Technical Analysis: Is it Still Voodoo?
Technical analysis is a popular method used by investors to predict future price movements of securities based on historical data. It involves the use of statistical trends gathered from trading activity such as price movement and volume. It can be compared to studying past weather patterns to predict tomorrow’s weather but for stocks.
Technical analysis has its champions, but it also has its challenges.
The Pros of Technical Analysis
Proponents of technical analysis argue that it is a valid tool for stock selection. I present a few of the claimed pros below.
Timely Indicators
Technical analysis can provide timely indicators for when to buy or sell. By identifying patterns and trends, investors can make decisions based on the projected future performance of a security.
Short-Term Predictions
It is particularly useful for short-term predictions. As it focuses on trends and patterns within the market, it can be a valuable tool for day traders and those looking to make quick profits.
Applicable to Various Investment Vehicles
It can be applied to a variety of investment vehicles, including stocks, bonds, commodities, and currencies. This makes it a versatile tool for investors.
Emphasis on Price Movements
It places a strong emphasis on price movements, ignoring other factors that can affect a security’s price. This allows investors to focus on what the market is doing rather than what it should be doing.
Technical Analysis at Online Brokers
A big chunk of the profits available to online brokers comes from trading. A focus on trading volume and the price movements of individual stocks, the analytical foundations of technical analysis, is tailor-made for active trading. You can guess that the tools available at online brokerages emphasize these sorts of analytical tools. Here is a simple chart of RY, the Royal Bank of Canada, Canada’s largest company by market capitalization, showing just a few of the many technical indicators available.
Candlestick
The price chart used is a “candlestick,” developed in Japan in the 1700s to help determine price movements for rice traders. It is like a more detailed story of a stock’s price. Each “candle” shows four key prices in one day: where it opened, where it closed, the highest, and the lowest points it hit. The candle’s color tells you if the price ended higher (green) or lower (red) than it started. It is used to get a quick snapshot of the stock’s daily ups and downs, helping the trader to see patterns over time.
Simple Moving Average
In addition to the candlestick chart, you can also see a green and purple line superimposed over the price chart. The green line reflects a 50-day moving average. In other words, at any point along the line you are seeing the average of the closing prices of the most recent 50 trading days. This can be combined with another simple moving average to suggest when to get in or out of a stock position. In this case, any point on the purple line represents the average of the closing prices for the previous 200 trading days. When the green line crossed over the purple line in a downward trend at the end of May last year, that represented a bearish signal and that a trader should have gotten out then. Conversely, when the green line crossed over the purple line in an upward trend, in early January of this year, that represented a bullish signal that the trader should buy the stock. Active traders can shorten these simple moving averages or use different tools to seek buy or sell signals. Whether these are effective or sufficiently timely is another matter.
Volume
In technical analysis, volume (the lower indicator in the chart above) serves as a measure of the strength behind price movements. High volume indicates strong interest and is often seen as a confirmation of the trend’s direction. In contrast, if a stock went up in price but the volume was low, it would suggest that there is a lack of conviction about the durability of the upward trend. Essentially, volume helps to validate whether a price change reflects a true market consensus or is just speculative “noise.”
The Academic and Professional Arguments Against Technical Analysis
Critics, both academic and professional argue that technical analysis lacks empirical evidence, is based on weak assumptions, and is less effective than passive investing strategies.
Lack of Empirical Evidence
Critics, including Burton Malkiel, author of A Random Walk Down Wall Street, argue that there is insufficient empirical evidence to support the effectiveness of technical analysis. They contend that past price movements are not a reliable indicator of future performance. This is based on the Efficient Market Hypothesis (EMH), which suggests that all known information is already reflected in current prices, making it impossible to consistently achieve above-average returns.
While some argue that the EMH is itself inadequately supported, the increasing use of technology and highly trained practitioners of stock selection is making markets increasingly efficient and undermining the ability of stock pickers to take advantage of perceived price anomalies. See the paradox of skill here, here, or elsewhere for the challenge faced by active stock traders. This is one of the reasons driving the move to broad-based index funds.
Inefficiency Compared to Index Investing
The CFA Institute, among others, advocates, either implicitly or outright, for broad-based index investing over active trading strategies like technical analysis. They argue that index investing, which involves buying and holding a diversified portfolio of assets, typically outperforms active trading strategies over the long term. This is due to lower transaction costs, the difficulty of consistently predicting market movements, and the risk of human error in active trading.
Overfitting and Data Mining Bias
Technical analysis often involves testing numerous patterns and rules until one that works is found. This process, known as overfitting or data mining bias, can lead to the creation of rules that appear to work on past data but fail to predict future price movements.
In Case It’s Not Clear…
In case it’s not clear, I see little value in technical analysis. I find more credence in fundamental analysis, but the challenges against either technical or fundamental analysis being a successful strategy over the long term are, well, challenging. When one considers the rarity of persistent market-beating performance in actively managed (i.e., different from benchmark indices) investment portfolios, especially given the high cost of the majority of such funds in Canada, most investors would do well to seek the return of the market, less a small fee, to buy an index-tracking fund.
Head and Shoulders Chart
If your curiosity persists, however, you can find all sorts of fascinating charts. My favourite, not because I use it but because of its name, easily remembered because of the shampoo, is the “Head and Shoulders” chart, which in the “top” version suggests a bearish (negative) signal.
The “bottom” version, however, is bullish (positive).
Chartered Market Technician
If you are really keen on technical analysis, you can even study to become a Chartered Market Technician®.
Concluding Thoughts
Technical analysis, with its intricate charts and enigmatic indicators, offers the promise of market-beating knowledge. The allure lies in its purported ability to transform the “random walk” of the markets into buy and sell signals. I’ve come to think of it as a version of Gnosticism, seeking hidden knowledge in patterns, using charts to reveal true market dynamics and, consequently, profitable opportunities.
Recently, a guest on the MoneySaver Podcast, a market technician, commented that technical analysis used to be considered Voodoo. Let’s set the record straight, though. Voodoo is its own spiritual tradition that is quite different from “black magic.” Technical analysis is a version of modern Gnosticism, decoding lines to discern hidden truths in the apparent randomness of the stock market. Take it for what’s it worth.
This is the 242nd blog post for Russ Writes, first published on 2024-04-08
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions