Blog - Investing Notes

September 21, 2006 - Technical Analysis as Folk Medicine

Is there a way to end the endless debate on the merits of technical analysis? In his September 2006 paper entitled "On the Analogy Between Scientific Study of Technical Analysis and Ethnopharmacology", Waldemar Stronka proposes bringing technical analysis into the financial economics fold in a manner analogous to the successful incorporation of folk medicine by pharmacology. Specifically, he notes that:

"...[O]ne of the greatest gulfs between academic finance and industry practice is the separation that exists between technical analysts and their academic critics. In contrast to fundamental analysis, which was quick to be adopted by the scholars of modern quantitative finance, technical analysis has been an orphan from the very start. It has been argued that the difference between fundamental analysis and technical analysis is not unlike the difference between astronomy and astrology." [quoting Lo, Mamaysky and Wang]

There are four areas of similarity between folk medicine and technical analysis:

• Both have foundations in folk science, with most claims proving false when subjected to rigorous scientific testing;
• Both have strong potentials for statistical bias, the placebo effect for folk medicine and data snooping for technical analysis;
• Both boast commercial popularities that support large markets for products/services; and,
• Both are possible sources of scientific knowledge (for pharmacology and financial economics, respectively).

There are also some areas of difference between folk medicine and technical analysis:

• The methodology for incorporating folk medicine into pharmacology is more advanced than the scientific study of technical analysis;
• Technical analysis has greater potential for contributing fundamental insights to financial economics than does folk medicine for pharmacology; and,
• Technical analysis is mutating and evolving rapidly, while folk medicine is fairly stable.

The essential lessons from folk medicine for testing of technical analysis are:

• The study of technical analysis should mirror the rigor of drug evaluation methodology (e.g., randomized, double-blind, placebo-controlled trials involving homogeneous populations);
• The study of technical analysis should include greater emphasis on explaining the behavioral mechanisms underlying hypothesized market inefficiencies; and,
• There should be a independent peer-reviewed journal devoted to the rigorous testing of technical analysis.

In summary, the incorporation of folk medicine by pharmacology offers a model for bringing technical analysis into the financial economics fold.

This paper provides a thoughtful framework for thinking about the state of financial economics.

For related research, see:

Blog Synthesis: Big Ideas for Investing/Trading; and,

Blog Synthesis: Some Trading Indicators, especially our blog entries of 4/11/05 and 9/18/06 on the testing of technical analysis.