Market analysis is far from a sure thing
As any regular reader of this blog knows, when it comes to trying to forecast what stocks might do, I use charts and technical analysis to help. But in spite of the fact that I rely on technical analysis, I know it has many shortcomings.
As defined by 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. 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.”
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.
One area of technical analysis in which I have no faith 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.” These refer to specific types of chart patterns. In my opinion, forecasting market action based on chart patterns is not reliable. Certainly one can find recurring patterns. One can also find recurring cloud formations. But seeing the same fluffy bunny formation three days in a row is not necessarily predictive of anything.
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, are to identify trends. Isaac Newton’s first law of motion states that “An object in motion will stay in motion and an object at rest will stay at rest unless acted upon by an external force.”
While an investment is not generally considered an object, the price of an investment moves from day to day and that movement can be illustrated on a chart. This law of motion appears to hold true for investments just as it does for physical objects. A trending investment will continue to trend until some circumstance or event changes the direction of that price trend.
In my opinion, long-term trends might be the best indicator available for forecasting market movement. While many traders focus on 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 can be 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.
Unfortunately at present, these tools are not providing a definitive picture of the market trend. As an example, look at the chart below of the New York Stock Exchange composite (NYSE) over the past three years.
I have added two moving averages (MA) to this chart. The blue line is a 200-day MA and the gold line is a 100-day MA. I use the 200-day MA quite a bit. It seems to be fairly reliable at identifying major market trend changes. Because it is using a shorter term, the 100-day MA is more subject to whipsaws when used as a trading tool.
As the chart shows, the NYSE crossed above its 200-day MA in June 2009. Normally that would be an indication that it might be time to begin investing back into the market. But given the serious nature of the prior downturn and the possibility that the move was a bear market rally, continued caution seemed warranted. Combined with negative economic fundamentals, that was enough to keep us out of the market at that time.
We started easing back into the market in the fall of 2009, but since then stocks have generally traded sideways until the past few weeks when a downward move gained momentum.
Today the NYSE remains above its 200-day moving average, but below the 100-day MA. In addition, the economy continues to give mixed fundamental signals. In this situation, all we can really do is remain patient and wait for more technical confirmation about which direction the market will go next.
Because although I understand that technical analysis is far from perfect, two decades of market experience has taught me that I am not smarter that the tools I rely on. So even though it is frustrating to remain on the sidelines for now it is still the safest to keep the bulk of your assets in a money market fund.
F.S.