Technical analysts beat Fama to the EMH

Beranda › efficient markets hypothesis › Eugene Fama › technical and fundamental analysis

The following quote is a great expression of the efficient market hypothesis:

...the bulk of the statistics which the fundamentalists study are past history, already out of date and sterile, because the market is not interested in the past or even in the present! It is constantly looking ahead, attempting to discount future developments, weighing and balancing all the estimates and guesses of hundreds of investors who look into the future from different points of view and through glasses of many different hues. In brief, the going price, as established by the market itself, comprehends all the fundamental information which the statistical analyst can hope to learn (plus some that is perhaps secret from him, known only to a few insiders) and much else besides of equal or even greater importance.

So who wrote these words? Fama, Malkiel, or Samuelson? Funny enough, I've pulled this quote from The Technical Analysis of Stock Trends by Robert Edwards and John Magee, the so-called bible of technical analysis. Published in 1948, it predates Fama by at least fifteen years.

In case you need reminding, technical analysts are interested in the historical record of asset prices. The traditional stereotype is that they work in musty offices filled with stock charts, the windows nailed shut so that no data from the outside world can pollute their analysis of odd-sounding chart formations. Now this view is a bit narrow. Cullen Roche points out that technical analysis comprises far more than just charting-gazing. It involves using past market data—volume, price, sentiment, etc—to divine the market's future direction. Old school chartists still exist, but so do algorithms that analyze reams of stale data in order to spit out the next period's price.

Before I explore the seeming paradox of Edwards and Magee subscribing to the EMH, here's a refresher on the various "forms," or levels, that efficient markets take. Each level refers to the type of data that is baked into efficient prices.

1. Weak form efficiency: All information contained in the record of past prices is already reflected in a stock's price. The implication is that technical analysis is worthless.

2. Semi-strong form efficiency: All information contained in past prices and all published information about a company are already reflected in the stock price. The implication is that both technical and fundamental analysis are worthless.

3. Strong form efficiency: Prices reflect all information contained in past prices, all publicly available information, and all insider information. No one can make a profit.

Now in the above quote, you'll notice that Edwards & Magee invoke aspects of both semi-strong and strong form efficiency by pointing out that market prices already contain all fundamental information and even a quantity of insider information. Of course, the two never believed in pure strong-form efficiency since they thought that abnormal profits could be made by anyone who followed their technical methodology. If anything, what Edwards & Magee are describing is a fourth level of market efficiency which, for lack of imagination, I'll call "semi-weak" efficiency:

4. Semi-weak form efficiency: Prices reflect all published fundamental and insider information, but not information from past prices. The implication is that no one can make earn profits from using fundamental data and only technical analysis is worthwhile.

Why do academic finance books list semi-strong efficiency but not semi-weak efficiency? Why open the "efficiency door" to fundamental analysts but not technical analysts? In general, I find that academics tend to display a strong aversion to technical analysts, compounding an already-existing sense of persecution felt by technical analysts when it comes to the rest of the investment community. Most discourse in the investment community is of a fundamental nature, and technical analysts are viewed as a bit weird. I remember observing this sense of frustration at a society of technical analysts meeting a decade ago. The running gag that day among the angst-filled technical analysts was to refer to fundamental analysts as fundamental ANALysts.

So what explains the bone that academics have to pick with technical analysis and semi-weak efficiency? My guess is that it starts with the random walk theory. The random-walk theory is important to academic finance because it implies the existence of a normally-distributed data set. It's relatively easy to run statistics with this kind of data. But if markets are semi-weak this implies that successive price changes are not independent of each other, or, in technical analysis lingo, that trends are meaningful. If changes are dependent on prior changes, the normal distribution can't be used. This means that finance theory is a lot more difficult than before.

On the other hand, if markets are ~~semi-strong~~ weak form efficient, prices still follow a random walk. Weak form efficiency was a way for financial academics to offer the investment community a bone, namely fundamental analysis, without throwing out the random walk baby. Technical analysis, on the other hand, needs to be thrown under the bus. But I'd be curious what others have to say.