and soon became so prevalent that people like William Stanley Jevons and James Wyld made their livelihoods from producing sophisticated charts and selling them to various offices.
Introduction
xi
Speculation provided another stimulus. Though speculation and technical analysis are not synonymous, they do share a certain awareness of market psychology and of the forces of supply and demand. It was precisely when speculative techniques were ripe that technical analysis became more concrete, such as on the Dojima Rice Exchange in seventeenth-century Japan, where the legendary trader Munehisa Homma developed the "candlestick" charting method to be able to visualize open, high, low, and closing market prices over a certain period, and formulated his version of technical analysis, which remains popular to this day. Despite the distance created by continents and thousands of years, the market wisdom of Charles Dow, the father of modern technical analysis, is astonishingly similar to that of his earliest predecessors, including the ancient Athenian practice of using price level as an indicator of market sentiment, Homma's rotation of Yang and Yin (bullishness and bearishness), and the emphasis in late imperial China on "the ultimate principle," which is that "when goods become extremely expensive, then they must become inexpensive again."3 Such similarities reveal technical analysis as a truly universal phenomenon and highlight how deeply ingrained it is in human psychology to reason in technical terms in order to ride and reinforce the trends, as was the case with the humble tulip bulb during the 1633 ­1637 tulip mania in Amsterdam. As de la Vega put it, "for on this point we are all alike: when the prices rise, we think that they fly up high and, when they have risen high, that they will run away from us."4 As long as humans, not robots, make the markets, bubbles and crashes will be a reality. This is an especially important lesson in the wake of the 2007­2009 global financial crisis, a time when many fundamentals have crumbled and in some spheres of financial practice there has been nothing left to work with other than technical analysis. In this book, we present a broad, largely nontechnical historical survey of technical analysis, tracing its roots and evolution from ancient times through the medieval and modern eras. While neither of us is a practicing technical analyst or "technician," as they prefer to be called, we have been fascinated by this strange craft for many years, and this volume is the outgrowth of our own attempt to make sense
xii
INTRODUCTION
of the discipline. As outsiders, we hope to bring a somewhat different perspective that can bridge the gap between academia and the technical analysis community. Our previous book, The Heretics of Finance, contained interviews with leading technicians in which they described their art in their own words. In this volume, we take a more expansive view and search for the origins of technical analysis throughout history. This endeavor was more challenging than we anticipated because, in many cases, the historical evidence of technical analysis is indirect, and many ideas were not fully developed by their originators. This is not surprising since, in the past, the concept of technical analysis as a separate discipline did not exist; rather, it was entangled with the intuitive, sometimes whimsical, and rarely systematic way of buying and selling practiced by speculators, bankers, and merchants. Hence when we say that merchants were the liberators of the independent human spirit and the driving force behind the progress of world civilization, we mean technicians, too. It was they who put an end to solely monastic education and the use of Latin in business and private life, and who initiated lay education in the Middle Ages. It is no coincidence that some of history's great scientists were also engaged in investing, their market experiences often motivating their scientific contributions (Fibonacci being but one example). Sapori once said that medieval merchants "traced for individuals and peoples of all times to come the only way that leads to a full realization of humanity."5 We hope this book will convey the same for technical analysts across all eras.
Chapter 1 Ancient Roots A lthough there is no direct evidence of technical analysis from ancient civilizations, scattered indirect evidence can be uncovered in early market practices. Bearing in mind that technical analysis is not merely a toolbox of head-and-shoulder-like patterns and MACD-like indicators--as many think of it today--but rather the use of past prices to forecast future ones in the most general sense, we find evidence of it in Babylonian price records, Greek market sentiment assessments, and Roman seasonality patterns. Our predecessors not only followed market prices but also made conscious attempts to measure supply/demand imbalances in price data and react to them for their profit, often combining their insights with "data" from fundamental nature or astrology. It should come as no surprise that in ancient times technical forecasting methods were inextricably linked with and in some cases arose from trading and speculation; hence in this chapter we review them side by side. 1

A Lo, J Hasanhodzic

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Title: The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals
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