Technical Analysis, Dow Theory, and Practice
The basis for technical analysis is found in a few principles and theories that deal with price behavior. In other words, prices move for specific reasons, some beyond the economic observations of supply and demand. So beyond the economic reasons for price movement, some ideas have been offered to explain price movement as either efficient or random.
An analysis of market behavior demonstrates, however, that price movement is neither efficient nor random.
It is inefficient in the short term primarily because prices tend to overreact to all current and new information and then to correct later. For example, when earnings exceed expectations, right after the announcement is made the stock price might move way ahead of what seems justified. In the following session or two, the surge is corrected and prices retreat. This is not efficient.
Contrary to popular theories, the stock market is neither efficient nor random. It is a risky venture to buy and sell shares of stock due to the unknown forces that drive prices upward or downward.
Prices cannot be justified as random, either. If prices were random, the 'cause and effect' of news and price movement would not be consistent by any measure. However, when good news is released, prices tend to rise; and when bad news is released, prices tend to fall. Furthermore, prices overall tend to follow market averages. So when there is a big price surge or a big price drop, a majority of listed stocks tend to move in the same direction as the big index stocks. This is not random; in fact, it is highly predictable.
By Michael C. Thomsett