The Revenge of the Chart Watchers
Why technical analysis is set to conquer mainstream investing
When Andrew Lo lectures on technical analysis, the MIT finance professor often airs a video that asks the audience to count the number of times a basketball is passed among a group of players.
As the players toss the ball, someone in a gorilla costume strolls onscreen, faces the camera, beats his or her chest, and silently exits.
Most people admit they don’t even notice the gorilla, focused as they are counting basketball passes.
Technical signals — “double top” patterns, Bollinger bands, and so forth — are a lot like the gorilla, according to Lo: visible but overlooked.
“All of us have these cognitive blinders,” Lo says. “Technical analysis addresses that.”
Lo’s view puts a decidedly charitable gloss on a controversial topic. Technical analysis surely ranks as among the most widely disdained professions on Wall Street, somewhere on the continuum between, say, penny stock brokerage, voodoo, and storefront clairvoyance. The thinking, according to these maligned market watchers, is that visual cues that show up when technical analysts are mapping price and volume figures can portend a market’s direction.
So-called technicians — some call themselves trend followers or chartists — have been ridiculed for decades by efficient-market champions like Eugene Fama of the University of Chicago and stock pickers such as Berkshire Hathaway’s Warren Buffett and Fidelity Investments’ Peter Lynch, who once quipped, “Charts are great for predicting the past.”
“Much of it is a fraud,” says Princeton University professor Burton Malkiel in a phone interview. “These patterns don’t work after transaction costs.”
In his seminal book, A Random Walk Down Wall Street, the 12th edition of which is scheduled to appear in January, Malkiel was more blunt: “Under scientific scrutiny, chart reading must share a pedestal with alchemy.”
And Martin Fridson, chief investment officer at Lehmann, Livian, Fridson Advisors, a fixed-income adviser, scoffs, “At one point there was phrenology — that’s gone because they proved it was wrong.”
The skepticism is understandable. “Death crosses” and “Hindenburg omens” are mumbo jumbo to “real” fundamental analysts who pore over the hard data of balance sheets or parse the nuances of CFOs’ earnings calls. Even seasoned technicians don’t agree on whether a particular chart squiggle is a “cup and handle” pattern, considered to be a mostly bullish sign, or not.
But skeptics be damned: Technical analysis today appears to be on a roll. Investors of different stripes — Dumpster-diving value, go-go growth, even the smart beta and quant crowds — are turning to the same tools that were once used almost exclusively by technicians. Says Sam Stovall, chief investment officer of investment research firm CFRA: “Portfolio managers today are more willing to incorporate technical analysis in the timing of their investment decisions.”
Take Pim van Vliet, head of conservative equities at Robeco, in Rotterdam, who uses momentum and other technical signals as he ranks a universe of 1,000 stocks on mostly fundamental factors, like buybacks and dividends. “What I like about chartists is that it’s evidence-based,” he says. “You look at the length, the strength of the trend, and you can back-test it.”
Van Vliet is not alone. The number of candidates for Chartered Market Technician certification totaled 1,995 in 2018, up 67 percent from 1,195 just three years ago, according to the CMT Association.
The popularity of exchange-traded funds dedicated to trend-following market timing strategies is also rising, albeit from a tiny base, according to ETF.com, a research firm that combed through its database of 2,208 funds to identify them. There were just two such funds in 2010, with a combined $903 million in assets. That’s ramped up to 39 funds, with a total of $11.7 billion in assets as of December 12.
All told, investors have poured $8.3 billion into such ETFs over the past ten years.
“Increasingly, we’ve seen investors seeking out and asset managers offering products that use momentum strategies either alone or in combination,” says Todd Rosenbluth, director of fund research at CFRA.
One of these products is managed by Rosenbluth’s colleague Stovall, who in July started the Pacer CFRA-Stovall Equal Weight Seasonal Rotation ETF.
Based on past technical patterns, the fund switches in May to an equal-weighted portfolio of consumer staples and health care stocks from one composed of consumer discretionary, industrials, materials, and technology stocks, then goes back again in November.
You know, a variation on the old “Sell in May and stay away” adage.
“On the buy side more and more people are integrating technical analysis into their processes,” says Alvin Kressler, CEO and president of the CMT Association, which oversees the certification of Chartered Market Technicians. “We are seeing more people gravitate to us.”
Most obvious is the burgeoning success of passive investing. In 2007 index funds accounted for 15 percent of ETF and mutual fund assets, according to the Investment Company Institute. In 2017 that number was 35 percent.
As recently as last year, fewer than one in ten active large-capitalization U.S. stock managers had beaten the S&P 500 during the previous 15 years.
Accordingly, active money managers today are on a somewhat desperate quest for new ideas, trading strategies, or tactics — anything to narrow the gap between their own performance and that of the big indexers. It is, after all, a struggle for their own survival.
“Wall Street is neither fundamental nor technical,” say MIT’s Lo. “They are opportunistic.”
Indeed, the problems bedeviling fundamental research feed into the rising popularity of technical analysis. “One reason people gravitate toward technical is they get frustrated with fundamentals,” says Stovall. “Price is never readjusted. Earnings are often readjusted. GDPs are often readjusted.”
The growth in indexing has resulted in something else: a sharp increase in the amount of assets effectively being managed on what amounts to autopilot. “What that’s done is create a much larger pool of investors that are in the same boat. That creates opportunities,” says Lo. “You have more naïve investors who react in predictable ways — that’s exactly how technical signals work.”
There is no doubt that the technical profession is also benefiting from massively better optics. More managers are willing to talk about their use of charting because the practice has found an unwitting ally in a newly popular academic discipline: behavioral economics.
Not long ago behavioral economists seemed eccentric — out of the mainstream. No longer.
Now behaviorists including Daniel Kahneman of Princeton University and Robert Shiller of Yale University are Nobel Prize–winning rock stars. Last year, Richard Thaler, professor of economics at the University of Chicago and a New York Times Sunday business columnist, won the Nobel Prize in economics as well.
Behavioral economics focuses on individuals’ tendencies toward what are irrational investment decisions — say, loss aversion, herd behavior, and anchoring. Those are exactly the same dynamics that technical analysts say they can capture en masse by reading price and volume patterns. “The technicians have been doing those things forever,” notes the CMT Association’s Kressler.
One simple example: If an individual is fixated — or anchored, as behaviorists say — on the idea that he or she will sell when the Dow Jones Industrial Average hits a nice round number like, say, 25,000, well, why wouldn’t hordes of other investors also sell then?
Hence “resistance levels” — the price points cited by technicians beyond which particular stocks or indexes struggle to rise or fall.
The return of volatility to the markets beginning this past summer should in theory give traction to trend-following strategies that successfully toggle between riskier and safer asset classes. Stay tuned: It bears noting that just 18 of the 38 funds for which ETF.com was able to calculate one-year benchmarks succeeded in beating them during that stretch.
The success of a cadre of high-profile quantitative hedge funds has probably lessened resistance to technical precepts — nobody sneers at Renaissance Technologies’ Jim Simons and his Medallion Fund for its roots in commodities-based trend following or Winton Group David Harding for saying “We are trying to capture crowd behavior in different broad markets.”
Academia, at least grudgingly, seems to be reconsidering its hitherto dismissive stance. Joining just a smattering of business and other schools such as Brandeis University, City University of New York’s Baruch College, and the University of Arkansas, other higher education institutions are rolling out courses and curricula that incorporate technical analysis.
Ralph Acampora, former head of technical analysis at Prudential Securities, is now an adjunct professor at the University of St. Thomas in St. Paul, Minnesota. He calls himself and the class he teaches “a bridge between the academic world and the real world.”
Getting technical analysis more widely accepted into the school curriculum could, Acampora says, establish a beachhead — and move it into what he and other chartists see as its rightful place alongside the tenets of modern portfolio theory, such as the capital asset pricing model, portfolio optimization, and the efficient-market hypothesis.
But don’t hold your breath.
Fast–forward to the early 19th century, when David Ricardo, the English economist, advised investors to “cut their losses” and “let their winners run” — axioms still subscribed to today by trend followers, who count him as one of their own.
At the end of that century, Charles Dow, the co-founder of Dow Jones & Co., set the modern era of technical analysis in motion, fueling widespread popular interest in trend following with his editorials for The Wall Street Journal. At the time, Dow recommended tracking the direction of the Dow Jones railroad index to draw a bead on the overall market’s direction, sometimes confirming the direction with industrials.
The history of the 20th century was eventually filled with technicians and chartists, simple trend followers — and yes, dumb-ass speculators. Think Jesse Livermore, who made a fortune during the 1929 crash by wagering all of his capital and so came to be known as the “Boy Plunger,” and more recently, Paul Tudor Jones, founder of Tudor Investment Corp.
Yet even with its lengthy history, technical analysis was eyed suspiciously — and its practitioners sneered at.
Louis Rukeyser was something of an anomaly in regularly inviting technical analysts on his television show, “Wall $treet Week with Louis Rukeyser,” which ran for three decades until it ended in 2002. Notably, it was only after his mainstream fundamentalist strategists were interviewed that he would bring in what he called “elves,” like Acampora.
“Why do you call us elves?” Acampora says he once asked Rukeyser.
“Because I don’t think our viewers know what you do,” Rukeyser replied.
The marriage of technical and fundamental isn’t necessarily an easy one. EquBot, a San Francisco ETF manager and research firm with $200 million in assets employs artificial intelligence to data-mine fundamental sources from around the globe — prosaic balance-sheet and earnings statements, of course, but also more than 1.2 million news articles and social media posts a day.
Earlier this year, says EquBot co-founder and CEO Chida Khatua, the firm’s systems used that information to develop what was in effect a bullish thesis on Tesla, the electric carmaker founded by CEO Elon Musk. The firm zeroed in on moving average trend lines, classic technical signals, before pulling the trigger on shares, buying as they traded at the lower end of the trend line.
“Technical analysis does work,” explains Khatua. “But you have to put constraints around it.” In August, Musk stated he was interested in taking Tesla private at $420 a share, sending the stock soaring. In September, Musk smoked what was purported to be a marijuana cigarette on a webcast, punishing shares.
Those incidents have conditioned Khatua’s views on technical analysis. “It works when there is absolutely no news on Elon Musk,” he says.
In general, quants are more adept at integrating technical factors like price and volume with the more fundamental ones — value and earnings quality. They are accustomed to pulling in data from any number of sources and harnessing their algorithms to let computers make a buy-or-sell decision.
That’s the case with Breton Hill Capital, a $3.3 billion firm bought by Neuberger Berman in 2017, which invests across asset classes globally using strictly quantitatively driven trading programs.
Breton Hill chief investment officer Ray Carroll says downward price momentum, a key technical signal, in early November forestalled investment in what, based on fundamentals, looked liked a buy in the case of Pacific Gas & Electric Corp., whose shares, based on then-current prices and a solid earnings record, were falling into bargain territory.
But computers weren’t reading headlines: Wildfires ripping through swaths of Northern and Southern California were punishing PG&E’s shares, cutting them by more than half over a fortnight. That generated negative-momentum signals that helped Breton Hill avert losses for the firm.
The lesson, Carroll says, is that technical signals offer insight that fundamentals sometimes can’t. “Maybe the market knows something you don’t see,” he says.
By contrast, Carroll points to the upward price momentum at graphic software powerhouse Adobe, whose share price, up 41 percent year-to-date through mid-December, is confirmed by strong fundamentals like growing earnings, cash flow, and sales. “We have the most conviction when we have both,” he says.
Where will the growth of technical analysis lead? Probably to a place close to where it began. As more investors flock to buy and sell signals, any anomalies will inevitably be traded away — a world where investors may just find themselves back in the same old “buy and hold” position.