A common topic of conversation between equity analysts, traders, and the media is whether technical analysis (TA) – in conjunction with fundamental analysis or on its own – can help investors divine the future movements of stocks or stock indices.
Date: Apr 3, 2012 Author: Andrew Clark
Keywords: Equities, Volatility
A common topic of conversation between equity analysts, traders, and the media is whether technical analysis (TA) – in conjunction with fundamental analysis or on its own – can help investors divine the future movements of stocks or stock indices.
Following a short study, I can answer this question with a “yes”, and can point to a family of TA techniques that could provide better results than other tools technical analysis tools.
The first thing I examined was volatility. Using the following price series: the Hang Seng Index, the SSE in China, the STI in Singapore, the TSEC in Taiwan, the KOSPI, and the Nikkei 225 – I found that over the past 10 years or so there has been a startling amount of independence of volatility.
There has been no “leakage” of volatility from one country to another; what is often called “volatility contagion” did not exist in these countries. This is not to say that a common external event, for instance something exogenous to them all, would not cause their volatility to correlate for some period. However, the countries’ stock index volatility would eventually de-correlate – quite possibly faster than some traders may expect.
Given the volatility independence of each index with the others, I examined “phase diagrams”, in particular one-variable and two-variable diagrams (1VD and 2VD, respectively). 1VD correlates three consecutive price points in the series, while 2VD correlates four consecutive price points in the series.
A positive slope in the correlation of either the 1VD or 2VD calculation indicates the presence of persistence and implies the price series is amenable to trend-following TA tools such as moving averages. A negative slope points to anti-persistence: a move up one day will more than likely be followed by a move down the next (or vice versa).
A stock that shows this sort of behaviour is probably going to yield up its secrets to oscillator analysis and similar techniques. A stock or stock index that has a flat line means TA may very well not work except on an occasional basis. This kind of stock is best analysed using fundamental analysis.
As a caveat to this analysis, the existence of persistence, anti-persistence or flat lines is a statement about a stock index in general, meaning that over the long term the index will be better understood using one set of tools instead of another.
So here is the surprising result, at least to me: each of the indices is anti-persistent and amenable to fundamental analysis.
The anti-persistent behaviour would best be examined with such tools as moving average convergence/divergence (MACD), the Aroon oscillator, and/or a stochastic oscillator. And the reason fundamental analysis yields clues to an investor is because each stock index price series follows a white-noise process – the most common economic description of stock price processes.
A white-noise process is random and shows no evidence of self-correlation (auto-correlation). This lack of auto-correlation is the reason trend-following methods would not do so well.
So, in several APAC countries both TA – with a focus on oscillators – and fundamental analysis could potentially benefit investors and traders.
