Post of the Day
April 03, 1998

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Compaq Board


Subject: Ye Ole Invisible Hand
Author: DDilts2704

Since 1776, when Adam Smith published his disquisition An Inquiry into the Nature and Causes of the Wealth of Nations (incidently the birth of capitalism) those interested in things economic have focused on a marvelous allocative device called a "Market." Smith accurately described how markets perform that allocative function, (market clearing) and that was accomplished through bringing buyers and sellers together through establishing a price. Each day in the equity market for CPQ there are millions of shares traded, but that implies that a pair of actors (a buyer and a seller) arrived at a mutually acceptable price. This is not alchemy, it is scientifically documented.

Neither market actor can be predicted by looking at what other market actors have done, unless there is irrational exuberance or panic. Each buyer and each seller has their own, unique, utility function (preferences for buying or selling a particular stock). Yet, markets are intensely impersonal. The market transforms those personal preferences into market clearly transactions through the pricing mechanism. Probably nothing in economics has been held up to such close scrunity as the market for equities.

One can spend untold fortunes on seminars, books, and all manner of commercial products designed to help one become proficient in one or more of the methods commonly called technical analysis, yet it is only the proprietor of that business who can expect to profit from the sales of such items.

Clearly and repeatedly, independent scholars (some of whom have done pretty well financially) have found that the efficiency in this market mechanism works. Perhaps with results that we may find unsatisfactory, even disturbing at times, but the market, in fact, works. Numerous leading scholars in the branch of economics that deals with equity markets (called finance) have searched for statistical filters, patterns in pricing and volume data, and virtually any other consistent predictor that may provide insights that will allow one to disrupt this efficiency characteristic of markets, and earn more in capital gains than the systemmatic risk in the market would permit. These studies have generated what we really do know of the equity market. Technical analysis in all of it's forms has been examined, re-examined, and then again re-examined. There is nothing as conclusive known in this field, of which I am aware, as the evidence concerning the efficacy of Technical Analysis. Among the classic works, which are the most readable, are found strong rejections of the hypothesis that Technical Analysis has ever, will ever, or even theoretically could improve upon random luck, or when used in conjunction with fundamantal analysis could even marginally improve trading performance based solely and singularly on fundamental analysis. Among these studies are:

Harry Roberts, "Stock Market 'Patterns' and Financial Analysis: Methodological Suggestions," Journal of Finance 14 (March 1959); Eugene Fama, "The Behavior of Stock Market Prices," Journal of Finance 38 (January 1965); Robert Levy, "The Predictive Significance of Five-Point Charts," Journal of Business 44 (July 1971); D. Keim and R. Stambaugh, "Predicting Returns in the Stock and Bond Markets," Journal of Financial Economics 17 (December 1986) among hundreds of others.

One need only pick up any college level textbook on Finance or Investments or Financial Economics and examine what those authors have to say on the subject of Technical Analysis, it is not as sophisticated or any more likely to produce gold than Alchemy (e.g. see Z. Bodie, A. Kane, and A. Marcus, Investments, Homewood, Ill: Irwin, 1989.)

In fact, there is another way to look at this technical analysis routine, and that is to be able to reject it's antithesis, the Efficient Market Hypothesis. The latest of the studies published concerning the efficient market hypothesis, found precisely the results that are predicted by this fundamental principle of finance, to wit: B.D. McCullough, "An Analysis of Stock Market Transactions Data," Quarterly Review of Economics and Finance, 27 (Fall 1997).

Novice investors are a fruitful ground for hypsters. They simply don't know what to believe, and it troubles me, no matter how well intended, that the naive be given to believe that somehow technical analysis can form any reasonable or rational basis for sound financial planning.

One can spend untold fortunes on seminars, books, and all manner of commercial products designed to help one become proficient in one or more of the methods commonly called technical analysis, yet it is only the proprietor of that business who can expect to profit from the sales of such items.

Standard statistical techniques can provide some insights into any long-term secular trends that may exist in the value of a stock, and whether the current price is within some statistical confidence interval of that trend. But statistical methods that rely on less than 30 independent observations are very highly suspect. One can form averages for specific periods, trading ranges for a stock's price, and gleen some information about what that stock has done over specific time periods, but prediction from that sort of information is also unsatisfactory. The only robust method yet identified is fundamental analysis -- and even that won't prevent you from being surprised by market failures of several different kinds

What is truly frustrating about the fundamentals approach, is that there is a great deal that one needs to master to be effective in performing such analyses. Besides the information contained in bits and pieces of the two basic economics courses, two basic accounting courses, the introductory finance, and corporate finance course (just before you get to Investments) one should know something of the product, production processes, and the industry, to become proficient in investing. I know a great number of people who have mastered enough of these things, without a single credit hour in college that they have faired pretty well, being self taught -- but you need to get the basics down.

One can often obtain an adequate perception of the market and be able to examine a company's financial data from what you pick up working in industry, or through reading on your own, but read the real deal; not hypster sorts of things promoting the psycho-babble du jour. The Motley Fool's stuff that I have seen will get you alot further, than all of the hypster stuff published since Adam Smith gave up on the East India Company and ran off to academe.

Novice investors are a fruitful ground for hypsters. They simply don't know what to believe, and it troubles me, no matter how well intended, that the naive be given to believe that somehow technical analysis can form any reasonable or rational basis for sound financial planning. I find that very hard to accept without engaging in one of my lengthy diatribes. Perhaps it's nothing more than I've been treated reasonably well by this equity market (still would have done better with an S&P Index Fund), but I've had some fun along the way, rather than the pain and grief that so many of the naive have experienced in paying what turns out to be bad money to learn methods to throw good money after. FWIW

If you're new to this market be Foolish, not foolish -- I'm not selling anything, but the Fool's method is a good starting point until you gather more knowledge and sophistication in this market. FWIW

IMHO
Warmest Regards
David


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