THE VALUE OF TECHNICAL ANALYSIS

Part of the October 21, 2006 “Big Picture� internet broadcast transcription spoke to technical analysis and technicians in a manner that gave this technician some pause to consider and speak critically to some of the points that were made. My purpose tonight is to provide some context toward the value or lack thereof of technical analysis. As a successful investor with roots as a value investor, there is value in technical analysis – especially in today’s market, which is especially short on actual value.

“JIM: Well, let’s take for example, technical analysis – let’s take reading the charts. What I find with technical analysis is that an investor can interpret charts almost anyway he wishes. So, for example, you can read the formations just about any probable result you would hope for. For example, if you’re bullish at heart on the market, you are more likely to interpret the charts optimistically. If you’re bearish you’re more prone to see bearish patterns in the charts.… Well, with all due respect to technicians, I firmly believe that technical analysis will never completely enable people to overcome their inherent traits of –once again – their emotions: hope, greed, pride of an opinion, and similar human feelings that we see that make successful investing one of the most difficult to master...And a lot of times simply what the charts are telling you is sometimes that consensus of opinion, but other times you can interpret charts in so many different ways. That’s why I tend to rely more on fundamentals on the reasons I base my investment decisions.�

Indeed, Jim is correct that an investor can interpret charts almost any way he wishes. Of course in a similar manner, one can interpret a company’s fundamentals any way too; but these interpretations, if not correctly applied, can result in extremely dangerous investments. Technical analysis provides a distinct advantage over fundamental analysis because technical analysis enables one to clearly and objectively establish if and when their analysis fails. But at what point does one throw in the towel on an incorrect fundamental analysis? Without the safety of technical charts and sound technical analysis, the analyst in left with only their emotions, hope, greed and pride of opinion as a guide. In my views, such “tools� are terribly inadequate in a grossly overvalued stock market.

Following is an example that is relevant to both a technical and fundamental approach – the stock of Caterpillar, Inc. (CAT). I’ve sketched the long term uptrend line on the long term chart below along with my Elliott Wave interpretation of the bull market in CAT stock. The blue set of numbers suggests that CAT may have completed the first three waves of a 5 wave up pattern. The pink numbered waves are an interpretation of the sub waves within Wave 3. If the blue set of waves does represent the first 3 waves of a 5-wave bull market, then the stock is in a Wave 4 correction, and there should be more bull run to follow in Wave 5, and the high of 81.32 should be exceeded by a large margin. Yet, EW theory suggests that Wave 4 (in progress) typically ends when it is between the starting and ending levels of subwave four of wave 3. That would suggest that the current Wave 4 would end somewhere between CAT’s current level of about 60, and 48.

As a technician, one would have to consider that there would be about 12 points of risk with purchasing the stock at 60. (As described above, it could drop to 48 while still holding true to the EW pattern.) As a Value Investor, one would seemingly not have to consider whether any trendlines were broken or whether the stock was going up or down; only whether there was value in CAT stock at a share price of 60.

However, I would submit that similar to technical analysis, the fundamentally based value proposition also carries the burden of reading the fundamentals any way one wishes based on their predisposition. If you are bullish at heart, you may be inclined to see CAT’s relatively low price to earnings ratio of 11 as value or (more likely) relative value. If you are bearish on CAT, you may be inclined to view the run from 16 to over 80 with an air of skepticism. Further, a value investor would probably question whether there was value in a stock such as CAT which pays a dividend of only 2%, and whose dividend increases have not nearly kept pace with its stock price, even at after the recent correction in the stock. In pre-bubble stock markets, a yield of 3% in the entire S&P 500 was the standard by which investors generally established whether the stock market is overvalued. At a dividend of only 2%, CAT’s dividend exceeds the previous “overvalued� standard by 50% (although 2% represents “relative value� in today’s market).

Further, a fundamental CAT bear could easily reflect upon the fact that CAT is a cyclical company and as a result, its current good business fundamentals are directly related to the economic cycle. A highly successful value investor, Peter Lynch, clearly describes the stock price cycle of cyclical stocks as relating to the overall economic cycle in two of his books (1, 2). Lynch suggests buying cyclical stocks when they are out of favor near the beginning of an economic expansion cycle, and selling them near the end of the economic cycle when the P/E’s are low. Such an investment philosophy would have seen actual value in CAT about the time its dividend topped out at 4% and the price was near $16 a share with the US economy sputtering. Now, the price action of CAT and the dividend at 2%, it makes one wonder whether the economic cycle has been repealed. Could Lynch’ philosophy of cyclicals have been right all along? Or have China, and Asia’s development resulted in a new economic paradigm? What direction is there for the fundamental bull who buys CAT when (if) it drops to 55, knowing the stock saw the high teens a few short years ago? If it dropped to 55, would a fundamental investor begin to question whether it is “relative� value or “actual� value that counts in the stock market? I submit that the long term “direction� may then be biased based on emotion, hope, greed, and pride of opinion.

As a technician, one does not have to carry the burden of all this complication. In the case of CAT, a purchase of the stock at 60 would have some technical rationale, as long as the long term support at 60 was not broken. As a technician, if the support at 60 was broken, one could sell CAT (at a small loss), and not have to wonder whether CAT was acting like a typical cyclical stock at the end of the cycle, or what the market was thinking when it sold the stock down to 16, or whether the contagion that hit the market in ’03 would hit it again.

Proper Application of Technical Analysis (or) Conversation Piece?

If properly practiced, technical analysis is not biased by inherent traits of, “emotions: hope, greed, pride of an opinion, and similar human feelings.� In fact, the use of technical analysis is designed to eliminate these factors from the equation entirely!

Most applications of technical analysis include establishing a favorable risk to reward ratio (3:1, or better), and trading objectively to these established ratios. However, there may be some confusion between properly practiced technical analysis and the technical analysis used to stimulate discussion and provide commentary or sell newsletters. For example:

“Hey Marty, what do you think the stock market will do this week?�

“I think it's going to crash!�

This is not technical analysis! This is idle speculation to make conversation and/or commentary.

There may also be some confusion with technical analysis in the preponderance of letter writers using what they think is technical analysis to make fundamental points. Such practices are oftentimes misuses of technical analysis. Following is a generic example of such a practice shown in the annotated chart below:

Here the writer suggests that there is a technical reason why a reversal of the charted currency is coming. Is such a reversal coming? May be the writer knows something fundamental about the currency that suggests such a reversal; but until the head and shoulders pattern is completed, there is nothing on the technical chart to suggest a reversal. The only technical observation that can be made is that there is minor support at the blue horizontal line.

The letter writer who made the following observation about the homebuilders used proper use of technical analysis in a timely manner.

In summary, properly practiced technical analysis is a tool that can be applied in a practical and unbiased manner to confirm or (especially) refute ones preconceived views, while minimizing risk. It eliminates such factors as emotions, fear, greed and pride of opinion. Proper application of technical analysis should not be confused with improperly practiced chart reading and commentary that is sometimes used for such purposes as to provoke thought or sell newsletters.

Today’s Market

On a day where Cisco (CSCO) reported a King’s Ransom, the Nasdaq opened up higher broke into a fresh 52-week high, reversed and then finished down for the day. Volume was high suggesting that something significant may have happened today. It is a common occurrence in the recent market (over the last 3-years), that stocks apparently break support, before coming roaring back. The market has had a bullish bias, so that it would not be appropriate to suggest today’s action as a false breakout, until it is confirmed with other technical indicators. Leaving my pride of opinion out of it, technically the market is overdue for a correction and is in highly overbought condition. If your fundamental view leads you to an opinion that the Nasdaq is overpriced, then you may point to the loss of momentum as technical ammunition for your fundamental case. But you surely better carry a safety net of a stop loss at today’s highs if you are inclined to “take a shot,� because there is little else to “go on,� technically.

Gold and gold stocks had a good day, the kind of good day that tends to occur in secular trends. Gold was up over $18 today, and silver was up over 4.5%. Here’s the long view of the $HUI. This analyst is waiting for Wave 3 (of Wave III) to begin. There is some evidence to suggest that it has already begun, and today’s action contributes to this technical evidence. Yet, a decisive break below 275 on the HUI negates this long term technical view of the HUI, in spite of my pride of opinion. Technical analysis enabled this analyst to calmly add to my position in gold stocks by buying the Gold Miner’s ETF at below 33 in early October. Had support been broken, there was a logical point in which to take a (small) loss and reassess, freed from the burden of having to decide which were right - the inflation or deflation folks.

Similarly, the short term chart of the US Oil Fund (USO) illustrates some key technical features which provide the oil bull with the tools to establish an appropriate entry point in which to enter with an appropriate stop out point (which was not hit to date). Note the loss of the downtrend’s momentum.

Have a great evening.