The Validity of Technical Analysis for the Swedish Stock Exchange Evidence from random walk tests and back testing analysis Master Thesis in Economics Author: Dan Gustafsson Tutor: Per-Olof Bjuggren, Louise Nordström Jönköping May 2012 Abstract In this paper I examine the validity of technical analysis for the Swedish stock index OMXS30 between 2001-12-28 and 2011-12-30. Results indicate that OMXS30 followed a non-random walk and that technical trading rules had predictive power over future price movements. Results also suggest that technical trading rules could be used to outperform a buy-and-hold strategy. i Table of Contents Abstract ........................................................................................... i 1 Introduction ............................................................................... 1 1.1 Background and Problem Discussion ..................................................... 1 1.2 Previous Research ................................................................................. 2 1.2 Method ................................................................................................... 3 2 Theoretical framework .............................................................. 3 2.1 The Random Walk Theory ...................................................................... 3 2.2 The Efficient Market Hypothesis ............................................................. 4 2.3 Behavioural Finance ............................................................................... 5 2.4 The Dow Theory ..................................................................................... 6 2.5 Technical analysis .................................................................................. 7 3 Research method ...................................................................... 8 3.1 Random Walk Tests ............................................................................... 8 3.1.2 The Box-Pierce Q-test ........................................................................ 8 3.1.3 Lo & MacKinlay’s Variance Ratio Test ............................................... 9 3.2 Trading Rules ....................................................................................... 10 3.2.1 Standard Moving Average ................................................................ 11 3.2.2 Exponential Moving Average ............................................................ 11 3.2.3 The Relative Strength Index ............................................................. 12 3.2.4 RSIstoch ........................................................................................... 12 3.3 Data Selection ...................................................................................... 13 4 Empirical Results .................................................................... 13 4.1 Empirical Results for the Random Walk Tests ..................................... 13 4.2 Empirical Results from Technical Trading Rules .................................. 16 4.3 Empirical Results for Different Investment Strategies ........................... 19 5 Summary and Conclusion ...................................................... 22 References ................................................................................... 23 Appendix ...................................................................................... 26 ii 1 Introduction In the course of years, literally thousands of research papers have tried to appraise the state of the stock market. In fact, during the past ten decades, few other topics have been so ex- haustively studied. The rewards to those who are able to anticipate the market are enor- mous - no wonder the field has attracted so many financial economist and practitioners. The intensive research has all tried to answer the investor’s problem of how to behave in the stock market. As a result, two rather different disciplines have arisen. The first disci- pline is commonly referred to as fundamental analysis and the second discipline as tech- nical analysis. Fundamental analysis tries to find the “correct” value of a security and, as the name implies, looks at economic fundamentals to do so. Technical analysis on the other hand, appraises securities with the use of historical price information. In this paper I will examine the validity of technical analysis for the Swedish stock index OMXS30 and see if a strategy based on technical trading rules could have outperform a buy-and-hold strategy. As such, this paper will be an interesting contribution to the general discussion of market efficiency, behavioral finance and technical analysis. 1.1 Background and Problem Discussion At a first glance, the use of technical analysis is quite appealing. The primary reason is the anticipation to time and beat the market (buy low and sell high) and spend an inordinate amount of time and research doing so. An investor would no longer need to depend on profit-loss-statements, auditor’s reports and dividend records. Instead, all an investor need is historical price data and a trading rule which generates buy and sell signals. However, finding a trading rule that generates profitable buy and sell signals is easier said than done. As such, to avoid being whipsawed by seemingly erratic market price movements, an inves- tor should first and foremost try to understand the fundamental condition of the stock market before applying technical analysis. For example, if stock markets follow a random walk, market timing would be impossible using technical analysis. As such, a long term in- vestment strategy based on the assumption that stock markets generate good rewards in the long run (from now on called the buy-and-hold strategy), would be superior to any strategy based on technical trading rules. If price movements are predictable, on the other hand, technical analysis should be the obvious choice for any investor when appraising securities. Previous studies have lent some support to the idea that technical analysis could be used to outperform a buy-and-hold strategy for the Swedish stock exchange (SSE). For example, both Frennberg and Hansson (1992) and Säfvenblad (2000) rejected the random walk hy- pothesis (the first obstacle for technical analysis) for the SSE, finding high levels of auto- correlation. Säfvenblad (2000) suggested that the underlying reason for the SSE’s non- random walk behavior was negative feedback trading1 (where investors sell after price in- 1 Feedback trading is a form of trading strategy including: profit taking, herding and dynamic asset allocation (Säfvenblad, 2000) 1 creases). An additional study supporting the use of technical analysis for the SSE is Metghalchi, Chang and Marcucci (2005). Findings suggested that simple moving average techniques have had predictive power over future price movements and could outperform a buy-and-hold strategy for the Swedish stock index OMXS30 between 1986 and 2004. However, except for Metghalchi et al (2005), the validity of technical analysis for the SSE has been notably unexamined until now. Furthermore, as Metghalchi et al findings were based on stock market data between 1986 and 2004, I believe it is high time for a revisit. As such, I will in this paper examine the validity of technical analysis for the Swedish stock in- dex OMXS30 and see if a strategy based on technical trading rules could have outperform a buy-and-hold strategy. To do this I will test the following hypotheses: (1) OMXS30 fol- lowed a non-random walk, (2) technical trading rules did have predictive power over future price movements and (3) strategies based on technical trading could outperform a buy-and- hold strategy. 1.2 Previous Research Criticism of technical analysis often derives from academic research supporting the “weak form” efficient market hypothesis as defined by Fama (1970). Specifically, the validity of technical analysis is often dismissed due to the belief that stock markets follow a random walk. Examples of studies supporting the random walk hypothesis are: Fama (1965)2, Fama & Blume (1966)3 and Jensen & Benington (1970)4. However, numerous of research papers have challenged the random walk hypothesis. In addition to Frennberg & Hansson (1992) and Säfvenblad (2000), empirical evidence supporting non-random walk behavior for stock markets are: Lo and MacKinlay (1988)5, Berglund & Liljeblom (1988)6, Chan (1993)7 and Lima & Tabak (2006)8. 2 Fama (1965) examined stock price movements of the Dow Jones Index between 1956 and 1962. Findings suggested that price changes were uncorrelated over time and therefore consistent with the random walk hypothesis. 3 Fama & Blume (1966) applied Alexander’s filter technique on closing prices of individual securities of the Dow Jones Index between 1956 and 1962. Fama & Blume concluded that the random walk theory was ad- equate for the average investor due to low serial dependence. 4 Jensen & Benington (1970) reexamined Levy’s trading rules for the NYSE between 1931 and 1965. Findings suggested that Levy’s trading rules were outperformed by a buy-and-hold strategy and that price move- ments had followed a random walk. 5 Lo & MacKinlay (1988) tested the random walk hypothesis by comparing variance estimators for the CRSP return index between 1962 and 1985.Findings strongly rejected the random walk hypothesis. 6 Berglund and Liljeblom (1988) examined the Helsinki stock exchange between 1977 and 1982. Findings suggested first order autocorrelation in index returns due to trading procedures. 7 Chan (1993) examined