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

[email protected]

3rd draft, not for attribution without permission

Graphs were from www.bigcharts.com; labels and arrows are mine

mailto:[email protected]

http://www.bigcharts.com/

mailto:[email protected]

http://www.bigcharts.com/



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:



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:



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:

A Failure of Technical Analysis on the Stock

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