Stock Picking: The Flaws of Technical Analysis

Among Wall Street researchers, there are two main approaches to stock picking: fundamental analysis and technical analysis. Fundamental analysis subscribes to the belief that the shares of companies will reflect changes in forward progress and financial health. In contrast, technical analysis concentrates on stock price action and how such changes reflect shifts in investor psychology. Technical analysis is totally indifferent to underlying company developments.

Therein lies its fatal flaw. As one might suspect, there are different approaches to technical analysis and there is what purports to be an academic treatise on the subject: Technical Analysis of Stock Trends, the ninth edition of which devotes nearly 800 pages to the subject. Devotees worship this tome much as fundamental analysts pay homage to Security Analysis, by Graham & Dodd. The book is filled with all kinds of lines, shapes, and other graphic devices in a comprehensive attempt to convince the reader that charts of prior price action foretell the future. Given the gravity of the portrayal and the extensive examples provided, the authors present an impressive case. This, however, is not the first time that the presentation of an impressive case has borne no fruit. (For more, see: Stock Picking: Keys to Successful Investments.)

Point-and-Figure Approach

One of the more interesting, though perhaps simplistic, technical strategies is what is known as the point-and-figure approach. The basic ledger of point and figure is graph paper on which the technician enters either an X (up indicator) or an O (down indicator), depending on the direction of prices. The number of entries depends on the extent of the price movement. So the chartist may decide, for example, that an individual X or O will be entered only after a price change of one, two or even more points. Once that data is entered, the point-and-figure technician enters a complex world of evaluating formations and calculating potential movements. It is a fascinating world not unlike the Land of Oz.

In my early years at Value Line, there was a young analyst who had become intrigued by point-and-figure charts, to the point where he spent most of his free time keeping up with the daily entries. Despite the fact that his ledgers developed a noticeable resemblance to the designs on the covers of tin boxes used for Whitman’s Sampler chocolates, I am not aware that any of this fellow’s charting efforts ever provided a meaningful reward other than whatever satisfaction he got from making Xs and Os. I suspect, however, that he may have become particularly adept at tic-tac-toe.

Popular Formations

Technical analysis has all kinds of names for interesting price action formations. Some of the more popular formations are known as head and shoulders and double or triple tops – there are corresponding labels for the reciprocals of these patterns. And there are such old standbys as support and resistance levels. According to the theory, a support level is one where buying is supposed to come in and keep prices up after periods of weakness. To my recollection, the key phrase is “supposed to.” In the same vein, resistance levels are what develop when stocks are moving up to toward prior peaks, which may be difficult to penetrate. At best, these ostensible barriers have a short-term effect. Over the longer term, they are of no significance. (For related reading, see: Investors: Don't Let Fees Reduce Your Returns)

Rather than a further discourse on technical analysis, I offer the following excerpt from The Money Masters by John Train:

"The study of value is the basis of stock investment. There are no shortcuts. The “technician,” however, tries to predict stock movement through the shapes on a stock’s chart, without reference to value. It is not knowable from what a stock did last month, or last year, how it will do next month or next year. Brokers' pronouncements on this subject are tea-leaf reading, fakery. Imagine a bookstore in which the salesman didn’t know what was between the covers, and instead offered guesses on next year’s prices for the merchandise! What a broker can and should do is establish facts and values, so the customer can decide if he wants to buy what has been described. This involves legwork, study, interviews with a company and its competition, consultation with industry experts, and the whole then to be presented in a form which permits an investment valuation, but also where errors will stand out. Personally, I do not think that the SEC should allow any registered investment advisor to put out advice on stocks based on technical analysis. I consider it unprofessional. Brokerage firms that I know have spent millions of dollars (literally) on computer programs for technical stock analysis and then quietly scuttled them.”

I agree with Train’s take on technical analysis, but suggest two cases in which price charts may have some value when viewed together with the relevant fundamental information. (For related reading, see: Behavioral Finance: How Bias Can Hurt Investing.)

In the case of individual stocks, however extensive the fundamental analysis, it is essential to view the concurrent price action. Although in most cases, there will be a correlation between the two, there may be exceptional situations where there is a marked divergence of direction. If the fundamentals appear strong while the price is eroding slowly, that may not be a problem. But when the price is plummeting, more likely than not some significant factor has not been properly appraised in the fundamental evaluation.

With mutual funds it is also worthwhile to be aware of the price charts since, unlike those of equities, they are direct reflections of the value of underlying holdings. There is, of course, a paradox here since over the long-term stock price charts tend to correlate with changes in fundamentals. But in the short term, changes in investor psychology may be of greater importance. To the extent that mutual funds diversify over wide ranges of holdings, the impact of psychology will be diminished. It is, therefore, often worthwhile to compare price charts of mutual funds with similar objectives to assess the relative value added by the investment manager’s approach.

Now why was astrology invented? So that stock market technical analysis could be called an accurate science. (For more, see: CNBC: Financial News, or Just Entertainment?.)