Technical analysis and efficient markets

Abstract

echnical Analysis, a tool used for security analysis and market timing, is based on analysis of past price and volume data to predict future stock movements. The validity of this technique is directly questioned by Efficient Market Hypothesis, which provides, that at all times prices reflects all available past and present information about a security and thus argues that technical analysis cannot generate a greater risk adjusted return as compared to a buy and hold strategy. In this paper, we analyze 1) Validity of Random Walk Hypothesis in the Indian Market 2) Empirical Risk-Adjusted Returns generated by various technical analysis strategies over August 2014 to July 2015 3) Conditions in which Technical Analysis and Market efficiency ideas reconcile. We find that because of low liquidity, the random walk hypothesis is rejected in Indian Small-Cap market which empirically exhibits positive autocorrelation in returns. Additionally, we find evidence that Momentum based technical trading strategies did generate greater risk-adjusted return as compared to a buy and hold strategy. Lastly, we find that academic literature establishes that information doesn’t get adjusted immediately in the prices as argued by proponents of Market efficiency. Thus technical analysis can be useful in identifying inflow of meaningful information in the market; which gets reflected in our finding of the validity of momentum based technical analysis strategies too.