# Chaos in Technical Analysis and Backtesting – Part I: Close vs. Adjusted Close

This is the first in a series of posts about the impact of data adjustments on technical analysis studies and backtesting, as well as, of the pitfalls of trading system development due to incompatibilities and/or conflicts between data series and analysis techniques. Use of the wrong data series for technical analysis and backtesting can under certain circumstances produce wrong, even chaotic results, as I will show with specific examples.  This first post concerns especially technical traders of ETFs and stocks with dividend payments and splits that are often used to adjust the price series.

A picture is worth a thousand words

Instead of trying to tackle this problem mathematically here, something I did a few years ago, it is better to show a couple of pictures. Math can provide the answer but it is a complicated route and I think in this particular case, common sense is the best tool for dealing with the problems one faces when using adjusted price series for ETFs and stocks.

This is a monthly chart of SPY since inception with no adjustments for dividends:

Figure 1:SPY monthly chart with no adjustments for dividends

Next is the monthly chart of the same ETF with prices adjusted for dividends:

Figure 2: SPY monthly chart with adjustments for dividends

Below is an annimation that better illustrates the effect of the adjustments on prices:

It can be seen that the effect of a series of adjustments due to dividend payments on the price series is a non-linear compression from current to past data. As a result, the double top in Figure 1 formed by the two peaks in 2000 and 2007 disappears in Figure 2 and instead the chart shows an upwards trending market. Specifically, the most recent peak in 2007 is displaced downwards from around \$155.75 to near \$142 and the older peak of 2000 is displaced near \$114.

It is clear that the chart in Figure 2 is not appropriate for technical analysis because reality has been distorted a posteriori, meaning that past data were changed based on future data. If this is not clear at this point based on the chart displays in Figures 1 and 2, it will become clear in the second post in this series which will include specific results from the performance of trading systems using unadjusted and adjusted data.

So, what is the chart in Figure 2 good for? I argue that this type of chart should not be used for technical analysis or backtesting but it is only good for calculating buy and hold performance. Actually, adjusted series are useful for buy and hold calculations because they include dividends and in some cases their impact on performance is significant. I have already used the adjusted close series in this post to calculate buy and hold returns.