In the investment world - and I use that term to distinguish from the trading world - we are quite familiar with the concept of fundamental analysis. This, of course, is the methodical picking over of a company's financial statements and business prospects to arrive at an estimation of fair value and to compare that value to the current market price. Fundamental analysis is the reliable meat and potatoes of the fund management business. Less frequently spotted in this world is a somewhat more exotic life form - the technical analyst or "chartist". In this post, I will use the term technical analysis and chartism interchangeably, as is the custom. Traditionally, chartism has been viewed with some skepticism (if not outright contempt) by a significant segment of the professional financial community. Nevertheless - and notwithstanding the fact that technical analysis as a rule is much more applicable to the short-term give and take of the trading world than to the formation of long-term investment strategies - it can be useful to know a little bit about what the chartists actually do and how they think.
The Essence of Chartism
The basic difference between fundamental and technical analysis is that the latter is concerned solely with the price and volume movements of a company's stock. That is to say, a chartist is not in the least bit concerned with whether he or she is dealing in the shares of Apple, or General Electric or Toyota, nor with anything about those companies' products, sales trends, after-tax net cash flows or number of satisfied customers. All the technical analyst cares about is what's on the chart - the stock's daily open, high, low, close, and the volume of shares traded. The technical analyst believes that any fundamental information about the company is fully reflected in the stock price and does not need to be subjected to any further analysis. What this analyst believes is worthy of analysis, though, is what a series of daily (or hourly or even per-minute) price points says about future direction. The chartist believes in trends - i.e. that once a trend has been confirmed, that prices will be more likely to continue in this trend than to reverse. But eventually, any trend will reverse, right? Yes, and the way the technical analyst takes action on this is to look for patterns. These patterns can go by some rather colorful names, like "head-and-shoulders" or "saucer-and-handle". Technical analysts have perhaps deliberately cultivated an image of being a rather mystical, Zen-like breed. And they are meant to inform traders as to when a particular trend is likely to reverse, when it is more probable to confirm, or when a directionless market is likely to break out one way or the other.
Case in Point: Support Lines and the S&P 500 in 2011
Why does any of this matter to goals-oriented, long-term investors? Probably the most important reason comes back to the psychology of investment markets. Our long-term assets are out there in the mix of the day-to-day trading roller coaster and it helps to understand the psychology of this environment. Momentum trends happen, in part, because investors believe they happen, and they put their money where their beliefs are. Consider the support line - one of the staple tools in the technical analyst's arsenal. In August 2011, the S&P 500 managed four times to graze the level of 1,120 without closing below it, while on one day, the intraday index fell below the 1,120 level, but closed substantially higher. Thus 1,120 became a technical support level for the S&P 500 - traders believed the market was more likely to resist falling any further, barring any new developments. That support level carried through September and into October - several times the index would approach 1,120 and then back off to close above it. On October 3rd, the index plunged below the support level to close at 1,099. Traders using chartist tactics could have seen this as the beginning of a new phase of the market meltdown and gone into short positions. But others, holding off for a day to see whether this really was a new trend, were the ones who profited. On October 4th, the S&P 500 fell to an intraday low of 1,074, but then jumped to close at 1,125. The support level had been maintained and, in fact, the October 3rd close was the low point of the 2011 market correction.
Does It Really Mean Anything?
Is there any real meaning to the support line, other than as something that is easy to show in hindsight, but much more ambiguous in real-time conditions? Maybe there is, maybe there is not. But even disciplined long-term investors can benefit from knowing what is going on in the market at any given time. The fact is that during the August-October correction, traders and market chatterboxeswere invoking the 1,120 support level and that made it at least somewhat meaningful. It is not necessary to agree with the professed eternal truths of any given investment philosophy to acknowledge that they can influence market behavior, and therefore that they are worth at least knowing something about.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.