How to Properly Use Technical Analysis to Boost Returns
Oxford Club and Investment U Investment Director Alexander Green and I agree on most issues when it comes to investing. It's one of the reasons I jumped at the chance to join The Oxford Club.
Alex's approach to investing and portfolio management is spot on in my opinion, and he has the track record to prove it. The independent Hulbert Financial Digest has ranked Alex's trading portfolio in The Oxford Club Communiqué in the top 10 for 10-year risk-adjusted returns for years. Despite all the other newsletter writers thumping their chests, you'll be hard pressed to find one who has a better track record than Alex.
But – you knew there was going to be a "but" – one area I don't agree with him about is the usefulness of technical analysis (the study of stock charts) in trading systems.
In his column on Friday titled Would You Invest in the "Math of God?" Alex took aim at technical analyst Tom DeMark, his use of Fibonacci sequences and the A-list names in finance who follow him.
I'm somewhat familiar with DeMark's work, but don't have a strong opinion on it. So this column isn't a defense of DeMark per se, but of the usefulness of stock charts in trading and investing.
A Little Background…
My first job in the markets was as an assistant on a trading desk. I learned about the markets by watching the "tape" – how stocks moved throughout the day. Trying to make some sense of it all, I turned towards technical analysis.
I soon became an enthusiastic convert. I joined and became the vice president of the Technical Securities Analysts Association of San Francisco, published papers on chart patterns and embarked on obtaining my Chartered Market Technician (CMT) designation.
I never completed the CMT because, at the time, the third and final part of the process dealt mostly with Elliott Wave theory – which I think is a load of bunk. So you can see that while I was a believer in technical analysis, I did not drink the Kool-Aid on every aspect of it.
Then, a funny thing happened. I was hired by a boutique contrarian research firm as a fundamental analyst. In order to get my required NASD licenses, I had to pass a grueling test that is equivalent to the first level of the Chartered Financial Analyst (CFA) exam. It was 100% fundamentals based.
I passed the test, got my licenses and published research on companies based purely on fundamental data (although my company also asked me to publish comments based on technical analysis).
I bring all of this up to show you that I have deep experience in both worlds. In my career I have studied thousands of stock charts and an equal number of financial statements.
Not a Crystal Ball
The biggest misperception about technical analysis is that it's a crystal ball and can tell you exactly when to get in and out of an investment or trade. That's not the case at all, and any technician who tells you that he's got a fool-proof system for doing so is lying either to you or himself.
Rather, technical analysis is a guide for risk. There have been many academic studies that have shown that certain patterns, such as head and shoulders, triangles and trendlines, have a greater than 50% chance of moving in the predicted direction (look up Thomas Bulkowski's excellent work on this subject). This isn't some kind of voodoo. It's because human behavior is somewhat predictable.
All the charts show is how humans are behaving in relation to fear and greed. And that behavior tends to repeat itself over and over.
How to Properly Use Technical Analysis
Let's take a look at how someone can use technical analysis in their investing.
Above is a two-year chart of Citigroup (NYSE: C). You can see that back in 2011, the area just under $40 served as support. That means every time the stock traded down to that level, it bounced.
If at that time, you liked Citigroup's fundamentals, that would have been a good place to buy it, because if you were wrong, you would've known right away. You can see that in August the stock began to fall well below that $40 level. Since the area around $40 held up before, when the stock fell below, it was a signal that investors' psychology on the stock changed. By realizing that, you'd get out with a small loss.
Today, the stock is approaching that $40 level again. You can see that each time it tried to break $40 to the upside this year, the stock was rejected. If the stock meaningfully breaks $40, that suggests the psychology has changed again and investors are finally willing to pay more than $40 for the stock, when they weren't several times before.
Just above $40 would be a good entry price from a risk-reward standpoint. If the stock falls back below $40, you know the psychology, in fact, didn't change and you can get out with a small loss. But with such significant resistance at $40 over the past year, a break above $40 is a very good sign that there are more potential gains to come.
Hopefully, from that description, you can see that technical analysis is an art, not a science. You may see something different in the chart than I do, just as two analysts can look at the same income statement and come away with different opinions.
Alex mentioned that legendary investors like Leon Cooperman and Paul Tudor Jones read Tom DeMark's technical work. Those guys aren't looking for a crystal ball. If they did, you never would have heard of them. People who depend on definite predictions don't have iconic careers. Rather, they're looking for a perspective they, perhaps, aren't trained to find themselves.
Sure, DeMark made a bad call on Research in Motion (Nasdaq: RIMM), as Alex pointed out. And I can name dozens of analysts who used nothing but fundamentals and downgraded a stock after the company reported weak earnings and the stock dropped dramatically.
How many investment strategists were telling you to load up on stocks in early 2009 or summer of 2011? Other than Alex, almost none. All of the other strategists and gurus were looking at the same financial statements and economic data, yet Alex was one of the only ones to conclude that investors should buy stocks at that time. The market went up 122% from the 2009 low and 37% from the low point in 2011. Scores of other analysts who had the exact same fundamental data got it wrong.
Technical analysis does work if you know how to use it – as a tool to guide your decisions based on risk versus reward. I know several people who make their living off nothing but stock charts and indicators. It's not a foolproof system for trading. Any technician worth his charts would tell you that.
And if they do say their systems never fail – don't walk away. Run. That's something Alex and I can both agree on.