Evaluation of technical Analysis

Technical analysis appears to be a highly controversial approach to security analysis. It has its ardent votaries, it has its severe critics. The advocates of technical analysis offer the following interrelated arguments in support of their position.

1. Under the influence of crowd psychology, trends persist for quite some time. Tools of technical analysis that help in identifying these trends early are helpful aids in investment decision making.
2. Shifts in demand and supply are gradual rather than instantaneous. Technical analysis helps in detecting these shifts rather early and hence provides clues to future price movements.
3. Fundamental information about a company is absorbed and assimilated by the market over a period of time. Hence, the price movement tends to continue in more or less the same direction till the information is fully assimilated in the stock price.
4. Charts provide a picture of what has happened in the past and hence give a sense of volatility that can be expected from the stock. Further, the information on trading volume which is ordinarily provided at the bottom of a bar chart gives a fair idea of the extent of public interest in the stock.

The detractors of technical analysis believe that technical analysis is a useless exercise. Their arguments run as follows:

1. Most technical analysts are not able to offer convincing explanations for the tools employed by them.
2. Empirical evidence in support of the random walk hypothesis cast its shadow over the usefulness of technical analysis.
3. By the time an uptrend or downtrend may have been signaled by technical analysis, it may already have taken place.
4. Ultimately, technical analysis must be a self defeating proposition. As more and more people employ it, the value of such analysis tends to decline.
5. The numerous claims that have been made for different chart patterns are simply untested assertions.
6. There is a great deal of ambiguity in the identification of configurations as well as trend lines and channels on the charts. The same can be interpreted differently. As an example, here is an extract from a commentary of a technical analyst:

To sum up, we are in a state where the market is either poised to recover, or go into a long term decline (a change in the major trend). A failure of the head-and-shoulders formation in the National Index, which could occur if the index clambers over 1,400 would be a good signal to suggest a market recovery, while a breakdown below the support levels given for the leading Sensex stocks would suggest harsher times ahead.
Despite these limitations charting is very popular. Why? It appears that charting appeals to a certain type of personality; the collector. Listening to a chart list describe the satisfaction he derives from sitting down after dinner with his charts for a few hours, one is reminded of the philatelist or lepidopterist. Finding a certain pattern gives chart lists satisfaction that transcends the possibilities of turning the patterns into money. John Magee, the guru of chart lists writes, ecstatically about the wonderful world of the logarithmic spirals (which) contains so much of beauty and so much of the sheer wonder of pattern and rhythm.

A pure chartist is almost monk-like in dedication, believing the essential truth about the market is to be found in squiggles and figures on graph paper. He is unmoved by a plant explosion or a profit explosion.

A pure chartist believes — What is my position on the practical utility of technical analysis? I believe that in a rational well-ordered and efficient market, technical analysis is a worthless exercise. However, given the imperfections, inefficiencies and irrationalities that characterize real world markets, technical analysis can be helpful. But I do not believe it can be of great value. Hence, it may be used, albeit to a limited extent, in conjunction with fundamental analysis to guide investment decision making.

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