a failure of technical analysis on the stock
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A Failure of Technical Analysis on the Stock
Market drop of February 27, 2007
February 28, 2007
Charles Higgins, Ph.D.
Dept. of Finance/CIS, Loyola Marymount University
One LMU Drive
Los Angeles, CA 90045-8385
310 338 7344
3rd draft, not for attribution without permission
Graphs were from www.bigcharts.com; labels and arrows are mine
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On February 27, 2007 the stock markets fell substantially, by
over 415 points on the Dow Jones Industrial average, by 96.66 on the
NASDAQ, and by 50.33 (or 50.26 per the Nightly Business Report)
on the Standard & Poor’s 500 average. I am struck by how technical
analysis repeatedly failed to correctly time this largest decline since
2001. At the time of this writing, in the early evening of the same
day, the Shanghai index had opened upward by over 1.6 percent; the
same market which presaged the world wide decline earlier today.
One type of technical analysis is to examine a security’s price
history as a chart, then to extrapolate the respective peaks or troughs
toward intersecting future prices, and then to regard those
intersections as signals to buy or sell the security respectively.
Examine the following graphs of the Dow Jones Industrials average:
A sell signal occurred in early September 2006, and again:
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in late November 2006, then another appeared in early January 2007:
and again in late January 2007:
and recently a fifth sell signal was generated:
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Some technical analysts might argue that this repeated set of
sell signals as demonstrative of how effective technical analysis is. I
would argue otherwise. The first sell signal, had it been utilized in
September 2006 as a signal to sell, would have missed the substantial
part of the subsequent gain which followed (another ten percent or
more). And to jump ahead to the fifth signal, one could easily argue
that by this fifth signal that it had become the “boy who cried wolf.”
Further, in my dissertation I found that if any value was to be found in
trend line charting, it was to buy with the third signal using peaks and
to sell with the first signal was using troughs, albeit for negligible
excess returns compared to a buy-and-hold strategy and only to those
paying the clearing house fee (available only to members of an
exchange).
Another way to show the weakness with technical analysis is tonote that for technical analysis to be effective it must be able to
differentiate which signal shall be deemed as valid. These five-in-a-
row sell signals seem to be ineffective. That is, had one acted earlier,
one would have missed a major raison d’être [to be] in the stock
market, and had one acted later then one should doubt the efficacy of
technical analysis in terms of its clarity to resolve which signal is
significant.
Yes, I should at this time note that the Dow Jones Industrial
average suffers from being a small sampling of thirty quality
securities and that it is neither price nor market weighted. However,
the Standard & Poor’s 500 index had a similar chart pattern. I now
leave it to the readers to supply, then test on their own, their own trend
lines and sell signals. I trust that a similar conclusion should result: