Does technical analysis work?

Yes.  No.  Maybe.

I think all three are correct depending on how we define technical analysis.  Academics have known for about 15 years that stocks with positive momentum tend to outperform stocks with negative momentum.  Traders and speculators have probably known this for centuries longer.  If we define technical analysis as using information contained in historical prices (and other information such as trading volume) to predict future prices than there is no question the answer is yes, technical analysis does work.  Most quantitative trading methods (including high frequency trading) is based on this sort of analysis.  In fact, I would go as far as to say that much of what people view as fundamental analysis is actually technical analysis.  I would argue that much of value investing (e.g. buying stocks with low Price/Book Value ratios or Price/Earnings ratios is actually a reflection of technical factors (the stock has gone down in the past) than it is of fundamental factors such as its book value or earnings.

If, however, we define technical analysis as humans looking at charts looking for patterns which they then give cool names, I am more than a little skeptical.  Not because the charts don’t contain good information (they contain the same information used by the computers discussed above) but because I am skeptical that humans can consistently and correctly interpret this information.  I do leave open the possible that certain exceptional individuals can indeed profit from interpreting such charts.

I’ve stated that technical analysis is essentially just momentum investing (I use the word investing loosely).  I think its worth mentioning that virtually all trading is based on momentum investing.  Of course the downside of momentum (from the trader’s perspective) as a strategy is that it works until it doesn’t.   Which is to say you’ve got to get out in time (no easy task), making it a risky strategy.  From the market’s prospective, it is not difficult to see the relationship between momentum and frothy markets.

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