History of Technical Analysis
One reason I decided to start this blog in the first place was to clear up a lot of the misconceptions about technical analysis and behavioral finance. Before getting into more detail, I think it is important to define what technical analysis even is and explain what some of the differences are between technical and fundamental analysis in the market. Throughout this platform I use the word “Market” interchangeably to describe all liquid capital markets including the Stock Market, Interest Rates, Commodities and Currency Markets. The principles discussed here can be seen across each of these asset classes on both short-term and longer-term time horizons.
In 1948 Robert D. Edwards and John Magee wrote what today is considered “The Bible of Technical Analysis”. Technical Analysis of Stock Trends is the most influential book written about the process of interpreting the predictable nature of markets and the investing community. In this book, Edwards and Magee defined Technical Analysis as, “The Study of the Action of the Market Itself, as Opposed To the Study of the Goods in which the market deals”. A lot of what Edwards and Magee wrote about in 1948 derived from the writings of Charles Dow over 60 years prior to their publishing.
Charles Henry Dow, who is widely considered to be the Father of Technical Analysis was the co-founder of Dow Jones & Company along with a gentleman by the name of Edward Jones. Although he was born and raised in Connecticut, Charlie got a job as a newspaper reporter in Springfield, MA when he was 21 years old. He wanted to write about companies so he would visit them to ask questions. Since there was no Securities & Exchange Commission at the time (the SEC was created in the 1930s), companies were not forced into answering the questions. “My business is none of your business”, they would tell him. But Charlie was aware enough to see big money moving in and out of stocks.
Charlie realized that the majority of the securities of established companies tended to go up or down in price all together. Stocks that went in the direction against the financial tide were few and far between. It was rare for a stock to move counter-trend to the overall market for more than a few days. If markets were going up, a large majority of the securities would rise, and if markets were falling, stocks would generally fall together. Although there were some instances where some stocks would rise faster than others in good times, and some would fall more rapidly than others during bad times, the point was that the direction of these trends coincided with the direction of the entire group. This was the case then and still is the case today.
Charlie recognized that there were two groups of companies that ran the economy. You had the companies that made the products, the producers, and you had the companies that hauled those products, the railroads (Remember this was just after the civil war, so it was just the railroads that moved products. Today we have other methods of delivery). In the 1880s, Charlie decided to create two averages: The Dow Jones Industrial Average and the Dow Jones Railroad Average. The original Industrial Average included just 12 issues, which was later increased to 20 in 1916 and eventually to 30 in 1928 (although the components have changed since then, the number of issues has remained the same). The other was the Railroad Average, which consisted of 20 Railroad companies and were some of the most dominant companies of their day.
Here is a photo of the first edition of the Wall Street Journal in 1889 where Charles Dow started recording prices changes in a column titled “Average Movements of Prices”:
Since the mid- to late-90s, technical analysis has gone from hand drawn charts to more sophisticated computer based charting software. I’m lucky to start my career after computers had already taken the role of plotting price and price derivatives like momentum oscillators and smoothing mechanisms. But prior to computers, these charts were created by hand with price data that was calculated daily.
Here are legendary Technician Ralph Acampora’s hand drawn charts from the 1970s that I found one day visiting some friends at the old Market Technicians Association headquarters on Broadway in New York City:
Technicians are often associated with charts or chart analysis. But it’s not so much that the charts tell you what to buy and sell, it’s just that technical analysis studies the changes in equilibrium between supply and demand. So it just so happens that the best way to visualize these changes in equilibrium is in chart form. This is why you’ll see many charts throughout this research platform.
Some of the smartest people in the past few hundred years have attempted to master the market and have failed miserably. The profits that one can achieve from successful market participation are enormous. So it should not be surprised that world renowned analysts and even Nobel Prize Winners have tried and failed at market speculation. Granted, there have been many success stories along the way, but they are the exception not the rule. They put in their 10,000 hours, as Malcolm Gladwell so eloquently put it in his book Outliers.
To really get a good understanding of the principles behind technical analysis, I think it’s important to be clear about the philosophy and psychology behind the supply and demand dynamics that make technical analysis possible in the first place.
Markets Trend
An important concept that needs recognition is that markets trend. There is a much higher likelihood for a market trend to continue than there is for it to reverse course. If a market is trending higher, there is a much much greater chance that it continues to rise, than for it to start a new downtrend. Same thing in a downtrend. If prices are falling, there is a higher chance that they keep falling, or keep underperforming, than for it to reverse and start a new bull trend.
Throughout this research platform we’ll use various tools that we have at our disposal to help us recognize that a trend may be changing. These range from momentum tools, to sentiment, to simple pattern recognition. But changes in trend are often a process. Remember that prices are driven by large institutional fund managers that move billions and billions of dollars each day. Changes in trend are therefore more of a process, not an event. Think of it like a cruise ship. These massive vessels can’t just reverse course at the press of a button. It takes time and there are certain characteristics that can be recognized as the turning is taking place. The market behaves in a similar fashion.
These changes in trends are reflections in the changes in supply and demand dynamics, which is driven by human nature. The terms Fear and Greed are two extremes in human psychology that help drive these changes in equilibrium between supply and demand. Regardless of whether these are humans entering buy and sell orders, or algorithms built by humans to buy and sell, these actions still reflect the fear and greed mentality that is inside the human brain. Therefore, for hundreds of years this behavior can be visualized through patterns in price charts that are repeated over and over again. Markets might change over the years in terms of how we execute, or perhaps the economic or political environment during different years, but at the end of the day, humans are still the same and human emotions are what drives price. This is why the behavior of the market does not change. This is also why patterns in price we see today can be identified in price charts 100 years ago. I’m willing to bet these same patterns will be seen in price charts 100 years from now.
Technical Analysis vs Fundamental Analysis
Technical Analysis focuses on the behavior of the market. We try to answer the questions “What?”, “When?” and “For How Long?”. Fundamental Analysis, on the other hand, concentrates on the reasons that drive the changes in Supply and Demand, trying to answer the question, “Why?”, if you will. The fundamentalist looks at forces that theoretically drive supply and demand such as company and economic factors.
Both of these forms of analysis try to answer the same question: In which direction is the market heading, higher or lower?. The fundamentalist takes all known information and calculates what he/she considers to be fair value for a security. If prices are below that “fair value”, then the security should be bought. If prices are above that “fair value”, then the security should then be sold.
The problem I have with this approach is that the data that it uses to calculate this “fair value” for a security is removed from the market dynamics themselves: the supply and demand the drives the direction of price. The analyst, therefore, has to assume that there is a direct causality between these outside data points and the movements of the market itself. This assumption is an inherent flaw in this form an analysis. The fundamental analyst first has to come up with a forecast for certain events and outcomes to these events, which is an estimate in itself. Then, the fundamental analyst has to come up with a conclusion as to how the market will react to these “forecasted events”. There are multiple steps involved here that are based off an assumption that is clearly false: that specific outside events directly impact the movement of securities. We know that it is supply and demand that drives price. So the number of assumptions taking place in this multi-step process, in my opinion, is a recipe for disaster. Technicians, therefore are at a huge advantage in that there is just one step involved.
These fundamental factors mentioned above, without questions, play a part in the supply and demand dynamics for a given security. Another inherent problem with this, however, is that there are many other factors involved that determine whether there will be more supply than demand or vice versa. The fundamental analyst must then assume that he or she is factoring only the correct data points in the fair value equation. The problem is that the price of a given market reflects the opinions of all of these analysts but also weighs in the moods of market participants, the fear and greed if you will. As much fundamental homework that is done to determine a potential fair value, it is mathematically impossible to quantify the additional factors that determine where buyers and sellers will agree on for a security to exchange hands at an agreed upon price.
As technicians, we approach the market knowing, with complete justification, that all known information, including what the fundamental analysts are opining on, is the reason that price is where it is. The market is forward-looking by nature. It is factoring in outcomes for events that have not yet taken place. The market is a smart discounting mechanism and this is why technicians focus on the behavior of the market itself, rather than the forces that may or may not impact it. As a market participant, would you prefer to focus on the cause or the effect? The fundamentalist spends time trying to find the cause, while the technician has the facts and looks for the most probable effect. Technicians do not believe that knowing the cause is necessary for determining the effect.
To put it another way, if price factors in all known information, including everything that fundamental analysts focus on, then by definition, technicians who study price are also factoring in the fundamentals of a given security. If you had to choose one method of analysis, which would it be? Would you be a technician who studies price, or would you go the fundamental route and focus on the causes of movements, blatantly ignoring the only detail that actually pays: price. Remember, fundamental analysis does not take price behavior into account.
The concept of paying one-hundred-and-something times earnings for any company for me is just anathema. Having said that, at the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?” – Paul Tudor Jones
The Benefits of Technical Analysis
One of the biggest advantages of technical analysis is the ability to apply its principles and philosophy to markets of all kinds. Whether a participant is trading stocks, ETFs, Futures, etc, the supply and demand dynamics remain exactly the same. In addition, technicians can focus on all sectors and different types of stocks in a given market. With the amount of data that would need to be digested to make fundamental conclusions in a given security, it is impossible for the fundamental analyst to be an expert on all things. Therefore fundamental analysts tend to specialize on a given sector or part of a market. The technician is open to anything and everything that is liquid.
This is where opportunity costs comes into play. If there is a given sector or group of stocks where there is a lack of trend, say Emerging Markets throughout 2011-2014, a fundamental analyst focused on that space is missing out on opportunities elsewhere. As a technician who follows price, these range bound markets lacking a direction in trend are a place to shy away from. During different times of the economic cycle, certain groups of stocks tend to do better than others. There is always a group of stocks where momentum is driving them higher while another group is simultaneously dormant. The ability for a technician to focus his or her attention only on the most actionable markets is a tremendous advantage. The technician is free to pick and choose what countries to be in, what asset classes to be trading, and more specifically how to take advantage of them: through equities, futures, ETFs or even options for hedging and/or leverage purposes.
Timing-wise, the technician can apply their principles to all time frames. The market is what we call, “Fractal”. Whether we are looking at a chart using weekly timeframes, or a daily chart, or even intraday patterns, the supply and demand dynamics remain the same. As a result, the technician can also apply multiple timeframes to the analysis. The top/down approach looks at a larger time frame, say weekly bar charts, to get a more structural perspective, and then the technician can work down to say a daily bar chart for more tactical execution strategies. There is a common misconception out there that Fundamental Analysis is for the long-term while Technical Analysis is for the short-term. This is a blatant lie. The truth is, the larger the time horizon, the more reliable our technical techniques tend to be. The shorter the time horizon, the more whipsaws, or ‘failed moves’, we’ll see.
Price leads market fundamentals. The reason is that as a leading indicator and forward-looking mechanism, the market not only prices in all known information, but also factors in unknown fundamentals that have yet to be seen. Some of the most dramatic bull and bear market throughout history began well before any serious changes in fundamentals could be seen. A fundamental thesis may take months or years to play out. As market participants, we do not have the time to let things, “play out”, particularly with the leveraged nature of the futures and forex markets. A 20% drawdown in a position in these markets, while a participants wait for fundamentals to price themselves in, is likely to wipe out the entire account balance for that person before a given thesis plays out fully.
I have found a tremendous amount of value in focusing on Technical Analysis and avoiding the fundamentals completely. I almost feel like the less about the company, the better. I’m human too you know. I have emotions as well. So the more I can avoid anything that makes me biased towards something, the better off I’ll be. This method may not be right for everyone. But I think we can all agree that Technical Analysis is the most valuable tool we have as market participants.
Technical Analysis is the most valuable way to look at the market……If what we are principally concerned with is price, then why wouldn’t we start and end with the study of price – Josh Brown @reformedbroker