Mike Swanson's picture

Technical Analysis as an Investment Tool

So you want to make money in the stock market. To do that you have to have a method. There are three basic investing methods that successful investors use to make money. They either use a growth or value oriented approach to investing, which looks for companies whose earnings are rapidly growing or whose stock is undervalued, or they employ technical analysis, which examines prior price and volume movements in order to forecast the future price movements of financial assets. Some investors use a combination of strategies, such as William O'Neill who combines a growth and technical approach to investing in his book How to Make Money in Stocks and in his newspaper, Investors Business Daily.

Growth investors base their investment decisions on a study of the earnings of a company, but completely disregard valuations. They don't care if a stock is highly valued, only that earnings are growing quickly. William O'Neill is the most popular proponent of growth investing. He looks for companies whose quarterly earnings are up at least 20% from a year ago, whose annual compounded earnings per share should be between at least 15% for the past five years, and who have a new product or service that will help it capture market share. Although O'Neill then takes into consideration how strong the stock is when compared to the rest of the market and the general phase of the market, most pure growth stock investors do not worry about the position of the market or the stock itself.

Even though growth stocks tend to outperform the rest of the stock market during bull markets, growth stock investing holds special risks. Part of the reason why growth stocks do so well is that their earnings tend to surprise analysts to the upside. That catches the attention of investors and causes traders to buy the stock in hopes that the company will surprise again, causing the stock to become highly valued. The problem with growth companies is that at some point the growth slows down. Usually this happens right as the excitement surrounding the company is at a crescendo. The stock then usually falters and goes nowhere despite the continued good news. What is happening is that company insiders know that the future is not going to be as easy as the climb up to ascendancy and start to sell out ahead of the crowd, thereby putting a lid on any future price advances. Because growth stocks tend to be highly valued they are susceptible to large and sudden drops on any negative news. An earnings warning or statements from a CEO that earnings are going to grow at a slower pace, are enough to crush investors. Strategies based on growth stock investing do not tell investors to sell until it is too late.

The opposite of growth stock investing is value investing. The most famous value investors are Warren Buffet and his mentor Benjamin Graham. Value investors look for companies with low debt, a high book value, a dividend yield, a high sales-to-price ratio, and a low price-to-earnings ratio, among other things. Most value investors look for companies whose stock is trading at a very low valuation due to a temporary market condition, such as low sales, a slow economy, or an extreme bearish sentiment in regards to the company that is unwarranted. One problem with value investing is that even after a company's earnings picture improves often its stock does not immediately respond. For instance when the price of gold fell from over 400 to under 260 between 1995 and 1998 the stock of large producing gold companies fell to ridiculously low valuations. However, it took two years for gold stocks to start to rally after they bottomed out. Value investing methods also tend to under perform strategies based on growth during bull markets and can cause investors to sit out on the best moving stocks. For instance Warren Buffet refused to invest in technology stocks during the 1990's, because they did not meet his valuation criteria.

Technical analysis does not tell you when a stock is cheap or expensive, but it can solve the problem of timing, which determines whether or not your investments will make you money or not. One of the biggest investment myths is that if you buy and hold you'll get rich. Timing is everything. Buying and holding can cause investors to lose so much money "on paper" that they will never get back to where they started, especially if they are near retirement age. For instance if you bought the DOW in 1929 it would have taken you 25 years to get back to even. If you bought IBM in 1987 and rode it down it would have taken you 10 years to recover those losses. If you bought Cisco at its 2000 price peak and held it down to its low it would take you 13 years to get back to even if the stock returned 15% a year. Investors have been convinced that they must buy and hold, because they had been brainwashed by the brokerage and mutual fund industries which want them to keep their money invested at all times in Wall Street funds so that they can keep control of the money and make a commission or management fee off of it. One of the big lies that they have told investors is that if you take money out of the market you'll be in danger of missing out on the best market days of the year and will therefore under perform the market. What they don't tell people is that if they miss out on the worst days they'll even come out more ahead of the market. Between July 1984 and October of 2000 the average annual return of the S&P 500 was 14.83%. If you disregard the 10 best days and the 10 worst days of each year during that time then the return on the S&P 500 jumps to 17.07%. I don't have to tell you how much better off those investors who got out of the stock market before the bear market that started in the year 2000 are compared to those that stayed in.

There is a time to play offense and a time to play defense when it comes to stock picks. The problem is that most investors don't know which team to put on the field. That's where technical analysis comes in. Although it is a fancy sounding term, the use of technical analysis goes back to the turn of the 20th century to the writing of Charles Dow, who created the DOW Jones Industrial Average and edited the Wall Street Journal.

Three principles guide the beliefs of technical analysis. First is that market action (price movements and changes in trading volume) discounts everything. In other words all of the relevant information about a company's earnings and fundamentals are already known and incorporated into the price of its stock. Looking at a company's balance sheet will rarely give you an edge over other investors. Everyone else knows that information too. Even information that is not known publicly, but will have an effect on the company later, is almost always reflected in the stock price. For instance if you notice that a company that normally trades 50,000 shares a day all of a sudden starts to trade 200,000 shares a day don't be surprised if some big news is about to come out. Insiders and their friends have a habit of discounting surprise company announcements before they hit the news wires.

The second principle is that asset prices move in trends. Predictable trends are essential to the success of technical analysis, because they enable traders to profit by buying assets when the price is rising, or as the popular saying goes, "the trend is your friend." Borrowing from Newton's Law of motion, technical analysis asserts that trends in motion tend to remain in motion unless acted upon by another force.

The third principle of technical analysis is that history repeats itself. Traders and investors will react in same way to the same conditions of the past, because the psychological motivations that drive them never change. This enables the technician to profit from patterns that repeat themselves in the market.

From these principles the technician attempts to identify trends in the market and reversals of trends. To distinguish trends from meaningless short-term fluctuations they use one of two types of analysis or a combination thereof: charting and mechanical trading systems. Chartists use graphs of stocks to identify meaningful patterns in the price and volume action of a stock. This requires a degree of skill, judgment, and interpretation. Mechanical trading systems attempt to do away with subjectivity by basing investment decisions on mathematical indicators calculated with the variables of price and volume.

Right now I want you to realize that very few people use technical analysis. There are two reasons. First the academic world holds it in derision and secondly the Wall Street investment community advocates a buy and hold investment strategy and views any attempt to time stocks or the market as inherently risky.

A survey published by the Northeast Journal of Business and Economics found that 60% of PhDs do not believe that technical analysis can work at all. Almost all economists hold it in contempt, arguing that to look at past patterns to predict the future is like astrology. Most economists hold to the theory of efficient markets, which argues that no investors or traders can make exceptional returns, because all data and information is already reflected in the stock. Although this sounds similar to what technical analysts argue, there is an important distinction. Efficient market theorists believe that prices move instantly in response to new information. That makes all past information, such as past price patterns or earnings reports, useless. Investing is like flipping a coin. You don't know which side it is going to land on. Therefore it is impossible for anyone to beat the market. Those that do so are simply lucky.

There is one major flaw in this theory. Efficient market theory is based on the economic theory of price equilibrium that comes from the forces of supply and demand. On a normal supply and demand curve demand drops as prices rise and vice versa. A rise in prices also creates an increase in supply, which will eventually lead sellers to lower prices to eliminate their excess inventory. The interaction of these forces creates a price equilibrium and economists argue that stock prices behave in a similar manner. The problem is they don't.

Efficient market theory ignores one important variable: investor psychology. Investors are anything but the objective and rational observers that economists picture them as. They are active participants in price creation and their emotions of fear and greed effect prices. A rise in prices often increases the anxiety of buyers and leads them to buy at higher prices and gives rise to trend-following behavior. On the other hand a decline in prices often leads to an outright selling panic. Investors do not simply weigh all of the information about a stock or market and come to a logical price. The movement of price itself influences them, which is a variable that efficient market theory ignores. If markets were efficient financial bubbles would never form and markets would never crash.

History is full of examples that disprove efficient market theory. One of the most recent is the near collapse of The Long Term Capital Management hedge fund in 1998. Founded by John Meriwether and teamed up with two Nobel laureate economists, Robert Merton, and Myron Scholes, LTCM employed massive leverage to profit between what it saw as temporary price discrepancies in the financial markets. It would play the spread between mortgage backed securities, corporate bonds, and government bond markets and try to profit from the belief that efficient markets would cause the spreads to narrow. Normally these bonds behaved as they expected, but when Russia declared a moratorium on its debt, spreads between the bonds that LTCM held grew wider and caused LTCM to lose $550 billion in one day. The people managing the fund never expected markets to act so irrational. The following year saw the growth of the Internet and technology stock bubble in the United States, a historic testimony to the role of psychology, hype, and momentum in financial markets.

Technical analysis allows you to factor in investor psychology when you make an investment decision. Fundamental analysis may help you value a stock, but it doesn't tell you how others will value it in the future nor can it tell you when to buy or sell it. If investors have learned anything over the past decade it is that the psychology of price is a variable that cannot be ignored. My goal in my writings and research reports is to bring this variable to life for you so that you can trade and invest against the crowd and make money.