Theoretical Foundation of Technical Analysis

Saturday - 20th June, 2009 | ResCon

It would be much easier and safer for investors if they could predict the future share prices accurately. Both the problem with predicting future prices is that it is not as easy as it seems it is. Statistics indicate that the predicted prices are more often inaccurate than they are accurate. Over the years, many prominent economists have tried to trace the behavior of stock prices with the assumption that stock prices, generally, reflect the future performance of firms and recurrent pattern in prices. But surprisingly a research done by Maurice Kendall concluded such predictable patterns actually do not exist. The prices fluctuated randomly on a daily basis, without consideration of past prices or future potential. Therefore, economists seemed to imply that the stock market is dominated by erratic market psychology, or animal spirits- that is, it follows no logical rules (Bodie, Kane, Marcus; 2002, pg.340).  Therefore obvious conclusion the research drew was that the market functioned irrationally. 

But subsequently, economists started realizing that this so called irrationality is actually the rationality of the market- the random price movements indicated the efficient functioning of the market. This realization had come afore with realization of the self fulfilling prophesy effect of the "good news" implicit in the forecasted price.  Let us take an example to explain the above statement. Suppose today's price of Company A's stock is Rs 1200 per share. The analysts predict that the price of the stock will rise to Rs 1400 in a week's time. Consequently, there will be a surge in demand for the Company A's stock with the flow of good news about its price increase.  This will obviously put an upward pressure on the stock price due to the increased demand for the stock. Evidently, this phenomenon of self fulfilling prophesies negated possibility of recurrent patterns in stock price. A forecast about favorable future performance leads instead to favorable current performance, as market participants all try to get in the action before the price jump (Bodie, Kane, Marcus; 2002, pg.341).

Then economists started inferring that the stock prices actually reflect the already available information. Thus, stock price increase or decrease in response to any unpredictable information or new information is unpredictable in itself. This is where argument of random walk comes into existence.  This argument stresses on the fact that the changes in the stock prices are unpredictable and random. The random walk of stock prices also correlate with the statement economists make about stock prices reflecting all available information, and changes in prices due to new information. "If stock price movements were predictable that would be damming evidence of stock market inefficiency, because the ability to predict the prices would indicate that all available information was not already reflected in stock prices. Therefore, the notion that stocks already reflect all available information is referred to as Efficient Market Hypothesis" (Bodie, Kane, Marcus; 2002, pg.341).

Hence, Technical Analysis is the quest to find the recurrent patterns in the historical price of the securities. Technical analysis is essentially the search for recurrent and predictable patterns in the stock prices (Bodie, Kane, Marcus; 2002, pg. 343).  It is done through different charts and diagrams by technical analysts who are usually called chartists as well. To conclude, technical analysis is the process of determining time movements in either the aggregate market or an individual stock by assessing changes in price through charts and technical indicators.