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Why does the efficient market hypothesis state that technical analysis is bunk?
By Sean Ross
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The efficient market hypothesis (EMH) suggests that markets are informationally efficient. This means that historical prices and expectations are already priced into investments and that it's not possible to exceed market-average returns by looking at past price data. Since technical analysis is completely predicated on the concept of using past data to anticipate future price movements, the EMH is conceptually opposed to technical analysis.
It should be noted that of the three versions of EMH, two conclude that neither technical analysis nor fundamental analysis can be useful when making investment decisions. Only the weak-form efficiency version of the EMH allows for some use of fundamental techniques.
The Role of Historical Data
The crux of the argument between the EMH and technical analysis is the role of historical data. Technical analysts argue that prices and investors tend to follow predictable patterns. Once identified, those patterns can be used to anticipate future trading opportunities for above market-average returns.
According to the EMH, security prices already reflect all available information. This includes investor sentiment about possible price trends and all recurring phenomena that might produce those trends again. Moreover, the EMH challenges the notion that past price and volume data have any relationship with future movements.
Self-Fulfilling Technical Trading
Some traders contend that, if enough traders are using similar technical valuation techniques, technical analysis could create a self-fulfilling prophesy.
Here's the argument: A large number of technical traders believe the price of a stock is likely to go up. Consequently, most of them enter the market as bulls. This bids up the price of the stock (at least in the short run), allowing them to override efficient market information through their collective bias.
Another way of describing this phenomenon is that large numbers of speculative traders can push the price of a security beyond is market-clearing level.
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