A Failure of Technical Analysis on the Stock Market drop of February 27, 2007 February 28, 2007

Charles Higgins, Ph.D.

Dept. of Finance/CIS, Loyola Marymount University One LMU Drive Los Angeles, CA 90045-8385 310 338 7344 chiggins@lmu.edu 3rd draft, not for attribution without permission Graphs were from www.bigcharts.com; labels and arrows are mine

On February 27, 2007 the stock markets fell substantially, by over 415 points on the Dow Jones Industrial average, by 96.66 on the NASDAQ, and by 50.33 (or 50.26 per the Nightly Business Report) on the Standard & Poors 500 average. I am struck by how technical analysis repeatedly failed to correctly time this largest decline since 2001. At the time of this writing, in the early evening of the same day, the Shanghai index had opened upward by over 1.6 percent; the same market which presaged the world wide decline earlier today. One type of technical analysis is to examine a securitys price history as a chart, then to extrapolate the respective peaks or troughs toward intersecting future prices, and then to regard those intersections as signals to buy or sell the security respectively. Examine the following graphs of the Dow Jones Industrials average:

A sell signal occurred in early September 2006, and again:

in late November 2006, then another appeared in early January 2007:

and again in late January 2007:

and recently a fifth sell signal was generated:

Some technical analysts might argue that this repeated set of sell signals as demonstrative of how effective technical analysis is. I would argue otherwise. The first sell signal, had it been utilized in September 2006 as a signal to sell, would have missed the substantial part of the subsequent gain which followed (another ten percent or more). And to jump ahead to the fifth signal, one could easily argue that by this fifth signal that it had become the boy who cried wolf. Further, in my dissertation I found that if any value was to be found in trend line charting, it was to buy with the third signal using peaks and to sell with the first signal was using troughs, albeit for negligible excess returns compared to a buy-and-hold strategy and only to those paying the clearing house fee (available only to members of an exchange). Another way to show the weakness with technical analysis is to note that for technical analysis to be effective it must be able to differentiate which signal shall be deemed as valid. These five-in-arow sell signals seem to be ineffective. That is, had one acted earlier, one would have missed a major raison dtre [to be] in the stock market, and had one acted later then one should doubt the efficacy of technical analysis in terms of its clarity to resolve which signal is significant. Yes, I should at this time note that the Dow Jones Industrial average suffers from being a small sampling of thirty quality securities and that it is neither price nor market weighted. However, the Standard & Poors 500 index had a similar chart pattern. I now leave it to the readers to supply, then test on their own, their own trend lines and sell signals. I trust that a similar conclusion should result: