Thursday, June 26, 2008

Technical Analysis: is it worth anything?

Followers of Barry Ritholtz's TheBigPicture and Felix Salmon's Conde Nast Portfolio will have noticed the battle between the pro-market-technician and anti-market-technician stance of the respective authors. Unfortunately for Felix, using Jim Cramer as an example of a market technician at work does little to help his cause (Jim Cramer is many things, but market technician he is not). Felix's key point was

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.

Barry responded with a point-by-point blow as to benefits of using technical analysis can bring the user:

-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;

Felix countered:

The problem here is that the argument is unfalsifiable: anybody who has anything bad to say about technical analysis, and anybody who's lost money using technical analysis, is by definition unqualified to make such a determination. It's worth remembering that given the sheer number of people who use technical analysis on a daily basis, statistically speaking a lot of them will make money quite consistently on say an annual basis for many years. But the existence of such people is no indication that technical analysis is any better than picking stocks based on Super Bowl results.

Felix's ideal valuation of a stock would be a net calculation of a company's worth:

Let's say you have a good fundamental analyst's report which came to a compelling conclusion that a company is worth somewhere in the region of $35 per share. Then if it's trading at $7, you buy. If it's trading at $150, you sell. No chart could ever be clearer than that. The problem is that fundamental analysts tend to be shy, and generally base their valuations on wherever the stock is trading right now. And that's not very useful at all.

Is there a right and wrong to the argument?

It is wrong to assume all technical analysis is based on chart watching. All chartists are technicians, but not all technicians are chartists is one of John Murphy's philosophies. If you interested in the movement of a stock's price, and price movement is part of your decision making in trading a stock then you are (in part at least) a technician. Given that, derivatives of price - be it oscillators or MACD - also qualify as tool of the technician, but so do fundamental valuations like price per earnings, price per book and price per sales which could be considered crossover fundatechnicals.

Technical analysis is not financial astrology, but is a tool to study the psychology of human participants in a collective market place. Does greed or fear rule the market place? Felix's ideal fundamental evaluation of a company fails to account for the emotional aspects of holding a stock; great that an analyst values your stock at $35 and it trades at $150 so you sell. But what if the stock trades at $45, should you sell then? If fundamental analysis was the core driver for the market shouldn't all stocks be trading at analyst evaluations? No - they don't because individuals see a roaring market so they hold for higher prices, but in a spiral of doom they dump what they have on the expectation it can be bought for cheaper later on (should they so wish).

The Random Walk Theorists have the same problem when it comes to markets involving human participants. There is no such thing as random price movement in the market; why? Because in a true random number sequence there is no bearing on what has gone before, but in a market the participants will always be influenced by what a stock was priced at yesterday, last week, or last year and will gauge their current participation on that background.

Its only by studying past behavior can we gauge what current participants may (or may not) do in the market. Technical analysis is a science and an art. If it was a pure science then quants would rule the day. Like ticker tape reading it is skill knowing where the best opportunities to act are available.

Many technicians avoid using fundamentals, but doing so is like looking at the market with one eye. Fundamentals provide a whole new set of tools which marry perfectly with technicals. Fundatechnical indicators aside, fundamental analysis is great screening tool to find the best quality stocks, on which technicals are applied to get the prices to trade such stocks.

Fundamental analysis alone is not averse to risk. You only have to look at the sub-prime participants to know how analysts got the true evaluations for Bear Stearns, Citigroup, Northern Rock etc so wrong. We won't mention the likes of Worldcom or Enron either....

It's our job at Zignals to give market participants all the information they need to make informed decisions; both fundamental and technical.

Dr. Declan Fallon, Senior Market Technician, the free stock alerts, market alerts, and stock charts website


Barry Ritholtz said...

Nice summary !

BTW, one "Z" and two "Ts"


Abby said...

Hi! I'm an editor for Seeking Alpha. Please contact me at your earliest convenience at Abby

Declan ( said...

Sorry Barry,

Corrections made.


Scott said...

Best article I have ever seen on this point. I am a strong believer that technical analysis is complete bunk EXCEPT that it does reflect the way that many people see the market -- they start with the chart and previous prices give them a frame of reference. The thing is that there are so many nimrods out there throwing around complete bunk that masquerades as "advanced technical analysis" -- stuff like fibonacci retracement, "filling the gap", crap like that.