The Investment U E-Letter: Issue # 142
Thursday, May 30, 2002 Stock Technical Analysis: Holy Grail Or Sham? What Works in Technical Analysis…and How To Use It To Improve Your Investing
By Dr. Steve Sjuggerud, Chairman, Investment U
It seems I've ruffled a lot of feathers in the investment business lately just by speaking my mind to you. And, on the topic of stock technical analysis, today will be no different… My job is to tell it to you straight, as best I can. Now the way I see it may not be the way a stock broker sees it, or a mutual fund brochure tells it, or a publication or a TV show presents it. But you can be assured; my only goal is to tell it to you straight. I may be wrong sometimes. But I'm drawing from a more diverse experience in the investment business than anyone I know… I've been in the trenches--as a broker, an institutional trader, and a hedge fund manager. I've got the education, heading research departments and completing my Ph.D. And I've been on the ground, with maybe 50 countries stamped on my current passport. So if I am wrong on occasion, it shouldn't be by very much. The Debate Over Stock Market Technical Analysis Today's topic of technical analysis is a touchy one. But before we dive into this heated debate, we should probably first come up with some sort of definition of technical analysis. How about this: Stock market technical analysis, at its core, is looking at price action alone to determine some course of action. That said, there are essentially two heated sides of the debate, both with convincing arguments: - On the "technical analysis is a sham" side, the argument (from guys called "fundamental analysts") goes something like this: "The value of a company is purely determined by the fundamentals of that company's business, not by some silly squiggles on a chart. Therefore, the only worthwhile analysis is analyzing the company's business."
- On the "technical analysis is the holy grail" side, the argument goes something like this: "Anyone who only looks at earnings and ignores emotions in the market is an idiot. The market is made up of live human beings, who always bid things up beyond any reasonable value, and sell things below any reasonable value. Sticking your head in the sand and ignoring market action is ridiculous."
Both arguments make some sense when you read them, no? As a rule, these two camps are firmly divided - you either believe stock technical analysis is useful or you don't. Generally, there is no in between. So by picking one side in this debate, I'm bound to outrage the other side. But where I stand on technical analysis actually makes NEITHER side happy… You see, I'm in the "in between" camp - I believe that both EARNINGS and EMOTIONS matter. And therefore I like to mix and match the two. Here's what I mean… Finding A Good Value…Without "Catching A Falling Knife" I like to buy good values - cheap stocks. You find those through fundamental analysis. And I don't like to try to "catch a falling knife" in those stocks - I like to wait until the share price at least starts to recover to give me a margin of safety. I prefer to buy in an uptrend rather than in a downtrend. The Investors Business Daily newspaper is the most popular example of this. It ranks stocks based on both fundamental indicators (like earnings) and technical indicators, like what's called "relative strength." (Relative strength is just what it suggests - how well a stock is performing relative to the market or its industry. In the case of Investor's Business Daily, this is based heavily on the latest three months action. So if a stock has high relative strength, it's likely beginning an uptrend. William O'Neil, the founder of Investors Business Daily, wrote a million-selling book called "How to Make Money in Stocks" detailing his investment approach. His book established the most widely known use of both fundamental and technical analysis in an investment system. (I checked for you and found that it's available on Amazon for five bucks used - worth that price just for its list of "Common Investor Mistakes" alone.) Earlier, you'll recall, we defined technical analysis as "looking at PRICE ACTION ALONE to determine some course of action." As an example, we pointed to O'Neil's Investors Business Daily and its look at RELATIVE STRENGTH. Relative strength is based on the idea, that O'Neil backs up with research, that the leading stocks are leaders for good reason, and are worth checking out. Technical Analysis and the Concept of Support and Resistance Another basic concept used in technical analysis is the concept of support and resistance. For example, one might say gold has "support" around $250 an ounce - because every time it's sunk to that level in recent years, investors have come in to buy it… to "support" it. On the flip side, over the past 18 months, Microsoft has shown "resistance" to rising once it gets above $70. That seems to be a point where investors sell. As your favorite stocks crashed in the last two years, the fundamental analysts over at Merrill and Goldman said, "The stock is cheap! Time to buy more!" Meanwhile, technical analysts wouldn't touch it. Because, based on their perspective, the stock had fallen below its support level. Once that happens (it's called a "breakdown below support"), technical analysts generally won't touch the stock until it starts an uptrend again. That concept alone could have saved all of us a lot of money over the last two years. The Importance Of The "Moving Average" For one other example of useful stock technical analysis, consider the "moving average" of a stock price. While stocks fluctuate wildly over days and weeks, looking at the movement of the average over a period of time can smooth out the fluctuations and let you grasp the underlying trend. More importantly, moving averages can be a great way to significantly decrease your risk and slightly improve your returns… Jeremy Siegel, author of Stocks for the Long Run and a noted Finance Professor at the Wharton School (University of Pennsylvania), broke with the tradition of academics and actually tested a simple technical analysis rule - the 200-day moving average - himself. During his test, when a stock's price moved above it's 200-day average, Siegel bought. And if a stock dipped below it's 200-day average, he sold. Siegel's Conclusions on Moving Averages What Siegel found is that since 1886, using the 200-day moving average as your indicator, you would have earned 2% points better than someone using a "buy and hold" strategy (11% instead of 9%, I believe), and you would have done so with significantly less risk. You were only in the market about 2/3 of the time. And my own research corroborates Siegel's - I've found that you simply don't make money in stocks when they are below their 200-day moving average. One final thing here - I've found the more basic the technical indicator, the more valuable it can actually be. Relative strength is basic, but you can see its usefulness in spotting stocks starting to move. A moving average is basic, but it has a 100+ year track record of success. However, once you start getting into the hundreds of bizarre and complicated technical indicators out there, chances are you're asking for trouble. The number of stock technical analysis indicators is mind-boggling. And quite frankly, I do believe that most of them are useless. (Some may work, sometimes…but be careful.) The same goes for fundamental indicators by the way. After crunching tons of numbers (both fundamental and technical), I've actually found that simple ideas are best. Bottom line: I like to combine both sets of indicators, both fundamental and technical. I want to buy a stock that is cheap (based on the fundamentals). But I don't want to try to catch a falling knife. So I use technical analysis to tell me when it's time to buy a stock. Today's IU Crib Sheet - Generally, most investors are either on one side of the technical analysis debate or the other. But I think it makes the most sense to take both EARNINGS and EMOTIONS into consideration when making investment decisions. Think about your most recent investment decisions - did you take both into account?
- The best book on the subject may be Technical Analysis Explained, by Martin Pring. If you're knee-deep in developing your own system, I would recommend reading Pring's book in conjunction with Tim Hayes' book, The Research-Driven Investor. But no matter what you learn about stock technical analysis, always remember this one important truism: simpler is better.
- Alex Green of The Oxford Club has developed a trading service based on the time-tested ideas of William O'Neil. The service is called the Momentum Alert, and it was successfully tested for an entire year before it was made available to the public. Learn more by visiting the link above.
Good investing, Steve Related Articles: - Technical Analysis Case Study: Trader Buys Baseball's Red Sox…Who Says You Can't Get Rich Trading?
- The MACD Indicator: What No One Will Tell You About…That Could Cost You Money
- Trend Trading: Two Decades of World-Beating Performance With No Market Correlation
- Trend Trading, Part 2: Turtle Trading and Trend Following
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