Exploring the link between behavioural finance and technical analysis

by Bijoy Kar, CFA
Technical Strategist at MIG BANK – a leading Swiss FX and CFDs online trading provider

The historical starting point for security analysis.
Historically strategists and asset allocation specialists have used macro economics/fundamental analysis, together with the concept of modern portfolio theory (MPT) as their starting point for security analysis.

Initially projections/assumptions are made for major macro statistics like GDP growth, unemployment, inflation etc. These projections are then used to make assumptions about the likely movement in government bond markets and then all other markets that are affected by the repo rate (base rate)
(see figure 1).

To assess the robustness of any form of analysis we need to take a closer look at any assumptions that are made. In the case of Modern Portfolio Theory, we make some major assumptions about the behaviour of the individuals that operate within financial markets. In particular we assume the following:

  • All investors are rational and risk-averse.
  • All investors have access to the same information at the same time.
  • Investors have an accurate conception of possible returns.
  • Asset returns are normally distributed random variables.
  • There are no taxes or transaction costs.

There are other assumptions but they will not be covered at this point.

The weakness of assumptions in MPT / The reality of trading.
The following points need to be considered when questioning the above assumptions:

  • Anyone who has traded their own account or worked on a trading floor will know that investment decisions are rarely made under conditions of rationality. Instead fear and greed dominate.
  • There is a clear divide regarding market information when it comes to institutional versus retail investment. Institutional investors are often in receipt of information far in advance of their retail counterparts.
  • Investors often have irrational expectations of possible returns, basing their expectations on an in built human inclination to linearly extrapolate the recent past.
  • Many asset returns are not normally distributed, this is just an assumption that makes the mathematics of risk evaluation easier and is often relatively accurate, however, skewed distributions with fatter tails are more accurate.

Purely using rational thought and fundamental analysis is unlikely to lead to success, which is why so many computer models have become dominant in the world of trading.
The best way to determine if the above assumptions are close to reality is simply to look at the evidence of investor behaviour from price history.

Evidence of Investor behaviour from price history.
We will focus on the first assumption of MPT stated above; that investors make rational decisions.
If we look at price history (a chart) and also look at the news stories and general investment mood that was prevalent at the time, we will always find that peaks are associated with euphoria/greed. The popular financial press will be full of positive stories. Similarly, when we look at troughs they are associated with despondency and fear. The financial press will typically be full of negative stories.


Consider the weekly candlestick chart of the S&P500, displayed in figure 2. The area circled contains a day on which a, now infamous, news story was released.The news story in question was the quote from Chuck Prince, the then CEO of Citigroup, who was quoted as saying: “As long as the music is playing, you’ve got to get up and dance. We are still dancing”. This quote is clearly a sign of the confidence that was being felt by the upper management, in, what was at the time, one of the largest banks in the world. We can see that this peak in confidence also occurred close to the actual 2007 peak in the market, see figure 3.

Also consider the quote in figure 4. When do you think that this headline was featured in the financial press?

 

As things turned out, this highly pessimistic headline occurred on 06/03/2009, just before the long-term low at 666.79, see figure 5. It seems that journalists and CEO’s alike are affected by the sentiment that dominates the press at various times over the cycle. Getting absorbed by the financial press, which is virtually unavoidable in the financial industry is unlikely to lead an investor to make the right decisions.

What we learn from this is that in order to get to a market top we need to witness euphoria. Without the euphoria we will be unable to convince the person (or people) who buy the high, that there is any value in the market.
Similarly at market bottoms the news tends to be relentlessly negative. This is summed up in a quote from a famous 18th century investor, Baron Rothschild who said; “The time to buy is when there is blood on the streets”.

Why does this happen?
As we have alluded to earlier, humans are hardwired to linearly extrapolate their recent experience. So if all that has been witnessed in the recent past is positive and bullish, it is human nature to extrapolate this same experience out into what should be expected in the near future. Similarly, if our recent experiences have been exclusively bearish, we tend to expect this to continue. This is why some highly skilled professional investors will sometimes buy from those with less experience close to market bottoms.
Thus, within the context of financial markets, evidence tells us that due to the way in which humans are constructed, they are unlikely to make rational decisions when they need to. Instead they are more likely to extrapolate recent experience.
This explains why markets can become excessively cheap at market bottoms and yet few are willing to invest. We thus need a means of analysing the markets based on the evidence that we continue to witness.
We need to factor into our analysis, that prices are affected by human behaviour. Furthermore, there is clear evidence that decisions do not appear to be rational as dictated by modern portfolio theory. This is the premise of Behavioural Finance (BF).
The best form of analysis that captures many of the weaknesses of MPT is the field of technical analysis. It forms a good complement to behavioural finance.

Advantages of technical analysis.
The advantages of technical analysis versus fundamental analysis are:

  • History may not repeat exactly but it rhymes, so understanding human behaviour is key to understanding markets. This is captured by technical analysis. We search for patterns of price behaviour that repeat over time reflecting human behaviour.
  • It captures the key of markets; they are driven by human behaviour which is often irrational (fear and greed).
  • Markets teach us that human confidence can be a disadvantage. Technical analysis enables us to try and avoid this.
  • Acting on impulses which are often fundamentally driven, may not produce positive returns for a very long time, if at all. This is captured in the famous quote from John Maynard Keynes: “Markets can stay irrational longer then you can stay solvent”.

Assumptions of technical analysis.

  • Prices are not bound by the notion of fair value.
  • Prices move in cycles and patterns that repeat over time.
  • The cyclicality of this price movement and the repetition of patterns is down to the link between human behaviour and price movement.
    Once we know which patterns to look for and where we are in each respective cycle we are better able to position ourselves for successful trades.

Examples of how we trade with this information.
We have already learned that depending on where we are in a cycle, taking a contrarian approach can be advantageous from an investment perspective.
We can use technical analysis to try and guage times that may lend themselves to this approach. As an example, the hourly candlestick chart in figure 6 shows a setup that presented itself in GBP/JPY, at the beginning of 2011.
The most striking feature that we can see on the chart is a clear rising wedge. This formation is generally negative for the markets in which it occurs. Why? In essence the price behaviour of the market is a reflection of the collective behaviour of investors; and it warns of a period where more sellers are returning to the market, as the market is no longer making large impulsive moves in the direction of the prior trend. So, just by studying the price action of the market we have been able to gain an idea of the likely positioning of investors. Most importantly we could position ourselves at a point in the market where many participants are likely to be bullish, due to the prior short-term strength. The pattern has essentially trapped those who remain bullish as it warns of reversal. In fact, frequently when rising wedges break lower, the market can return to the base of the wedge. In this case the base is at 129.52. We can try and sell the market in the short-term for a return to this region. This was a strategy that we used, with a stop over 135.53, at 135.60. We placed an order to sell at 134.10, with objectives at 132.60/131.13/129.52. The first objective was chosen to be the same distance from the entry point as the stop.
The other two objectives were chosen as they corresponded to other key historic lows on the hourly chart. figure 7 shows what took place after we made our recommendation.

 

We can see this pattern again by looking at EUR/GBP in the hourly and daily timeframes from the beginning of May 2011, as shown in figures 8 and 9. The most striking feature is a rising daily wedge and an hourly rising channel. Both formations have exhibited breaks higher over their respective resistances, warning of reversal. This made selling over 0.9000 a good bet, with scope for a return to 0.8714. This is what we did.
Our strategy was to sell at 0.9010, with a stop at 0.9080, which was filled. The chart in figure 10 shows what happened next.

It is interesting to note that while trading close to 0.9000 and above, the following UK economic statistics were released:

  • UK manufacturing PMI was released for April at 54.6, 57.0 was expected.
  • House prices had fallen and the BOE left interest rates unchanged.
  • UK services PMI for April was 54.3, 56.0 was expected.
  • UK construction PMI was released at 53.3, 55.9 was expected.

All of the above economic releases are likely to bias even a rational investor to trade from the long side, but following all of these releases Sterling was bought, forcing EUR/GBP lower. It is clear that fundamental analysis would not have been a great deal of help at this point. Understanding human behaviour would have helped. However, fundamental analysis should not be dismissed. Instead the market reaction to fundamental releases can potentially be used to assist the astute investor in trying to determine the general positioning of the market.