Adaptive Markets and Technical Analysis

"It's better to be approximately right than precisely wrong."  -unknown

I was listening to Barry Ritholz's interview with Professor Andrew Lo from MIT yesterday and I actually drove the long way home just to catch the end of it.  What a fascinating discussion that touched on so many meaningful topics...

  • the financial markets as a complex biological system (which brought me back to The Nature of Investing by Katherine Collins, a very interesting read)
  • the meaningful role of hedge funds in the financial markets 
  • the paradox of skill and the challenges for active management
  • the impact of index funds on the equity markets
  • trading simulations as a potential replacement of marketing surveys

I've heard Professor Lo present a number of times over the years, and I'd definitely recommend listening in to the podcast here or here.

The Case for Adaptive Markets

"It takes a theory to replace a theory."  -Prof. Andrew Lo

One of Professor Lo's great contributions to behavioral finance is the Adaptive Markets Hypothesis, which acknowledges the incomplete nature of the Efficient Markets Hypothesis.  By considering not just supply and demand but also fear and greed as drivers of price movements, the AMH validates what technical analysts have been doing for well over a century.  In his most recent book, Adaptive Markets: Financial Evolution at the Speed of Thought, Prof. Lo discusses the concept in great detail.

Professor Lo acknowledges the value of technical analysis in the interview, pointing out that although the discipline has often been derided in academia, the data actually supports the non-random nature of stock prices and the impact of emotional triggers as drivers of short-term price movements.

It's worth mentioning that there is large and growing body of research that supports the trending nature of stock prices, often using labels such as price momentum or relative strength.   Robert Levy's work on relative strength, published in the Journal of Finance in 1967, is a great early example of the phenomenon that many technically-oriented investors have been capitalizing on for decades.  

The Mathematization of the Markets

"Imagine how much harder physics would be if electrons had feelings."  -Richard Feynman, physicist

"We have to be careful about how we use mathematics." -Prof. Andrew Lo

Another theme I found fascinating was the backlash to what he calls the "mathematization of economics."  The Feynman quote above captures the issue you have when you try to apply the rules of the physical world to a system comprised of emotional human beings.  Indeed, Andrew Lo has often spoken of the "physics envy" of finance, where we feel the need to define the markets by immutable laws instead of accepting the impact of irrational decision making.

I've gotten to know many quantitative analysts over the years, and I've found plenty that fall victim to the assumption that the markets are a mathematical problem instead of an emotional/biological/behavioral problem.  Of course, I've also found plenty of technical traders that ignore the fundamental drivers of stock prices.  As Professor Lo mentions, in the short-term prices are driven by emotion, in the long-term they are driven by logic.  In the end, combining different disciplines allows the holistic investor to align the short-term fear and greed with the long-term fundamental picture.

Price and Pattern

"The most bullish thing the market can do is go up."  -Paul Montgomery

I attended the MTA Symposium a few weeks back and thought Rick Lehman's presentation on the key behavioral issues facing technical analysts was excellent.  He spoke on chart patterns and how humans are essentially wired to see patterns that aren't there.  It made me think of Thomas Gilovich's fantastic book How We Know What Isn't So, which addresses this challenge not only in financial analysis but in all areas of our lives.

This all reminds me of the value of reviewing the classic Edwards & Magee type of literature, yet also the importance of using techniques that are profitable, repeatable, testable.  

Most importantly, Professor Lo's interview reminded me of why I was attracted to technical analysis in the first place.  It started as a shorthand for understanding market psychology in a time before computers and even in a time before fundamental data was reliable or even available.

So for now, legendary technical analyst Paul Montgomery's quote above tells the story.  Breakouts in many markets, and for the S&P 500, a bull flag that resolved to the upside.  Up and to the right is bullish.

Disclaimer: This blog is for educational purposes only, and should not be construed as financial advice.  Please see the Disclaimer page for full details.