THE IMPACT OF TECHNICAL ANALYSIS ON PORTFOLIO PERFORMANCE

Abstract

Technical analysis was used by Japanese rice traders in the 1700s, In the West, technical analysis started in the 1900s with the Dow Theory, later developing into precise mechanical trading rules which used mathematical formulae. One principle of technical analysis is to identify and follow the trend. This assumes that 'smart money' acts on information before it becomes public. Thus prices would reflect the information available to 'smart money', Due to its popularity among investors, the information given by technical analysis will be valuable. Since a major use of technical analysis is to follow the trend, technical analysis is, to a certain degree, self-reinforcing. That this self-fulfilling nature will lead to higher accuracy of technical indicators has been well documented. Studies have found market timing to be both important and useful. It was found that: • Stocks that were extreme losers tend to have strong returns relative to the market during the following years, and vice-versa. • Some fundamental data like price earnings ratio, dividend yields, business conditions and economic variables can predict to a large degree the returns on stocks. • Technical analysis does consistently produce returns that are significantly superior to the buy-and-hold strategy. • Portfolio performance, when measured using risk to return measures, could be improved with technical analysis. In Chapter 3, we tested three classes of indicators, the Moving Average, the Relative Strength Index and the Linear Regression. We used the event study methodology to test if the indicators were indeed effective. From our results, we found that the Single Moving Average was the most effective. This was followed by the Dual Moving Average, the Relative Strength Index using the '50 Crossover' method, the Triple Moving Average, the T-Ratio on Moving Average, and the Linear Regression. All these produced very impressive results. Only the Relative Strength Index produced dismal results. However, the results from the other indicators have shown as conclusively that technical indicators can play a useful role in the timing of stock market entry and exits. In Chapter 4, we tested the Standardized Risk Premium (SRP) which is essentially based on the earning yield and the bond yield. In this case, we used the monthly data and tested across 5 countries. We found that for all the 5 countries, the SRP was useful for long trades. In the United States, Japan, and Germany, the SRP was also useful for short trades. In the United States, Japan and Germany, the SRP was also useful in indicating when the respective index would perform substantially better or worse than its mean level. In Singapore, the SRP was useful in indicating when the index would perform substantially worse than its mean level. All this goes to show that there is a significant relationship between the risk-premium and the share price in a market, thereby supporting the loanable funds theory. Overall, the findings from these studies suggest that technical analysis is useful as a timing device in the stock market.