Efficient Market Hypothesis and Technical analysis – A Prequel to The Dispute for The Human Nature

Three decades ago, the efficient market hypothesis (EMH) was widely accepted by academics (for example, see (Fama, 1970). It was generally assumed that securities markets were highly efficient in reflecting information about individual stocks and the stock market in general. The commonly accepted understanding was that when new information comes to life, it spreads fast and is assimilated into the prices of securities right away. In that sense, neither technical analysis, which is the study of past prices in an effort to forecast future prices, nor even fundamental econ analysis, which is based on financial indicators such earnings, asset values, etc., to support speculators in the process of selecting “undervalued” securities, would allow an investor to achieve returns greater than those that could be obtained by holding a randomly chosen portfolio of individual stocks with comparable risk.

The EMH is connected to the idea of a “random walk,” which is a notion somehow freely used in finance  to characterize a price series where all subsequent changes represent random deviations from previous prices. The general idea is that if the flow of information is not hindered and is immediately embedded in prices, then tomorrow’s price change will reflect only tomorrow’s new information and will be independent of the today’s price change. However,  news is by its nature unpredictable and, thus, associated price changes should be also unpredictable and random. Therefore, prices fully reflect all available public information, and even uninformed speculators buying a diversified portfolio at the existing “menu” of prices given by the market will get a rate of return as hearty as that achieved by the “professionals”.

As I’ve once read somewhere, a blindfolded monkey throwing darts at the Wall Street Journal could pick up a portfolio that would do as well as the so called professionals. Of course, the idea was not literally to throw darts but to throw a towel (or at least a napkin) over the stock pages – that is, to buy an index fund that followed buy and hold strategy for all the securities and that charged very low costs.

Since the start of the new century, the academic prevalence of the efficient market hypothesis had become far less wide. A growing part of the financial experts, economists and econometricians began to believe that prices of securities are at least in part predictable. A new “wave” of economists underlined psychological and behavioral elements of securities price determination, and assumed that future stock prices are somewhat predictable on the ground of past price patterns as well as certain “fundamental” valuation indicators.

Furthermore, many economists of the new “wave” were even making the far more disputable assertion that those predictable patterns enable investors to earn excess risk-adjusted rates of return.

Now, EMH is just  one side of the story.  Objective analysis requires clarification of the opponent’s opinion, namely – the technical analysis and the Dow theory.

Technical analysis is involved with the study of historical market price and volumes to evaluate securities transactions. Technical analysis is based on the concept that all information concerning stocks, including risk, earnings, products, etc. is reflected in market behavior. Market price dynamics are of fundamental importance to the transaction decision. Some technical analysts pay large attention on charting historical market prices of securities. In his bestseller on charting, Edwards and Magee [1997][1] claim that

 “The market price reflects not only the differing fears and guesses and moods, rational and irrational, of hundreds of potential buyers and sellers, but it also reflects their needs and resources – in total, factors which defy analysis and for which no statistics are available.”

The market price and its attitude over time provide meaningful information and signaling. Therefore, the current price may possibly  not be the best and only indicator of the intrinsic value of a security. Furthermore, it may well be worthless to try to determine this intrinsic value. In addition to price sequences, which indicate the market participant’s psychology in a better way compared to firm fundamental factors, transaction volumes and information about other participants and strategies would probably be in interest to most technical analysts.

The theoretical basis for technical analysis is derived from the following list of assumptions:

  1. Market price is determined by the interaction of supply and demand, which are functions of a number of factors, some rational and some irrational.
  2. Security prices tend to move in trends that remain for a considerable length of time, despite some fluctuations in the market. It is quite possible that these trends can repeat over time in a sustainable manner.
  3. Trend changes are caused by shifts in supply and demand.
  4. Changes either in supply and/or demand can be identified sooner or later in the price charts in the form of patterns.

A considerable part of technical analysts (chartists) assume that security prices and market dynamics are based on the market “psychology”. The latter is revealed through historical price patterns and charts. A given pattern may be related to a given market psychology condition, which will result in the same future price movements as did in previous identical patterns. Thus, the market “responds” in a same way every time it encounters the same psychology as shown by the price pattern.

Short and clean, this is the basis of the debate over the existence of the market’s perfect rationality and efficiency. Slowly, step by step we will reveal and discuss most popular charting systems, different forms of market efficiencies, as well as evidences, experiments and real examples. What’s the purpose of all that ? Well, let’s say that we are kind of obsessed by the puzzle regarding the possibility of achieving better that average market returns (given certain level of risk). Shaping the puzzle in another form, that is laying out the question – is irrationality embedded in our nature, or not.