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Market Intelligence

What I Think Of Technical Analysis

Seaver Wang | May 4, 2011

Some people speak about it with disdain. Others swear by it. So, does technical analysis work? In the traditional sense; I doubt it.

Technical analysis is a forecasting method that looks at historical prices and trading volume. The theory is that humans tend to repeat trading patterns and so an investor can anticipate the next price movement.

So why do I doubt its effectiveness? Name a famous technician who has made a fortune using this methodology. I discovered one in a Jack Schwager “Market Wizards” book, but I’d never heard of him before and I haven’t heard about him since. I don’t know of a technical analyst on the Forbes 400 (richest 400 people in America), but Warren Buffet, and a slew of hedge fund and mutual fund managers who employ fundamental analysis are on it. I don’t know of any renown technical pundits either.

In my opinion, there is some validity to technical analysis but it is completely unreliable as a primary method to invest. I do believe that patterns occur over and over, but I still believe that the patterns occur due more to fundamental reasons, and not because of behavior. For instance, a company announces that its earnings are much higher than originally expected, and the stock rises. Without that bit of information, unless leaked by someone illegally, the movement could not have been predicted, because what if earnings were poor. In fact, any previous price movement would have been completely random. One could argue that the “smart money” would already know that results were good and start buying which would show on a chart, but good traders know how to not move a stock.

So what did I mean that I doubted technical analysis in its traditional sense? Well, if you are referring to looking at the shape of a stock’s price movement on a chart or a single spike in volume over a short period of time; NO, I don’t think you can figure out what will come next. But there are successful ways of using similar methods using price movement and trading volume to anticipate future patterns using computers. These practitioners are called Quants, or Quantitative analysts that also look at price movement and trading volume, but they use computers to make several lightening fast trades to take advantage of short-term momentum, which a regular person could not execute. In this category, there are many successful investors, however, most of these practitioners also incorporate fundamental factors. That said, I do have an acquaintance who programs computers to mostly just look at money flow and trading volume and he seems to be quite successful.  D.E Shaw is a hedge fund that is a highly successful quantitative shop, although I doubt they would only use price and volume and patterns to manage money.

At the end of the day, I am a fundamental analyst. I care about sales, supply, demand, profitability, and even management’s competence, but I do look at a stock’s technicals. Why? because it tells me about how people are reacting to news or investor’s sentiments about the stock.

Example: I once discovered a company with a great brand name and almost as much cash in the bank compared to its market value. It was cash flow positive but needed a new product to grow the business. The stock had flat lined and when it announced another unimpressive quarterly report, the stock barely went down. This signaled to me that most people were very pessimistic about the company limiting its downside. The stock had essentially formed a base that it would be unlikely to go below barring a complete disaster. Soon, this stock began to appreciate when it hired a new CEO and came out with new products. It returned over 30x (thats 3,000%) over the next 6 years.

A stock that is highly volatile during short periods of time with little change in fundamentals is unattractive to me. It tells me there is little conviction on whether it will go up or down.  If a stock that  may have a high valuation has increased volatility, but previously had been going up in a straight line, it might be a good time to get out, not necessarily because the company is not doing a good job, but because the price action is telling me that investors are not as comfortable supporting the stock at its current high price.

To summarize, some degree of technical analysis is probably used by quantitative analysts, but in terms of the traditional chart reading, it hasn’t made too many people rich. I first look at fundamentals of company and then assess how others perceive the stock based on the technicals. In all, I use technical as more of a tool to find entry and exit points, not as a way to determine whether it merits an investment.

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