Stock Picking - The Flaws of Technical Analysis

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Intermediate
10

Russell Wayne

16 Dec, 2016

in Equities and 1 more

Among Wall Street researchers, there are two main approaches to stock picking: fundamental analysis and technical analysis. Fundamental analysis subscribes to the belief that the shares of companies will reflect changes in forward progress and financial health. In contrast, technical analysis concentrates on stock price action and how such changes reflect shifts in investor psychology. Technical analysis is totally indifferent to underlying company developments.

Therein lies its fatal flaw. As one might suspect, there are different approaches to technical analysis and there is what purports to be an academic treatise on the subject: Technical Analysis of Stock Trends, the ninth edition of which devotes nearly 800 pages to the subject. Devotees worship this tome much as fundamental analysts pay homage to Security Analysis, by Graham & Dodd. The book is filled with all kinds of lines, shapes, and other graphic devices in a comprehensive attempt to convince the reader that charts of prior price action foretell the future. Given the gravity of the portrayal and the extensive examples provided, the authors present an impressive case. This, however, is not the first time that the presentation of an impressive case has borne no fruit.

Point-and-Figure Approach
One of the more interesting, though perhaps simplistic, technical strategies is what is known as the point-and-figure approach. The basic ledger of point and figure is graph paper on which the technician enters either an X (up indicator) or an O (down indicator), depending on the direction of prices. The number of entries depends on the extent of the price movement. So the chartist may decide, for example, that an individual X or O will be entered only after a price change of one, two or even more points. Once that data is entered, the point-and-figure technician enters a complex world of evaluating formations and calculating potential movements. It is a fascinating world not unlike the Land of Oz.

In my early years at Value Line, there was a young analyst who had become intrigued by point-and-figure charts, to the point where he spent most of his free time keeping up with the daily entries. Despite the fact that his ledgers developed a noticeable resemblance to the designs on the covers of tin boxes used for Whitman’s Sampler chocolates, I am not aware that any of this fellow’s charting efforts ever provided a meaningful reward other than whatever satisfaction he got from making Xs and Os. I suspect, however, that he may have become particularly adept at tic-tac-toe.

Popular Formations
Technical analysis has all kinds of names for interesting price action formations. Some of the more popular formations are known as head and shoulders and double or triple tops – there are corresponding labels for the reciprocals of these patterns. And there are such old standbys as support and resistance levels. According to the theory, a support level is one where buying is supposed to come in and keep prices up after periods of weakness. To my recollection, the key phrase is “supposed to.” In the same vein, resistance levels are what develop when stocks are moving up to toward prior peaks, which may be difficult to penetrate. At best, these ostensible barriers have a short-term effect. Over the longer term, they are of no significance.

Rather than a further discourse on technical analysis, I offer the following excerpt from The Money Masters by John Train:

"The study of value is the basis of stock investment. There are no shortcuts. The “technician,” however, tries to predict stock movement through the shapes on a stock’s chart, without reference to value. It is not knowable from what a stock did last month, or last year, how it will do next month or next year. Brokers' pronouncements on this subject are tea-leaf reading, fakery. Imagine a bookstore in which the salesman didn’t know what was between the covers, and instead offered guesses on next year’s prices for the merchandise! What a broker can and should do is establish facts and values, so the customer can decide if he wants to buy what has been described. This involves legwork, study, interviews with a company and its competition, consultation with industry experts, and the whole then to be presented in a form which permits an investment valuation, but also where errors will stand out. Personally, I do not think that the SEC should allow any registered investment advisor to put out advice on stocks based on technical analysis. I consider it unprofessional. Brokerage firms that I know have spent millions of dollars (literally) on computer programs for technical stock analysis and then quietly scuttled them.”

I agree with Train’s take on technical analysis, but suggest two cases in which price charts may have some value when viewed together with the relevant fundamental information.

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RE: Stock Picking - The Flaws of Technical Analysis

The author, Russell Wayne, is a CFP who runs an asset management firm (essentially a sell side operation) in CT. He rips technical analysis while appearing to have barely researched the topic. Instead he quotes John Train, a 90 year-old stock market author and strong adherent to fundamental analysis. A technician could respond by quoting prolific financial author and technician Jack Schwager. Neither approach effectively analyzes the wide ranging discipline.

This article is so brief and superficial as to not even be worth reading, something in the past you would have expected in something like Reader's Digest.

Dec 18, 2016

Member (1 post)

I can only speak from personal experience.
In the early 90s I invested and made some money.
In the mid 90s I traded on T25 and made a much higher return.
From the late 90s I have day traded and done even better, so much so that I sold my dental practice in 2000 to trade for a living.
Why and how in very general terms?
I have a very brief look at fundamentals just in terms of news flow, price moves which demonstrate clear sentiment in various set ups and price action itself as a refining trigger. Sometimes I use margin, usually not. I am in and out of trades in the same day so I repeatedly use the same capital over and over again every day. That you cannot do in investing.
So I read an article such as this which demonstrates a rigid and inflexible and biased (as tomorton rightly points out) attitude and it is all I can do to be polite and not laugh at sneering ignorance masquerading as knowledge and experience.
Yes, of course most day traders blow up, but that is because they think they know what they are doing and plunge in steeped in a total failure to understand what they are doing. Trading appears simple but requires the knowledge and the experience practice and thought bring in their wake, not to mention personality traits including the ability to ignore emotional experience. It's rather like not learning to drive properly as it looks very simple and straightforward so why not just go out and buy a Ferrari and drive round Marble Arch at 80 mph. Or trying to drive on the San Diego Expressway at the same speed in heavy traffic or the Paris Peripherique.
So yes, most people who do that mess up spectacularly.
It's like a lot of things in life, know what you're doing, practice, gain experience, then do the business, enjoy and prosper. Rocket science it isn't.

Dec 16, 2016

Member (7098 posts)

tomorton;2850026


I continue to argue that the elimination of daytrading alone as a style of trading would eliminate many losing traders before they had a chance to blow up


Or deny traders the option of trading on margin. That alone might motivate traders to determine just what it is that they're doing. Daytrading in and of itself is not the problem.

Dec 16, 2016

Member (5916 posts)

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