selection criterion over the mean return selection criterion is that it selects the strategy with the highest return/risk pay-off. Although for 23 stock market indices it is found that they could not even beat a continuous risk free investment, we find for both selection criteria that for each index a technical trading strategy can be selected that is capable of beating the buy-and-hold benchmark, even after correction for transaction costs.
The profits generated by the technical trading strategies could be the reward necessary to attract investors to bear the risk of holding the asset. To test this hypothesis we estimate Sharpe-Lintner CAPMs. For each local stock market index the daily return of the best strategy in excess of the risk-free interest rate is regressed against a constant (α) and the daily return of buying and holding a market portfolio in excess of the risk-free interest rate. The coefficient of the last regression term is called β and measures the riskiness of the strategy relatively to buying and holding the market portfolio. The market portfolio is taken to be the local stock market index, but we also examine the possibility that the market portfolio is represented by the MSCI World Index. If technical trading rules do not generate excess profits after correction for risk, then α should not be significantly different from zero. In the case of zero transaction costs case, it is found for the mean return as well as the Sharpe ratio criterion that for all indices the estimate of α is significantly positive at the 10% significance level, if the local index is used as the market portfolio. Even if transaction costs are increased to 1% per trade, then we find for more than half of the indices that the estimate of α is still significantly positive. Moreover it is found that the estimate of β is simultaneously significantly smaller than one for most indices. Thus for both selection criteria we find for approximately half of the indices that in the presence of transaction costs the best technical trading strategies have forecasting power and even reduce risk. If the MSCI World Index is used as market portfolio in the CAPM estimations, then the results for α become less strong, but even in the 0.50% costs per trade case, for almost half of the indices the estimate of α is significantly positive.
An important question is whether the positive results found in favour of technical trading are due to chance or the fact that the best strategy has genuine superior forecasting power over the buy-and-hold benchmark. This is called the danger of data snooping. We apply White's (2000) Reality Check (RC) and Hansen's (2001) Superior Predictive Ability (SPA) test, to test the null hypothesis that the best strategy found in a specification search is not superior to the benchmark of a buy-and-hold if a correction is made for data snooping. Hansen (2001) showed that White's RC is biased in the direction of one, caused by the inclusion of poor strategies. Because we compute p-values for both tests, we can investigate whether the two test procedures result in different inferences about forecasting ability. If zero transaction costs are implemented, then we find for the mean