Last summer I was having dinner with an old friend that I hadn’t spoken to in some time. I moved to the northeast at age 18 and he stayed down in Miami. Although we grew up playing baseball together, it’s impossible to keep up with everyone. So it was really nice catching up after all these years. As it turns out, he currently works at fund that doesn’t incorporate any technical analysis into their decision making. His exact words were, “we try to ignore price action as much as we can”.
I almost spit my food out when he said that. But he couldn’t have been more serious.
Over the weekend I was reading an article in Forbes that reminded me of that dinner. It was written by Michael Kahn in April of 2010. As usual, Kahn does a nice job clearing up misconceptions and detailing some of the advantages of technical analysis. Here are a few of my favorite bullet points:
- Technical analysis is a bit of a misnomer since it is really not that technical. A better name for the use of charts to make investment decisions might be risk/reward analysis or even market psychology. Sure, there are some complex mathematical concepts involved with some of its more esoteric indicators. But at its core, technical analysis is simply a method of determining if a stock or the market as a whole is worth buying or selling. Once we identify this we are way ahead of the game with regard to assembling a winning portfolio.
- Simply stated, technical analysis is the study of data generated from the market and from the actions of people in the market. Such data includes price levels that have served as turning points in the past, the amounts of stock being bought and sold each day (volume), and the rate of change of price movements (momentum) over a given span of time.
- Technical analysis also attempts to measure the collective investor psyche, calling heavily on the psychology of crowds and the cycle of greed and fear. If everyone thinks one way, the odds that the market thinks the other are usually high. Was investor sentiment ever as negative as it was in March 2009 when the market put in a very important bottom?
- Contrast that to the more ephemeral fundamental analysis, the standard analytical backbone of Wall Street for several generations. Fundamental analysis, which seeks to uncover the intrinsic or true value of a stock, is dependent on future sales, earnings and cost estimates of a company being studied. Often, these numbers change as circumstances, such as the status of the overall economy or the competitive landscape for a company, change.
- By contrast, the inputs of technical analysis–the price of shares and the volume being sold–never change after the fact. Charts are never revised later. Critics will point out that forecasting future price movement based on past price movement is akin to reading tea leaves or divining the future from the textures of chicken entrails. Many of the high priests of fundamental analysis are quick to call technical analysis the financial world’s alchemy. Indeed, chart watchers cannot predict the future any better than your broker, your spouse or a Ouija board. But what they can do better than most is make a decision about what to do–buy, sell or hold–based on the probabilities of the actions of others given certain conditions. In other words, if a pattern on the chart appears, a chart watcher can create a framework for what the market might do if and when prices break free from that pattern. It does not work every time, but past performance does give us an idea of what will happen so we can do something about it.
- Something chart watchers keep pasted to their computer screens is a sticky note that says. “All big losses begin as small losses.” When the initial reason for buying is gone, we do not hang around hoping the stock will go back up. Hope is a four-letter word in the world of investing.
All of this is great. But I think the most important aspect about what we do is the Risk Management. This, to me, is the most under-appreciated piece of the puzzle. We’re not trying to make outrageous predictions about the future. We’re looking at price and market behavior to manage risk. That’s it. I don’t know how it would be possible to do that without looking at price.