What I Think Technical Analysis Is
Tuesday, June 21st, 2011I have internally debated about writing this for years. I hold the following with weak conviction, and invite correction.
If I want to describe fundamental investing, I will use a model of free cash flows. Now, few value investors invest that way, but most approximate it. There is one theory behind fundamental investing — the real returns of businesses drive stock prices.
But for technical analysis I see it this way: 80% of the time, follow trends. 20% of the time, when trends move to extreme levels, resist trends. None of this involves chart-reading, which to me seems arbitrary.
The way that I view momentum here is in accord with behavioral finance. But testing this would require a global theory of technical analysis — something that could be mechanized so that the theory, rather than the practitioner could be tested. Looking at the audited values of accounts of a subset of managers is not valid — we would need to look at all accounts following the same theory, and unsuccessful accounts don’t line up to be identified.
I am still looking for a global theory of technical analysis. Every chart should be able to have the same analysis applied. Someone give me the expert system that applies to all situations.
But as for now, I think most of technical analysis is just following price momentum.
