This might seem like a pretty out of the character subject for me to discuss, since I write about sensible, non-hype, and long-term investing principles. Those would be exceedingly prudent and timely given the market onslaught. If you are at all familiar with general investing terms, then you would most likely associate technical analysis with the image of someone hunched over multiple LCD screens, fixated by indecipherable charts and graphs in a range of neon colours, and occasionally yell “Buy!” or “Sell!” with a touch of craziness into the phone. Needless to say, your average value investor would not approve of this behaviour. In fact, Warren Buffet famously dismissed technical analysis and quipped, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” So far not great, then why am I talking about it?

But first, what is technical analysis and why the bad rep?

It all depends on what you believe in.

Belief numero uno: Efficient market

At the crust of the matter, technical analysis is deemed the opposite of fundamental analysis. Where fundamental analysis make buy or sell decisions based on intrinsic value of a stock compared to market valuation; technical analysis disregards intrinsic value (since it assumes the market is efficient enough) of the stock, and focuses purely on supply and demand in the market.

In modern finance, this rests in something called the efficient market hypothesis (EMH). Most economists believe in a weak version of EMH, which is to say that the market does a pretty ok job when it comes to incorporating public information into the stock prices. But it’s not perfect, since insider information may still exist. On the other hand, technical analysts assume the market is perfect in incorporating valuation related information as well as market psychology into the stock price, or at least accurate enough for its purpose. The rest of the market movements are determined by more immediate demand and supply, as well as market psychology.

Belief numero dos: History tends to repeat itself

Fundamental analysts do not believe historical trading patterns serve any purpose in stock evaluation. The technical analyst on the other hand, believes that investors behave in rather predictable ways. Market psychology is believed to contribute to the repetitive nature of price movements, and technical analysts expect market participants to react in a consistent manner over similar market stimuli.

Belief numero tres: Trends

Chartists love trends, and a collection of rather imaginative terms have been created to describe them. Technicians frequently talk about moving averages, lines of support and resistance, channels, and many other obscure formations. They believe that as a result of behavioural consistency, prices also move up or down following trends. And once a trend has been established, future price movements tend to move in the same direction.

Then what’s with the bad rep?

All these will most definitely make Benjamin Graham turn in his graves. What would grate him more, you think, that these analysts 1) disregard intrinsic values and trust the mob? Or 2), their over-reliance on past trends and data? Granted, technical analysis is mainly used by traders who do not claim to be investors. And as to looking at past data, Peter Lynch said, “Charts are great for predicting the past.” Warren Buffet was equally unforgiving, he said, “If past history was all there was to the game, the richest people would be librarians.”

That’s just as well, since empirical evidence is largely inconclusive when it comes to either confirming or refuting the validity of such practice. Much of the gains made by technical analysis are eaten away by high transaction costs. But it’s important to bear in mind that there is sound technical analysis and badly practiced technical analysis, just as there are sound investing principles and bad investing ideas masqueraded as good ones.

The issue of timing – technical analysis’ redeeming feature

Most investors are given more or less the same advice: diversify, have a long-time horizon, be fearful when others are greedy and be greedy when others are fearful, etc. We are thus fixated on the idea of asset allocation based on one’s perceived risk tolerance. And this tolerance is based on your age, financial obligations, investment horizons and overall comfort level with market movements. Nowhere do most advisors talk about the importance of timing.

I’m not talking about market timing in the context of one’s attempt to bottom-fish or sell at the peak. Consistently doing so is next to impossible, with or without the help of either fundamental or technical analysis. What I’m talking about is this: most people who are told to buy and hold are not advised on the issue of entry or more importantly, exit timing.

Charts and statistics are always portrayed in a way to tell the story of a market that in the long run, has nowhere to go but up. That is all and well, but should your investment exit point comes in the middle of a market correction, or worse, a structural recession such as what we have now, what are you going to do? Are you going to push back your retirement by ten years until the market picks up its upward trajectory again, or tell your kids that they need to hold off college for a few years until the glitch in your investment portfolio corrects itself? In the long run, the market will move up. But in the long run, we are also all dead.

The important thing to consider here is that when we choose to enter or exit the market, because those two acts can have significant impact on our overall portfolio return. In that department, fundamental analysis does not provide enough information. Even if a business possesses an impeccable set of financial statements and favourable long-term prospects, it cannot fight the overall depressed (or euphoric) market sentiment. When you decide against entering the market because you’re pessimistic on broader market sentiments: on some level, that was a call made compliments of technical analysis.

Various accounting scandals of the past decade, as well as the widely publicized abuses of special purpose vehicles (SPVs) also provide another legitimate use of technical analysis. Fundamental analysis is performed based on financial statements and qualified opinions provided by firms and their accountants. If this information is inaccurate, or worse, fraudulent, then what good is fundamental analysis? In the Satyam case, technical analysis signaled selling pressures before evidence of accounting fraud eventually surfaced. In the least, would it not make sense to use technical analysis as a way to aid and affirm your conclusion drawn from fundamental analysis?

For the average investor, none of this really matters, because the average investor should not be so heavily invested into the stock market as to become severely affected by adverse market conditions. But I know that’s not the case. Decades of bull markets have made stock market investment as ubiquitous as Starbucks, so everyone’s a shareholder now. So if you plan to dive into the shark pool at some point in the future (if you’re already invested then be prepared to park it for a while), of course, perform all due diligence. Invest in what you know and understand, or invest with someone that can do that for you. As the last cautionary step, check with technicians on when to enter before you find yourself neck deep in a sinking market. Knowing your exit timeline, it would also pay to watch the market carefully. If you ask a technical analyst, a persistent downward trend may very well take away all your years of hard-wrought gains.

Hindsight is always 20/20. Here’s to another tool that may help investors with some sorely lacking foresight.

If you like this article, please spread the word and tell your friends about it, I would love to hear what you think! For more discussion and ideas on the market, please subscribe to my RSS feed.

picture source: ~sarcasticmalfunction

Thank you to The Penny Daily for including this article as its “Editor’s Pick” in Carnival of Everything Money #5.

We set out to see what the experts are saying about 2009.  What we didn’t realize was how the art of providing financial outlook has become a game of “one down-manship.“  How else would you explain the boom in competition for the title of Dr Doom?

So it would seem that the Rapture is upon us, are you ready?  Yeah, we feel the same way.

Here’s our survey of what some of the bigwigs in the investment industry have said about 2009 in recent months.  In our mock* roster, we have Warren Buffet the sage; Nouriel Roubini aka Dr Boom/perma-bear, or our favourite, the playboy Professor; Nassim Taleb aka Black Swan; Peter Schiff who’s-laughing-now; Jim Rogers my-kids-speak-Chinese-and-that-is-my-investment-hedge; Marc Faber the original-Dr-Doom; Don Coxe via Basic Points; and John Embry the Canadian goldbug.

Outlook for 2009

Investoralist: So how bad is 2009 looking?  Don’t hold back now, give it to us straight-up!

Warren Buffet: We have lived in one way in one type of economy. And we’re now deleveraging that economy. We’re gonna have to live without the same impetus from credit expansion that really helped propel the economic engine for a long period of time. That wind will not be at our back.

The economy will be in shambles throughout 2009, and, for that matter, probably well beyond, but that conclusion does not tell us whether the stock market will rise or fall.

Nouriel Roubini: The worst is yet to come.  I don’t want to name names, but many [banks], given the housing bust, will become insolvent. Their losses are mounting because they have written down only their subprime loans so far. They haven’t started writing down most of their consumer-credit losses, and reserves for losses are much less than they should have been. The banks are playing all sorts of accounting gimmicks not to recognize them. There are hundreds of millions of dollars outstanding in home-equity loans that eventually could be worth zero, too.

Nassim Taleb: The problems are still here. People that were in charge, they are still around. The bankers that got us here are still around. And we’re giving them more money. It’s not a regular crisis, the whole system need to be changed. We need to reduce debt. We need to reduce asymmetric pay-offs of the banks. This is just the beginning, we need to de-leverage so massively.

Peter Schiff: I wouldn’t get to enthusiastic about it. I think the lows are not in for the Dow, if you measure Dow in terms of ounces of gold, then US stocks are headed for a lot lower in 2009. Ultimately, everything that Obama is proposing is destructive to our economy.

The government is interfering with the free market cure, and they are worsening the disease. We are broke because we borrowed and spent too much, we need a serious recession by going back to saving and producing. The government is trying to re-inflate the bubble, to dig us into a deeper ditch. And therefore it’s going to be much more difficult to get back to the viable economy again.

Had they allowed a more severe recession to take place in 2001-2002, we never would’ve had the housing bubble in the first place. We need to let the market function.

We’ve had a bull market in bonds since the 1980s.  We’re now in the maniac stage, when the bubble bursts, we’re gonna take out the lows in the bond market in the 1970s.  The dollars in which they’re denominated in are gonna plunge too.  People are going to get wiped out in its purchasing power.

Jim Rogers: We are in a period of forced liquidation, which has happened only eight or nine times in the past 150 years. The fact that it’s historic doesn’t make it any more fun, of course.

But it is a pretty interesting time when there is forced selling of everything with no regard for facts or fundamentals at all. Historically, the way you make money in times like these is that you find things where the fundamentals are unimpaired. The fundamentals of GM are impaired. The fundamentals of Citigroup are impaired.

Marc Faber: Well, economically it will be very bad. We have a contracting economy, globally, everywhere. And, I mean, not mildly contracting, but falling off a cliff. However, after this fall off of a cliff, the news in the next 3 months could look somewhat better than expected. In other words, there could be some rebound from the lows in economic activity.

John Embry: [On the subject of currencies] Nouriel Roubini recently checked in with his latest prognostication and it qualifies as a true shocker.  He suggested that credit losses in U.S. institutions could now peak at a level of $3.6 trillion, half of them absorbed by banks and broker-dealers, and to him, this means the US banking system is insolvent.

However, those wishing to flee the U.S. dollar aren’t going to be all that thrilled with their alternatives in other currencies, all of which appear to be terminally flawed.

The euro is being dragged down by the countries formerly known as Club Med but now derisively being referred to by the acronym PIGS (Portugal, Italy, Greece and Spain).  These countries are suffering from economic and financial infirmities that are approaching or, in some cases, exceed those of the U.S.  The question is not what the relative value of the euro might be but whether it can even survive if things continue to worsen.

The English pound does not even deserve mention in view of the horrific state of the British economy, while the Japanese yen, despite its current strength, will ultimately be dragged down by the endemic deflationary problem plaguing the country which has one of the highest government debt-to-GDP ratios in the world.  The Russian ruble is headed down the toilet hand in hand with the discredited oligarchs whose proclivity for debt has brought many of them to the edge of ruin.

[And] I honestly think most observers may be missing what is really going on in China.  The country for years has had one of the most unbalanced economies on the planet with exports and capital spending constituting an inordinate large amount of economic activity in the country.  To keep the Yuan from rising, China is going to have to print a lot of money domestically.

This will all be part and parcel of the world’s major nations staging a race to the bottom in a declining currency derby.

Exit Timeline?

Investoralist: What do we have to do to get out of this, can we get out of this, what’s the timeline here?

Warren Buffet: Well, I don’t think it’ll be five years. But I don’t have the answer to that. I don’t know what the stock market will do in the next year. What I do know is that, if you go back to the 20th century, 100 years, you had two great wars, you had other very large wars, you had the Great Depression, you had the flu epidemic, you had a dozen recessions and panics, you had all kinds of things.

At the end of that century, the average American was living seven times as well as the start of the century. The Dow Jones average went from 66 to 11,497. With all those problems. This is a country that has the ingredients that well, it unleashes the potential of humans. And they’re still here. So five years, you can put me down on that one. You can’t put me down on one year.

Nouriel Roubini: Every time there has been a severe crisis in the last six months, people have said this is the catastrophic event that signals the bottom. They said it after Bear Stearns, after Fannie and Freddie, after AIG, and after $700 billion bailout plan. Each time they have called the bottom, and the bottom has not been reached.

Nassim Taleb: The ones that saw the crisis coming, should be put in charge. Nationalize banks, guarantee bad assets. Do what they did in Sweden versus what they did in Japan. We need to look at the credit losses.

Peter Schiff: This is a bear market that began in 2000, we’re 8 years into it, I think there’s 5-10 years minimum left of the bear market.

Jim Rogers: The (biggest issue) right now is that the American government is printing gigantic amounts of money right now and that in the end is going to be the worst problem. They’re propping everyone up everybody in sight; throughout history, when you’ve printed that much money it’s led to inflation, and in some cases runaway inflation.  I think in the end, the credit problem is not going to be the serious problem.

Marc Faber: I think a recovery will not come for the next couple of years— maybe in five, ten years time. But I really don’t see a catalyst that would propel economic growth to a higher rate. I think we’ll fall sharply like we fell in economic activity in October, November, early December. And we’ll be at the bottom of the valley for quite some time, and maybe we’ll go even lower. I think 2009 is going to be a catastrophe, economically speaking.

Don Coxe: Both Keynesian and Friedman policies are put into place.  There’s some serious heroin economics going on, but the alternative is dying in horrible pain.

In the meantime?

Investoralist: Capital preservation?  What can we invest in while the rest of the world falls to pieces?

Warren Buffet: If you own a farm nobody tells you when it’s gone down 50 percent ’cause you don’t get a quote every day. But you really look to the farm and what it produces to determine whether you made a good investment. Now if people look to the newspaper every day at the price of a stock to determine whether they made a good investment they’re making a mistake.

They have to look to the business, the asset itself. If you own an apartment house you wouldn’t get a quote on it every day. You’d just look at– what the rent rolls were, and what your taxes were and expenses were. And if they all came in with– in line with what you expected when you bought it you’d feel you’d made a satisfactory investment, and you’d never get a quote on it. So I don’t look at quotes. I can’t tell you what Berkshire Hathaway is selling for today.

Nouriel Roubini: Cash.

Nassim Taleb: Cash.

Peter Schiff: Opportunities are to preserve your purchasing power. By getting out of US dollar assets. The biggest casualty is going to be the value of our money. Seek out a tax haven from the inflationary tax, and invest aboard. There’s been a firesale on foreign assets.

Load up on quality companies outside the US, continue to buy precious metals (gold), and we’ve had a major dip in commodities, industrial, energy, agricultural commodities. This is one of the best commodity buying opportunities that I’ve seen.

Jim Rogers: Virtually the only asset class I know where the fundamentals are not impaired – in fact, where they are actually improving – is commodities. But if and when we come out of this, commodities are going to lead the way, just as they did in the 1970s when everything was a disaster and commodities went through the roof.

What I’ve been buying recently is agricultural commodities. I’ve also been buying more Chinese stocks. And I’m buying stocks in Taiwan for the first time in my life. It looks as if there’s finally going to be peace in Taiwan after 60 years, and Taiwanese companies are going to benefit from the long-term growth of China.

I have covered most of my short positions in U.S. stocks, and I’m now selling long-term U.S. government bonds short. That’s the last bubble I can find in the U.S. I cannot imagine why anybody would give money to the U.S. government for 30 years for less than a 4% yield. I certainly wouldn’t. There are going to be gigantic amounts of bonds coming to the market, and inflation will be coming back.

In my view, U.S. stocks are still not attractive.

Marc Faber: Buy gold, buy commodities, and buy natural resource stocks while getting ready to short U.S. debt massively.

Well, I personally, I think that the Chinese economy will suffer very badly. They’ll have a bad recession. And I also think that politically in the world, geopolitically, we have tensions coming up. And so I would be trading Chinese stocks— maybe you buy them here and you resell them like other emerging economy stock markets that have underperformed the U.S. over the last 14 months. Since the market peaked in November 2007, the emerging markets and those of commodities have been hammered. And so the rebound may occur there more than, say, in the United States. But, as I said, look at it as a trading opportunity.

I continue to like gold. And, at the present time, that is very depressed compared to physical gold are gold miners— the exploration companies. I would also say that oil at around this level is becoming attractive, and that oil companies are reasonably attractive. So these are the investments I would carry out at the present time. And the big mining companies— CVRD, Rio Tinto, BHP, and larger gold producing companies like Newmont. But after their very strong rebound I think we have to wait for a correction.

I think the dollar is a disastrous currency. But the others are not much better. The Swiss franc is not the Swiss franc we had in the 1950s. Its quality has gone down very substantially. And the Fed, by pursuing this zero interest rate policy, which leads essentially to dollar weakness, it’s to some extent a trade war. You cheapen your currency, so you export problems to somebody else. But since the whole world is engaged in trying to lower the value of their currencies, it may very well happen that all currencies lose value against, say, hard currencies like precious metals, silver, platinum and gold.

Don Coxe: Commodities stocks, not commodities.  You want to be able to identify management talent.  For coming out the other side, an appropriate portfolio should be 50% commodities.  There will not be a dawning of the new world unless the banking sector reforms.  Commodities in 2011 will go higher than I thought they would ever go, because of what’s been done in response to the [banking] crisis.  The next commodity bull market will make the first one look tame.

In 2008, commodities caught up with the rest of the market and other risk assets.  they were the last to go down, which is characteristic of where they should fit in the cycle.  They have traded as if they were stocks.  The slaughter was more dramatic because they had a last-minute run up when the stock market was going down.  As for oil, for the majority of the cycle, demand was always slightly ahead of supply, driving the price up.  Once the recession hits and supply drops, you fill up the extra tankers, and that extra little supply is enough knocks the price out.

John Embry: Gold. [But] as long as people are abandoning the sector and taking money out of these funds, then there’s a lot of irrational selling. The fund manager has no choice but to sell. This is creating a phenomenon where prices don’t make much sense. The larger cap stocks are the ones being bid up; they trade because generalists buy them. There’s a far bigger pool of capital prepared to buy them. That’s why you’ve got this remarkable discrepancy in valuation between the little guys and the big guys.

You can’t get into production because it’s hard to attract capital and the capital costs have risen so much, but an existing mine with a good orebody is fine. This credit problem will significantly impact gold production over the next three or four years. There’s a bunch of mines coming off the table as they get depleted and the high-grade ores run out. Without new mines, production is going to fall regardless of the gold price. The supply-demand gap, which is already yawning, is growing wider and wider. Central banks will do what they can to fill the gap but if they can’t, the price is going to explode.

The downturn in both gold and silver was literally preposterous in magnitude relative to the rise in the dollar. This was a violent intervention by the paper players. Three U.S. banks on COMEX shorted something like 8,000 contracts in a very short time. That’s more ounces than all the world’s miners produce in a month.

———————————————————————————————————————–

*Not real questions, but the responses are taken from interviews given in various TV and newspaper, thus very real.

Thank you to Penny Daily for including us in its Carnival of Investing Strategies #5.

What makes a successful long-term investor? Is it an exceptional understanding of the market? Is it a Blackberry full of Wall Street contacts that tip you on every insiders’ move? Is it a PhD in quantum-physics or mathematics?

No. Because if that was the case, then most investment funds with their well-paid, well-educated, and well-connected managers would not be walking around with their portfolios 50% lighter.

So what is it about the market that suckers in so many people? How is it that some investors are ruthlessly spit out, and others remain relatively unscathed in the long-run?

Knowledge.

But not just business knowledge. What has been taught in business school and other rudimentary business classes do little to improve one’s chances when it comes to investing. Why? Because the knowledge presented in those accounting and finance classes only give you a myopic look at the whole picture.

For example, say you are an accounting maven but know nothing of what’s going on in the mortgage market in 2006. You look at the balance sheet of banks, match up the debit and credit sides, check off the triple-A rated loans, and marvel at how the bank has managed to grow so quickly in the last few years. But any economists looking at the picture would be alarmed at the rate of growth, probe deeper into the loan ratings, gasp at the poor judgment exercised on part of the bankers, and issue a warning. Someone who is schooled in politics would take a hard look at the political contributions made to head of committees that signed off on the predatory lending policies and yell foul! And any Tom, Dick, and Harry, who’s been canvassed by sketchy pseudo-lending institutions would tell you that if it walks like a scam, and quacks like a scam, it is a scam.

So there, it only takes someone who is in touch with reality to smell the foul. If confined to an academic or industry-conformed bubble, it will take someone who is willing to see the whole picture and dare to ask questions to reach the same, sane conclusion.

Here’s another more direct investing example, taken real-time off the happenings of the current market bloodbath.

When the market started going off the deep end beginning of the year, many respectable economists and analysts called for a sharp decline in the US dollar.

Not that the dollar didn’t deserve it. The stock market was abysmal, debts were piling up, inflation was fuelled by the astronomical rise in crude prices, and the gold bugs went nuts.

But the dollar didn’t fall, at least, not in 2008. Contrary to what many expected, the greenback went from strength to strength against the pound, the euro, the Aussie and Canadian dollars. How could they have been wrong? Their analysis made so much sense.

Myopia was to blame, again. Two things worth noting, both should drive you to pick up the paper and read the World section and brush on financial history.

First of all, many experts failed to survey the whole picture while predicting the greenback doom. Instead of examining the economic health of other currencies relative to the US, they either ignored or failed to consider the effect of a US belly flop. It turned out that part of the Eurozone had just as much of a real-estate fuelled credit bubble as the US. Many had even more dire loans made out to emerging markets that were unlikely to be recovered in the near future. Ouch!

Remember the fuzz raised when upscale retailers in the New York area accepted euros in fear that the dollar would become worthless, and everyone rushed out to open their euro accounts? Nowadays, the very survival of this currency is debated. The market is fast, furious, and seems to retain no medium to long-term memories. Who else but you can add all these episodes to your experience notebook and defend your money against market schizophrenia?

Secondly, nobody seemed to remember the experience of LTCM. I watched a PBS documentary on the failure of LTCM in first year statistics class, and later went on to read “When Genius Failed”. On a curious note, this book was on the curriculum for the CFA Level III exams back in the days.  Not sure what the case is now, but considering most buy-side investment advisory would require their analysts to hold such designation, did nobody remember the lessons from mass de-leveraging?

It turned out that in September and October, when panicking investors started withdrawing their capital en-masse form the market, many investment funds were forced to liquidate their holdings regardless of performance. This exodus of cash resulted in two things. One, an enormous demand for the US dollars rose as people liquidated out of their holding currency to settle accounts. Two, mass withdraw resulted in a capital exodus (i.e. forced liquidation) from the well-performing commodities group. This, combined with a reduction in demand for certain raw materials, contributed to the weaknesses in the currencies of commodity producing countries, namely, Russia, Canada, and Australia. The weakening of many previously perky economies, whether its due to a fundamentally weak economy and credit system, or the reduction in commodity revenues, further drove jittery investors to the relative “safety” of the dollar.

I didn’t see this coming, of course. But unfortunately, nor did many of the economists or analysts whose job it was to pay attention to these events and extrapolate these scenarios. A truly brilliant analyst, like a good historian, should be a good storyteller. They should be able to navigate through the muddy terrain that is the ecosystem of the market, and find a stable tree to build their theory from. From this tree, they should be able to split off the branches, testing assumptions and viability of their stories. They should anticipate thunderstorms, tornadoes, snow in July and the odd Indian summers. They should consider the vast ecosystem of where the tree is planted, consider the various interactions the tree would have with the other inhabitants in the woods.

Because staring at that one branch and self-congratulating on the infallibility of one possible scenario will in no way help you see the bigger picture. It’s only by recognizing the existence of the bigger picture, and acknowledging and anticipating the inter-connectedness of the wider business ecosystem, that any of the business education can be put into use.

picture source: boojamon