Speaking the Unspeakable
The Wall Street Journal recently featured an unusual teaser: "Thumbs Up For Technical Analysis." In the article, Wasatch Funds president Sam Stewart described his company's increasing use of price-based signals with stock selection. "We used to be 100% fundamental analysis," Stewart told the Journal. Now the firm reviews "several technical indicators."
It's been a while since I've seen a portfolio manager confess to using technical analysis. Well, not using that word.
Picking stocks because of their price movements fell into academic disfavor in the 1960s, when mainframe computers gave professors the ability to collect and crunch large data sets. The University of Chicago's Gene Fama showed that past stock prices had little if any relationship to future prices. Since then, academics have conducted many follow-up studies, nearly all reaching the same conclusion. Among the ivory towers, "chartist" is not a compliment.
The investment industry retained its faith for a little longer, but by the 1980s technical analysis was in retreat. Few mutual funds used technical analysis as their primary selection tool, and those that did tended to be obscure. Their results were almost uniformly bad, leading such funds to fold or be merged into other, more successful competitors. Today, the technically managed mutual fund is effectively extinct.
Or so the story is told. That's not correct, though. While nobody today runs mutual funds by seeking stocks that exhibit candlestick or head-and-shoulder patterns, technical analysis by another name remains alive and well. Today, it is calledmomentum investing. To be sure, momentum investing is a dressed-up version of technical analysis, replete with academic support and the attempt to explain why the strategy is a "risk factor," but it is nonetheless technical analysis: a signal based solely on a security's price behavior.
The idea, of course, is nothing new. Back in the day, the approach was called either price momentum or relative strength--the latter being such a popular term that in the 1980s, newcomer Investors Business Daily trumpeted its relative-strength data as being a prime advantage over incumbent The Wall Street Journal. Whatever its name, favoring stocks that had led the way over the previous several months--and avoiding those that had lagged--was popular long before the academics offered proof.
Which, surprisingly, they did. Ironically, among the early proponents of momentum was a student of Gene Fama's, Cliff Asness, who documented the strategy's success in his 1995 doctoral thesis. (Also ironically, the University of Chicago has likely done more to advance of the cause of technical analysis than any other school, beginning with Asness and extending in recent years to the work of TobiasMoskowitz.) Oddly, whereas candlesticks and other more-complex patterns had failed, the simplest possible tactic--buying more of what was rising--was vindicated.
While I'm not enthralled with momentum investing, as it appears to be an easily understood free lunch, and easily understood free lunches typically offer few investment nutrients, it's certainly a legitimate approach. It has research support, it has been used successfully by many mutual (and hedge) funds, and it is accepted by the toniest of institutions. So I won't rush to judge Wasatch's Stewart because he owned up to straying from the fundamentals. In that, he is far from alone.
(In the 1990s, when Fidelity's U.S. stock funds were riding high and consistently beating their benchmarks, Fidelity supported its portfolio managers with a small centralized technical-analysis group. The group's output, I was told, was not used to determine whether a stock should be bought or sold but rather as a secondary signal to assist in the timing of a trade. For example, if a manager felt that a holding had become overvalued but the technical reading was currently favorable, the trade might be delayed.)
I do worry about this particular application, though. In the article, Stewart credits his newfound acceptance of technical signals to his 2008 experience, when like so many other investment managers he bought into a declining market--only to see it decline precipitously further. He now watches "several technical indicators that were flashing warning signs prior to the global financial crisis." That sounds like fighting the last war. As always, the next stock market debacle will differ substantially from its predecessor.
Perhaps there's more depth to the research than came through in the article. At any rate, I'll measure Stewart's approach on its results--pretty good so far--rather than opposing it because it crossed the fundamentals line.
Sorta Hot Hands
As with technical analysis, the "hot-hands fallacy" in the newer field of sports research has also been modified upon further review.
Published in 1985, "The Hot Hand in Basketball: On the Misperception of Random Sequences" disproved the universally believed notion that basketball shooters can be hot or cold. They are neither. How a shooter performed on the previous shot has no bearing on whether he will make his current shot.
The paper shot to prominence (to speak). Quickly, it became a staple of MBA decision-making classes, a warning against trying to make sense out of the senseless. Less quickly, it affected how NBA general managers evaluated talent, as the league began to rely more on detailed statistical analysis and less on anecdotal impressions of "clutch" ability.
During the past year, though, the article has been subjected to revision. Yes, there was no statistical correlation between the two shots, before and after. However, upon further examination, it turned out that shooters who had made a previous shot tended to take moderately more difficult shots on their next attempt than those who had missed. (Some of those seemingly senseless basketball fans had long made that argument.) Thus, adjusted for difficulty, there were hot and cold hands.
It's only a modest effect of a couple of percentage points, and it doesn't alter the paper's main finding--that fans erroneously perceived a pattern when no pattern existed. Still, a useful lesson in taking initially sweeping findings with at least a few grains of salt.