Back to the Future. A Behavioural Perspective on Technical Analysis into PIGS Countries

Abstract

(ProQuest: ... denotes formulae omitted.)1. IntroductionDuring the economic recession that started in 2008, some members of the European Union, namely: Portugal, Italy, Greece and Spain, were grouped together and given the acronym PIGS. The reason why these countries were grouped together is due to the great weakness and instability of their economies which became a very big and open problem in 2009. Several members of PIGS were in serious financial trouble due to their external or sovereign debt. Their debt became very risky due to their weak economy.Accurately predicting the future is a difficult thing in any academic discipline, particularly in a discipline that involves limitless human interactions. For a discipline like behavioural finance, which focuses on the study of worldly human behavior, there is too much timeless abstraction and too little scrutiny of real-world events. The typical economics theory (Efficient Market - EMH) starts with the study of how rational agents interact in frictionless markets, producing an outcome that is best for everyone. In the early 1990s, several financial economists conducted studies in the field of behavioural finance. Behavioural finance isfinance from a broader social science perspective including psychology and sociology (Shiller 2003).Technical analysis is the study of prices of stocks, with charts as the primary tool, to make better investments. In other words, technical analysis is a methodology for forecasting the direction of stock prices through the study of past market data, primarily price and volume (Kirkpatrick & Dahlquist 2006). The basic idea of technical analysis is to forecast the equity prices based on past prices.In behavioral theories, investors suffer from cognitive biases and cannot process available information rationally (Thaler 1993). Consistent with the experimental results that motivate behavioral finance, the background assumption in most behavioral theories is that investors act irrationally. In contrast, Efficient Market Theory states that security prices represent everything that is known about the security at a given moment. This theory concludes the notion that it is impossible to forecast prices, since prices already reflect everything that is currently known about the security. In behavioural finance, it is observed that there are rational and irrational expectations about returns. The same applies to technical analysis.In behavioral economics and quantitative analysis, the same tools of technical analysis are mostly used (Mizrach & Weerts 2009; Azzopardi 2010). Shiller (1981) attributed financial anomalies to irrationality, using the evidence that stock prices move too much relative to news about future dividends. Lakonishok et al. (1994) presented evidence to show that excess returns earned by portfolios based on publicly available accounting and price data are consistent with excessive extrapolation of past performance into the future. Hong & Stein (1999) also studied overreaction and underreaction, modelling the interactions of traders who follow price trends. Brav & Heaton (2002) showed that rational uncertainty and behavioral biases can deliver similar price patterns. In behavioural models, noise traders buy when prices rise and sell when prices fall, the same as technical analysis.Several studies tried to incorporate the Behavioural phenomenon into Technical Analysis. Behavioural models suggest that technical trading profits may be available even in the long run if technical trading strategies are based on noise or other models and not on information such as news or fundamental factors (Shleifer & Summers, 1990). According to some articles from the psychological literature (Mussweiler 2003; Mussweiler & Strack 1999b; Tversky & Kahneman 1974), investment decisions are likely to be influenced by past prices as depicted in charts. They suggested that investors' expectations about future stock prices are assimilated to a salient high or low on the chart. …