From: jmo@courant.princeton.edu (Mike Orszag)
Subject: Re: Chartism -- charlatans?
Originator: news@ernie.Princeton.EDU
Organization: Princeton University
Date: Wed, 15 Apr 1992 04:45:56 GMT

In article <kuna04INNdsg@almaak.usc.edu>, ajayshah@almaak.usc.edu (Ajay Shah) writes:
|> 
|> How do you deal with the fact that _every_ single time an academic has
|> carefully investigated claims by any chartist of "systematically
|> beating the market", those claims have been proven false?
|> 
|> I have never been able to see a coherent theory in any chartist scheme
|> I looked at.  I mean, they aren't even trying the "reasonable but
|> misguided things" like removing high frequencies in a fourier
|> spectrum.
|> 

....

|> Considering what is known about prices being a random walk, I guess
|> folks who do investment for a living would clutch at straws.  Just
|> like it is not in the interest of the like of Microsoft to have
|> computer-literate users, it is important for the zillion investment
|> consultants and newsletters to make the peasants feel there are some
|> incantations which the peasants can't figure out themselves.
|> 
|>         -ans.

As an academic, I find it difficult to support technical analysis and
my feeling is that those who perform technical analysis tend to be
very defensive when asked about any details or theoretical justification
for their technique. 

However, that being said, the claims that Ajah Shah makes about the
finance and empirical literature are not true. First, as to whether
technical analysis can "beat" the market, I don't know but the
empirical literature is not one-sided as Mr. Shah claims. One example
is Treynor and Ferguson, "In defense of technical analysis", Journal
of Finance, July 1985 (The Journal of Finance is the leading journal).
Another example is S.W. Pruitt and R.E. White, "Who says technical
analysis can't beat the market" (Journal of Portfolio Management,
Spring 1988. pp. 55-8). I do not claim that these studies are good,
only that Shah's claim that "_every_ single time an academic has
carefully investigated claims by any chartist... those claims have
been proven false" is false.

The second troublesome statement that Shah makes is: "Considering
what is known about prices being a random walk..." is troublesome.
The basic idea that stock prices follow a *geometric* random walk
(no one except Bachelier in 1900 ever said that stock prices
followed a random walk; if you think about it, if prices did follow
a random walk, all stock prices would be below zero at some point
with probability 1 which is absurd given limited liability) has been
challenged seriously in the past ten years. The first part of this
challenge has been to small-scale dynamics in which it has been
successfully shown by dozens of researchers that a wide variety
of asset prices exhibit time-varying conditional variances. The
second part of this challenge has looked at mean reversion in stock
prices at large scales (low frequencies) and also found significant
deviations; this research effort has included for instance Eugene
Fama who is known for his 1960s work on the weak-form efficiency
hypothesis. More fundamentally, I don't think anyone even back in
the 1960s believed that stock prices followed a geometric random
walk; there is a large literature on fat tails and the Pareto-Levy
distributions applied to transition densities of log stock prices
and options are typically priced taking into account jump processes;
almost no one believes the arrival of information is uniform.

There is an unfortunate confusion that prices near a random walk
imply efficiency and so on. This is wrong. Prices could be completely
irrational as Robert Shiller of Yale University has poignantly 
pointed out and still be close to unpredictable. Prices could
also behave like a sine wave and as long as the term structure
of interest rates adjusted in the appropriate way to eliminate
arbitrage opportunities, markets would be efficient; a situation like
this might for instance arise where productivity of firms has cyclical
components.

The important point to realize is that the geometric random walk
assumption is made for modelling purposes because the underlying
model behind the decisions of agents in the market is far too hard
to solve or analyze. As a practical matter, though, most people
are not smart enough to really keep the market straight. A lot of
investors have serious trouble distinguishing nominal and real
interest rates, let alone determine risk-adjustments and expected
devaluation adjustments on foreign exchange options. A trader
in Chicago told me a story last weekend about how after the Black
Scholes model was developed, traders did not know how to calculate
the variance of the changes in log stock prices so Fisher Black
calculated the variances and sold a service which gave the variances
to firms every Monday. One trader made a fortune by calculating
the variance a day early. Major Wall Street firms regularly overcharge
their customers grossly because their customers have no idea how
to value what they are buying. It is thus a mistake to regard
speculative markets as rational especially in the short run; Keynes
(a very successful investor himself) compared choosing a good stock
to picking the winner in a beauty contest -- this should not be
forgotten.

MIKE ORSZAG