Technical analysis is useful, but it also has many flaws
Long time readers know that when it comes to trying to forecast what stocks are likely to do, I use charts and technical analysis to help. But in spite of the fact that I rely on technical analysis, I am also aware that it has many shortcomings. Today I am going to tell you some of the weaknesses of technical analysis that I have observed through years of study and practice.
Let’s start with a definition of technical analysis from Wikipedia: “Technical analysis is the study of past financial market data, primarily through the use of charts, to forecast price trends and make investment decisions.[1] In its purest form, technical analysis considers only the actual price behavior of the market or instrument, based on the premise that price reflects all relevant factors before an investor becomes aware of them through other channels.”
In other words, technical analysts attempt to forecast future market activity by studying what has occurred in the past. Technical analysts use a wide range of tools and philosophies. These include everything from moving averages to candlestick charting. Some proponents rely on a single tool or methodology while others combine a number of tools to make investment decisions. That brings us to one of the major weaknesses, which is actually not a weakness of technical analysis but of technical analysts.
Many believe too strongly in the infallibility of their tools or systems. There is no tool or system that can accurately forecast every market top or bottom and there never has been. Over the past 20 years I’ll guess that I have met or talked to at least a couple of dozen technical analysts who are convinced that they have found the Holy Grail tool or system that is essentially perfect at predicting market turning points. The common factor is that they all eventually fail. In most cases these analysts have mistaken luck for perfection. It’s kind of like the guy who flips a coin that comes up heads 20 times in a row. After 10 times he is convinced that he can control the flip of the coin and after the next 10, he is believes he is the most skilled coin flipper of all time and is willing to wager ever increasing amounts on each flip. So what are the odds that the coin will come up heads on his 21st flip? Fifty percent. Just like the odds on every one of the previous attempts. While his run of luck is unusual, it has nothing to do with his ability nor does it matter what he believes.
One reason that these analysts all eventually fail is that no system can account for all of the variables that impact the financial markets. For example, no technical tool foresaw the 9-11 attacks and their impact on the financial markets. On that day every foolproof system got fooled. Such unpredictable events are called “black swans.” This refers to the fact that when a when swan is hatched, we expect that it will be white and in almost every instance it is. But on rare occasions a black swan is born, taking everyone by surprise.
Events the magnitude of 9-11 are rare, but smaller unpredictable events happen with regularity. They can range from unexpected comments from a Federal Reserve chairman to a currency meltdown in Indonesia.
The opposite weakness is technical analysts who develop a good trading system or rules and then don’t stick with them or constantly second guess their own systems. I can specifically recall an investment manager several years ago who had developed a reliable technically based trading system. Yet in spite of an impressive back-tested track record and of real trades in his own account, once he started to manage other people’s money he kept second-guessing and overriding the signals. Invariably his decisions proved wrong. At one point he even started seeing a psychiatrist to try and help him figure out why he couldn’t adhere to his own methodology. He never could resolve the problem and he eventually failed as a money manager.
Another manager had few very simple, but solid rules. These included things like: never by a stock that isn’t in an uptrend. Or, don’t buy a fund unless it is trending above its 50-day moving average. As simple as these rules were, he could not make himself stick to them. Anytime an investment moved sharply upward for a few days, he worried about missing the move and would jump in even if it were in a long-term downtrend. He also often sold funds in long-term uptrends if they had a few days of correction.
The area of technical analysis that I find most amusing is the attempt to forecast the movements of investment vehicles based on chart patterns. There are many books devoted to the study of chart patterns. Most investors have heard phrases like “double bottom” or “head and shoulders.” I believe that studying chart patterns is about as reliable as looking for images in the clouds. Seeing the same fluffy bunny formation three days in a row is not necessarily predictive.
When it comes to charts, I do believe there is some value in identifying areas of support and resistance. Because so many investors and traders watch these levels, I think they often become self-fulfilling.
The main value of charts and the main value of technical analysis, in my opinion, is to identify trends. Remember that law of physics that says “an object in motion tends to stay in motion”? While an investment is not generally considered an object, I think this rule holds true. The best indicator available for forecasting market movement is long-term trends. I don’t worry much about short-term trends. I like trends that have been in place for at least six months to a year. Longer is better.
Most of the technical tools I rely on–moving averages, MACDs, RSIs, momentum, stochastics, etc.–are all helping me to try to answer a single question: Is the trend intact? As long as a long-term trend has not been violated, I can hold through some corrective action without much worry. When a long-term trend breaks down, it is usually a signal that the underlying instrument is going to be in serious trouble for some time.
In addition to technical tools, I also consider cyclical tools and fundamental analysis when making investment decisions. Once again, these elements primarily help me determine whether or not a trend is likely to remain in place.
In spite of many years experience and reliance on some pretty good and sophisticated tools, I’ll be the first to admit that I have no ability to predict what the markets will do. I’ve made my share of investing blunders through the years. On one of my very first forays into investing I bought the Japanese market when the Nikkei peaked at 42,000. Unwilling to admit my blunder, I held on to the position until it dropped to about 17,000.
I’ve learned a lot since then. I still make mistakes–just like every other manager or investor I know. But I’ve learned to be more conservative and to accept my losses when I am wrong.
Right now most of the technical tools are giving a mixed picture of the market’s health and direction. But the economic fundamentals remain strong and the long-term trend still seems to be up, so holding on appears to be the smart decision. Let’s hope we don’t run into any black swans in the next few days.
F.S.
If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group. This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call Flint Stephens, Mark Sumsion or Scott Garbutt at 800-279-3377.
You requested this Dental Dollars free e-newsletter. Please add support@dentaldollars.net to your e-mail address book to ensure prompt delivery.