Module - 54
Academic Approaches to
Technical Analysis
CMT LEVEL - I

Theoretical Underpinnings
• A great deal of research has been devoted ever since to formulating
theoretically the efficient market hypothesis, building up market efficiency—
the idea that “prices fully reflect all available information”— into one of the
most important concepts in economics.
• In markets where, according to Lucas (1978), all investors have “rational
expectations,” prices do fully reflect all available information and marginal-
utility-weighted prices follow martingales.
• Market efficiency has been extended in many other directions, including the
incorporation of nontrade assets such as human capital, state-dependent
preferences, heterogeneous investors, asymmetric information, and
transaction costs.

Theoretical Underpinnings
• In Fischer Black's (1986) presidential address to the American
Finance Association, he argued that financial market prices were
subject to “noise,” which could temporarily create inefficiencies
that would ultimately be eliminated through intelligent investors
competing against each other to generate profitable trades.
• Financial markets by hypothesizing two types of traders— informed
and uninformed— where informed traders have private information
better reflecting the true economic value of a security, and
uninformed traders have no information at all, but merely trade for
liquidity needs

Theoretical Underpinnings
• Grossman and Stieglitz (1980) suggest that market efficiency is
impossible because if markets were truly efficient, there would be
no incentive for investors to gather private information and trade ,
provide a more detailed analysis in which certain types of
uninformed traders can destabilize market prices for periods of time
even in the presence of informed traders.
• The evidence against the EMH and in favor of technical analysis
emerged in the work of Treynor and Ferguson (1985), who show
that it is not only the past prices, but the past prices plus some
valuable nonpublic information, that can lead to profit.
•

Empirical Evaluation
• Grossman and Stieglitz (1980) suggest that market efficiency is
impossible because if markets were truly efficient, there would be
no incentive for investors to gather private information and trade ,
provide a more detailed analysis in which certain types of
uninformed traders can destabilize market prices for periods of time
even in the presence of informed traders.
• The evidence against the EMH and in favor of technical analysis
emerged in the work of Treynor and Ferguson (1985), who show
that it is not only the past prices, but the past prices plus some
valuable nonpublic information, that can lead to profit.

Adaptive Market Hypothesis
• The adaptive market hypothesis (AMH) combines principles
of the well-known and often controversial efficient market
hypothesis (EMH) with behavioral finance
• Andrew Lo, the theory’s founder, believes that people are
mainly rational, but sometimes can overreact during periods
of heightened market volatility.
• AMH argues that people are motivated by their own self-
interests, make mistakes, and tend to adapt and learn from
them.

Adaptive Market Hypothesis
• Adaptive market hypothesis (AMH) attempts to marry the theory
posited by EMH that investors are rational and efficient with the
argument made by behavioral economists that they are actually
irrational and inefficient.
• For years, EMH has been the dominant theory. It states that it is
not possible to "beat the market" because companies always trade
at their fair value, making it impossible to buy undervalued stocks
or sell them at exaggerated prices.
• Behavioral finance emerged later to challenge this notion, pointing
out that investors were not always rational and stocks did not
always trade at their fair value during financial bubbles, crashes,
and crises.

Adaptive Market Hypothesis
•Adaptive market hypothesis (AMH) considers both these
conflicting views as a means of explaining investor and
market behavior. It contends that rationality and
irrationality coexist, applying the principles of evolution
and behavior to financial interactions.
•The adaptive market hypothesis (AMH) is based on the
following basic tenets:
- People are motivated by their own self-interests
- They naturally make mistakes
- They adapt and learn from these mistakes

Example of Adaptive Market Hypothesis (AMH)
•During the housing bubble, people leveraged up and
purchased assets, assuming that price mean reversion
wasn't a possibility because it hadn't occurred
recently. Eventually, the cycle turned, the bubble burst
and prices fell.
•One of them referred to an investor buying near the
top of a bubble because he or she first developed
portfolio management skills during an extended bull
market.