An Analysis of Technical Trading Strategies By Kadida Ramadhani Shagilla Mashaushi Submitted in accordance with the requirements for the degree of Doctor of Philosophy The University of Leeds Leeds University Business School September, 2006 The candidate confirms that the work submitted is his own and that appropriate credit has been given where reference has been made to the work of others. The copy has been supplied on the understanding that it is copyright material and that no quotation from the thesis may be published without proper acknowledgement 11 Acknowledgements I take this opportunity to express my respectful appreciation on the help, guidance and supervision made by my supervisors Professor David Hillier, the Centenary Professor and Ziff Chair in Financial Markets, Leeds University Business School (LUBS), Professor Kevin Keasey, the Director of the International Institute of Banking and Financial Services (IIBFS), Leeds University Business School (LUBS) and Dr. Charlie Cal. I can not find words that can appropriately represent their contribution to my achievement. A very special mention is in the name of my farther, the late Ramadhani Shagilla Mashaushi. He had all along inspired and encouraged me towards higher levels in my carreer progression and achievement. Special thanks also goes to Professor Joshua Doriye, the Principal, Institute of Finance Management (IFM) and Dr. S.R. Mohamed, the Director of Graduate School, Institute of Finance Management (IFM) for their innumerable and immeasurable contributions to my study. I would also like to mention Michelle Dickson and Natasha Mullea of LUBS Research Office for their support and encouragement. I sincerely underscore Michelle's support and caring assistance. I am indebted to my wife, Kamaria, for her patience and moral support; my mum, brothers and sisters; my sons Othman, Ishaq and Luqman and to my daughter for Malkia-Bilqis -a big thank to you your patience and understanding. Many thanks to my fellow students lain and Suntharee (Mint) for your fruitful discussions and moral support. 111 Abstract This dissertation extends the literature on the efficacy of technical analysis in the direction of the `risk premium view' as an explanation for excess trading rule returns. First, we generally rely on the theoretical alternatives to the efficient market hypothesis which encourages possibilities for markets to be inefficient. We then investigate the link between the risk involved in trading rule strategies and the resulting excess returns. The empirical analysis is based mainly on a sample of stocks drawn from the London Stock Exchange, (LSE), portfolios constructed from three US markets; the New York Stock Exchange, (NYSE), the American Stock Exchange, (ASE), and the National Association of Securities Dealers Automated Quotation market, (NASDAQ). Data from ten small emerging markets of Africa is also used in empirical analyses. Focusing on documented evidence of differences in risk levels among several markets or market segments, the empirical analyses examined whether these risk differentials can explain excess trading rule profits as compensation for bearing risk. The empirical analyses find that, to a large extent, liquidity, book-to-market ratio, and institutional arrangements can explain the excess profits from technical analysis. These empirical analysesare carried out in chaptersthree, four and six. As part of the analysis, I conduct empirical tests to assess the appropriateness of some risk estimates for trading rules. Using recently developed techniques, the evidence in chapter five is consistent with the notion that certain risk estimates may not be appropriate for adjusting trading rule returns for risk. 1V Contents Acknowledgelnents ii ................................................................................................... Abstract 111iii ................................................................... .................................................. Contents iv .................................................................................................................... List Tables of .......................................................................................................... viii Chapter 1 Introduction 1 .................................................................................... 1.1 Importance the 1 of study ............................................................................. 1.2 Objectives of the study: is return predictability consistent with the EMH? 4 ........................................................................................................ 1.3 Chapters 7 outlines ....................................................................................... Chapter 2 Literature Review 12 ........................................................................ 2.1 Introduction 12 ............................................................................................. 2.2 The Theoretical Background of Research in Predictability of Asset Returns 17 .................................................................................................... 2.2.1 Assumptions the Efficient Market Hypothesis 19 of .......................... 2.2.2 Forms Market Efficiency 20 of ........................................................... 2.2.3 Theories Supporting the EMH: The Rational Expectations Hypothesis 21 ...................................................................................... 2.2.4 Models for Testing Predictability Asset Returns 23 of ....................... 2.3 Alternative theories explaining the behaviour of prices: the theoretical Basis Technical Analysis 28 of .................................................. 2.3.1 Overreaction 29 ................................................................................... 2.3.2 Overconfidence Optimism 30 and ...................................................... 2.3.3 Herding Models 31 ............................................................................. 2.3.4 Asymmetrical Information Diffusion Process 31 ............................... 2.4 Early Empirical Works 32 ........................................................................... 2.5 Recent Empirical Works 36 ......................................................................... 2.5.1 The Foreign Exchange Markets 37 ..................................................... 2.5.2 Futures Markets 39 ............................................................................. 2.5.3 Stock Markets 40 ................................................................................ 2.5.4 Technical in Emerging Markets 43 analysis ....................................... V 2.5.5 Studies of Technical Analysis via 44 non-linear models .................... 2.6 Empirical Explanations of Sources Trading Profits 46 of rule .................... 2.6.1 Market Microstructure Deficiencies 47 .............................................. 2.6.2 Data Snooping ................................................................................ 48 2.6.3 Temporary Inefficiencies 50 ............................................................... 2.6.4 Transaction Costs 51 and other adjustments ....................................... 2.7 Adjustments for Excess Profits for Risk Premium 54 ................................. 2.7.1 Risk Adjustment Measures 54 ............................................................ 2.7.2 Risk Factor Adjustments 58 ................................................................ 2.7.3 Adjusting for Time Varying Risk Premium 59 - ................................ 2.8 Summary Conclusions 61 and ..................................................................... Chapter 3 Applying Simple Trading Rules to B-M based Portfolios........ 66 3.1 Introduction 66 ............................................................................................. 3.2 Research Objectives Significance 69 and .................................................... 3.3 Literature Review 70 .................................................................................... 3.3.1 Trading 73 rules .................................................................................. 3.3.2 Test 75 statistics .................................................................................. 3.3.3 Testable Hypotheses Test Statistics 77 and ........................................ 3.4 Data Methodology 78 and ............................................................................ 3.5 Empirical Results 79 .................................................................................... 3.5.1 Summary Statistics 79 ......................................................... ....... 3.5.2 Comparative Performance of Book-to-Market based Assets......... 80 3.5.3 Can Risk Premium Excess trading 83 explain rule returns? ............... 3.5.4 Can risk premium explain superior performance of trading rules profits: Results from the extended Fama - French (1993) 86 model .................................................................................. 3.5.5 Further tests of time - varying risk premium using the bootstrap 88 method............................................................................ 3.6 Conclusions 91 ............................................................................................. 3.7 Appendix 1 95 .............................................................................................. Chapter 4 Technical Analysis: Returns, Risk Liquidity 101 and ..................