What is Technical Analysis, and Why You (May) Need to Know It

analyze this 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.

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picture source: ~sarcasticmalfunction

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  • http://www.trendsImwatching.com Myke

    Excellent post.

    Too many people don’t realize that Bold and Hold has no exit strategy and how important an exit strategy is. Of course, there are powerful interests that benefit from that blind spot.

    Using fundamental analysis to decide what to buy and technical analysis to decide when to buy and sell makes sense to me.

  • http://www.trendsImwatching.com Myke

    Excellent post.

    Too many people don’t realize that Bold and Hold has no exit strategy and how important an exit strategy is. Of course, there are powerful interests that benefit from that blind spot.

    Using fundamental analysis to decide what to buy and technical analysis to decide when to buy and sell makes sense to me.

  • http://investoralist.com Dana

    Myke, I could not have put it any better. One needs to be aware of the what, and why certain tools are used in order to deploy them effectively. Thank you for the succinct point.

  • http://investoralist.com Dana

    Myke, I could not have put it any better. One needs to be aware of the what, and why certain tools are used in order to deploy them effectively. Thank you for the succinct point.