In this paper we have investigated the possibility that technical rules contain significant return forecast power. To that end, we have evaluated simple forms of technical analysis for the General Index of the Madrid Stock Exchange (IGBM), using daily data for the thirty-one-year period from 1966 to 1997.
On the one hand, our results suggest that technical trading rules generate buy signals that consistently yield higher returns than sell signals, suggesting that technical analysis does have power to forecast price movements. Moreover, the returns following buy signals are less volatile than returns on sell signals.
This evidence could indicate the existance of nonlinearities in the IGBM data generating mechanism. In addittion, we find that returns following sell signals are negative, which are not easily explained by any of the currently existing equilibrium models.
On the other hand, we combine bootstrap methods and technical trading rules for the purpose of checking the adequacy of several models frequently used in finance [such as AR(1), GARCH and GARCH-M models]. We find that returns obtained from buy (sell) signals from the actual IGBM series are not likely generated by any of these models.
Not only do they fail in predicting returns, but they also fail in predicting volatility (even in the case of the GARCH and GARCHM models). Given that the period covered is very long and heterogeneous, with a number of important events that could affect the structure of the series, we have also considered two nonoverlapping subperiods, being 19 October 1987 the breaking point. However, we found no evidence that the results are different across subperiods. Therefore, our results provide strong support for profitability of simple technical trading rules and are in general consistent with those previously reported by BLL (1992) for the Dow Jones Index from 1897 to 1986, suggesting that earlier conclusions that found technical analysis to be useless might have been premature.
Nevertheless, the results should be taken with caution since reported gains may not seem to be high enough to translate into profits after transaction costs are considered. It would be worthwhile to investigate the performance of more elaborate trading rules and their profitability after transaction costs and brokerage fees are taken into account. This question is left for future research.
By F. Fernández, S. Sosvilla and J. Andrada
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