Understand the Value of Technical Analysis

"Ninety percent of science fiction is crap, but then ninety percent of everything is crap."   
-Theodore Sturgeon

 

Yesterday morning, Portfolio's Felix Salmon had a post "Adventures in Technical Analysis, Jim Cramer Edition."

I cannot put aside the fact that Cramer is not, and has never been, any sort of technician. We do not dismiss medicine because accountants cannot do open heart surgery, so it seems odd to use a bad call of Cramer's -- a self-admitted non-technician -- as proof that technicals are worthless. 

But what really caught my attention was what amounts to the standard critique of Technical Analysis:

They all do it: even much smarter and much more analytical traders like Barry Ritholtz do it too. Do what? Resort to "technical analysis", which is the art of drawing lines on charts and extrapolating from them what the market is going to do next.

Whenever you hear words like "overbought" or "oversold" or "momentum" or "support" or "resistance", it means that whatever you're hearing is garbage. But it also means that the person you're listening to has no idea what's about to happen, and is therefore resorting to the financial equivalent of astrology. In such cases, it's worth ignoring the message completely, but it's also worth having some serious thoughts about the messenger, too.

 

There are so many ways to analyze this, its hard figuring out where to start. Let's begin with a definition of what technical analysis is not.

Technicals are not magic. They are not a way to forecast the future, nor are they a guarantee of future profits. They are not based on someone's estimate of what future earnings might be, nor do they require you to guesstimate management's skill set or presume the desirability of a new product. Pure Technicians don't listen to conference calls or even talk to management.

Technicals can be, however, far less squishy than fundamentals. Technicians use the data that is generated by the markets itself: Price and volume to start, then many other data points and derivatives thereto.

From this basic data, there are many variations of Technical Analysis:

• Trend followers believe markets exhibit persistence, mostly due to big institutional purchasers. This leads to buying uptrends and selling or shorting downtrends. John Henry and Richard Dennis are classic examples of trend followers.

• Quants use a variety of mathematical data points. A goods example is the fund Renaissance Technologies.

• Contrarians use Sentiment data to determine when markets have moved too far in one direction or another. The goal is to anticipate a major reversal. See Jason Goepfert as a prime example.

• Pattern recognition traders look for various pictures -- pennants, flags, cup & handles, head & shoulders, etc.  I find that this last form of TA (Pattern Recognition) is especially prone to Sturgeon's law (above).

There are lots of other types of technicals, but this isn't meant to be an exhaustive survey.

The question as to whether technicals "work" or not is actually framing the wrong issue. There is as much art as science in the application of TA. That some people are lousy technicians proves only that it requires skill. A better discussion to ask is "What information do charts and related data provide, and how can this be used by investors and traders?"

I posit that charts and data provide tremendous insight, if used appropriately: 

Provides a statistical approach to investing, one that describes the probabilities of various outcomes (versus making predictions);

Charts show you if we are in a bull or bear market, allowing you to manage risk appropriately;

Trends can keep you away from the wrong sectors (Housing, Autos, and Finance are obvious examples) or keep you in the right sectors (eg., Energy and Ag)

Developing good risk/reward analyses;

Tracking what the institutions are doing;

Identifying specific stocks that might be appealing;

The bottom line is that TA is merely a tool, albeit one used more skillfully by some than others.

Finally, consider this question: If you could look at one and only one source before buying your next stock or fund, which would you choose: a fundamental analyst's report (with no charts in it), or any chart of your choosing? While I like having access to both, I cannot ever imagine buying something without first looking at the chart ...

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Note: We previously addressed these issues a few years ago in Tracking the Elephants (Part I and Part II).

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