Technical Analysis- A somewhat scientific look
By DanielXX  •  February 18, 2009
[caption id="attachment_1803" align="alignright" width="192" caption="Photo by Brittany G"]Photo by Brittany G[/caption] I like reading the Review segment of the Straits Times because there are occasionally interesting analysis, and Andy Ho sometimes has interesting articles. This guy writes extensively on a variety of topics ranging from health to science to philosophy to political systems to economics ... all of which interest me (save maybe for health). Saturday's article in ST is the inspiration for this latest blog entry. I had read a book on chaos theory some years back, which is the subject of Andy Ho's article, but had not really made the connection to stock market dynamics then, probably because my market experience then was not too extensive for me to make that connection. But some years later, on reading this article, it struck me how economic and stock market behaviour can be described by chaos theory's derivative, complexity theory (if it can even be called a theory, since there're no real quantitative equations). The story goes that classical mechanics can describe the interaction between two bodies, such that if given a set of initial conditions (eg. position, speed) for both bodies, the equations can predict their future trajectories for all eternity. This is known as a deterministic system (ie. its future is predictable). However, things get much more complicated for a system of three bodies. Where initial conditions vary by a little bit, the subsequent behaviour of the system can vary by a lot. This finding forms the basis for complexity theory, which attempts to describe complex systems. Imagine what happens when you have n bodies! The system will be too difficult to characterise, it appears at first glance. The first thought that comes to the stock market player's mind will be the parallels to the stock market where you have n millions of players interacting with one another. However, one of the key findings of complexity theory is that, rather than throwing our hands up in despair, it is possible to find so-called "emergent" properties within such systems. Basically the idea is that although "their futures cannot be predicted, such systems exhibit patterns, so their stability is bounded" (I couldn't have described it better than Andy Ho, hence the quote). The example of the graceful flocking behaviour of birds is given, where even though there is no preconceived coordination the herd movement appears elegant when viewed as a whole. In fact, the only rule that has to be followed individually is for each bird to keep constant the distance between itself and the one in front while flying in the same general direction. Extending it to anthropology, the way that people congregate in urban areas and interact gives their cities emergent personalities ie. small-scale interactions among many individual parts can lead to large-scale order. You can see where all this is going. If we characterise technical analysis as an attempt to identify such emergent patterns within the interaction of millions of bodies ie. a complex system, it may not be too far off the mark. Note the word ---attempt --- that suggests discretionary judgment and interpretation and hence practitioners should always remember to exercise prudence in implementation. I used to be more sceptical of technical analysis, primarily because of the lack of true scientific logic and its lack of quantitative rigour. My doubts were expressed in an earlier writeup in 2006 on the subject --- Technical Analysis --- where I attempt it describe it as a technique for the short-term while fundamental analysis is more effective for capturing market-beating returns over the longer term. I also expressed my views that since the market often priced in breaking news swiftly, it tended to be efficient over the short-term and hence it was more advisable to assess companies fundamentally and position for the long-term. Read more...
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By DanielXX
DanielXX operates a series of popular stock blogs through which he channels his passion for stock investing. He has been sharing his experiences and views on the Singapore stock market for the past year on these blogs, and is best known for his HotStocksNot site where he makes regular calls against certain hot stocks on the Singapore market. DanielXX considers himself a medium-term investor and focuses on fundamental analysis in his stock-picking approach

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