What I Think Technical Analysis Is

I 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.

19 Comments

  • Randolph says:

    Not offering a correction, but interested in clarification. Are you suggesting that “technical” investors follow trends 80% of the time (and resist the other 20%)? Without reading a chart, how do you decide when an extreme level has been reached?

    Or by chart-reading, are you referring to things like “head-and-shoulders” and/or trying to determine support and resistance levels?

    If you view momentum as an aspect of behavioral finance, wouldn’t that necessarily involve testing the practitioner (who is engaging in investment *behavior*)? Or are chart readers implementing a technical strategy based on the behavior of others (but not themselves)?

    Momentum investors would be part of the phenomenon they are trying to exploit. When do you buck the trend (identify the 20% situations)?

    There must be technical traders trying to implement various chart reading strategies (certainly they are writing plenty of analyses on-line about it.) How successful they are either at (1) implementing those strategies or (2) making money with those strategies is subject to debate.

    When you say most of technical analysis is just following price momentum, do you mean that is the only technical analysis that is valuable/potentially successful? Or that is what most end up doing, regardless of their stated claims about charts?

    There is no expert system that applies to all situations. Do technical analysts believe there is? Or are they just assuming they can get it right more often than not?

    • I have more questions than answers also. I think what gets me is that support and resistance lines get drawn with seemingly little rhyme or reason, or that someone sees a pattern in the data, perhaps head-and-shoulders, and someone else disagrees with it.

      Technical analysis doesn’t seem to have one unified set of rules — my comments about momentum are a very weak attempt to offer an underlying structure even if practitioners would say, “That’s too simple.” It probably is too simple, because I have seen mean-reversion effects also, but at longer and shorter periodicities. Momentum is a fairly well-established phenomenon over 6-12 months, at least until too many people start playing it, and the market goes nuts until enough momentum players get shaken out.

      That’s my first stab. Sorry that I didn’t answer everything.

  • hodedofome says:

    Here’s a technical trader (pure chartist, doesn’t trade based on fundamentals or anything else) with audited 40% return/yr for 30 years… from 1996 to 2006 he wasn’t even trading! http://peterlbrandt.com/

    • I’m aware of him. I wonder a little at the audit, because it’s too large. Did he have all of his money on the line, and did he compound the sum at 40%? If it doesn’t count the safe assets on the side, I would be wary.

      I’ve read many articles at his blog also — he writes well enough and seems to be a bright guy. Maybe he did do it, but if one is compounding, it gets harder as the sum gets bigger. 24000x in 30 years? Be interesting to see the audit.

      • hodedofome says:

        After watching the realtime trades of @vader7x on twitter, as well as following several other professional traders out there, I’m becoming ‘somewhat’ convinced that there are guys out there that can literally double their capital every year or two. Or less.

        They also run the risk of their system breaking down and can blow up for sure.

        With the leverage provided by commodity futures trading, if your winning trades are big and your losing trades are small, you can make out like a bandit. I don’t know how they do it but I’m trying to learn myself. I mean, if you average 2 points a day profit on emini S&P futures, on $25k in capital you can make $125k a year even without compounding. And there’s plenty of liquidity in commodity futures even with large sums in trading capital.

        I am a fundamentals/value investor myself. But this kind of performance, if it’s real, intrigues me.

        • dhom says:

          It is real, and they really do blow up. Futures traders who add to their positions as they are winning are trading synthetic long options. Michael Covel mentions this in the book titled “Trend Following.”

          Of course, the problem with being long options is that you take lots of small losses to get the big wins, and the small losses can wipe traders out. Another, even more serious, problem is that price distributions become more fat-tailed the shorter the time frame is, and the trader may not be able to adjust fast enough to protect himself from massive losses. The Market Wizards books contain several examples of futures markets that didn’t give traders a way to get out; I assume this is before the advent of exchange-traded options that now allow the traders to get out through synthetic positions.

          The exchange-traded options as a substitute for futures avoids the risk of losing everything quickly, but the trader pays for this by buying overpriced premium.

      • Mike C says:

        I’d recommend getting Peter Brandt’s book….not to try and convince you of his approach, but to see how an actual technical analysis practitioner uses it that really is 180 degrees apart from your perception of technical analysis in this post.

        I’d also recommend this book highly:

        http://www.amazon.com/How-Charts-Help-Stock-Market/dp/0071426841

  • dhom says:

    David, I agree with you in that I think much of, if not most of, the benefit chart reading can be quantified and traded as a system. I think the momentum-based attempts to do this have missed out on something important.

    Momentum players may look for (as an example) the stocks with the strongest 3, 6, and 12-month performance with a skip-month and buy the top quintile. What the advent of leveraged funds has made clear is that when this methodology is applied to ETFs, the leveraged ones always win. They shouldn’t, but they do. I suggest that the weakness with most momentum systems is that the variables are not adjusted for volatility.

    This is where the human eye still has an advantage over momentum systems as they exist today. The human eye sees the charts for GLD and UGL (2x leverage) and can tell that they are the same chart. A momentum system, unadjusted for volatility, will always pick UGL.

    Of course, this is an easy fix. It seems obvious. So why don’t people implement the fix? I’d be interested in hearing your input.

    Please let me know if I’ve missed anything or can clarify anything I’ve said.

    • Interesting thought. How would you propose adjusting for volatility?

      • dhom says:

        A long-term trend-following system can use moving average crossovers instead of 12-month momentum. A long-term moving average smooths out a lot of volatility.

        Traders that rely on shorter-term momentum might be able to use a Sharpe ratio or just take 3- and 6-month momentum and divide by historical volatility. I don’t trade the shorter-term momentum and the moment and would be interested in hearing ideas for implementing volatility adjustment.

      • ljoneill says:

        David,

        You probably remember or know Louie Navellier from your old Provident Mutual days…or have read his stuff elsewhere. I won’t be able to recall the exact details, but his initial screen looks for those stocks with the best volatility-adjusted momentum over the prior 12 months. I don’t recall the actual math, but it rather simple – something like dividing the TTM total return by the trailing 252-day standard deviation. You get a Sharpe Ratio of sorts for every stock in the universe. He then uses the highest ranking stocks and does all sorts of other quantitative machinations with them to arrive at his portfolio, but the basic step of vol-adjusting the momentum seems pretty basic. It certainly does the job of penalizing those stocks with excessive vol but still allows them in the portfolio if the absolute return has been high enough.

        • That’s interesting; will try it out. Thanks, Luke.

        • dhom says:

          Yes – and it makes sense that he doesn’t stop with vol-adjusted returns. One of the reasons I don’t trade pure momentum is that the stocks that show up in the screens are likely to be highly correlated. Perhaps one of the variables Navellier is using is related to correlation.

  • ljoneill says:

    David,

    Again, I doubt I tell you anything you don’t already know. However, in my experience, tehnical analysis is no different than fundamental analysis in that much of the success is based on “art” rather than something that can be quantified. I don’t believe there is any sort of expert system that applies to all situations. You are 100% right that people draw support and resistance lines in seemingly random spots sometimes, which just goes to show that it is art. And which technical indicators do you use? RSI, MACD, Bollinger Bands, Fibonacci Retracement Levels, Stochastics, and so on ad nausem? Many people use one or two indicators almost exclusively, while others use them in combination with each other, and others use different indicators depending on the type of stock or type of market.

    What I don’t agree with is that technical analysis is basically synonymous with momentum. For some people, that might be the case, but it depends on the details. Many people play breakout stocks for a quick 5% gain. Is that momentum? Well it could be, but I’m guessing the correlation of that return stream with a pure momentum strategy would be very low. But many others play bounces off a 200-day MA when the MACD crosses over, etc., and i just don’t think that’s the same. Technical analysis is all about the details of when to buy and sell and is much more granular than a basic momentum strategy. Expert system? I don’t think it exists.

  • dhom says:

    As if this weren’t fun enough, here’s some more controversial research.

    Head and shoulders pattern
    http://www.cxoadvisory.com/technical-trading/testing-the-head-and-shoulders-pattern/

    Technical indicators tested
    http://www.cxoadvisory.com/technical-trading/technical-trading-thoroughly-tested/

    Returns from pattern-based analysis
    http://www.cxoadvisory.com/technical-trading/classic-papers-returns-from-pattern-based-technical-analysis/

    Support and resistance (intraday, currency markets only)
    http://www.newyorkfed.org/research/epr/00v06n2/0007osle.html

    Volatility around 52-week extremes in price
    http://www.cxoadvisory.com/volatility-effects/how-the-52-week-high-and-low-affect-beta-and-volatility/

    One-week price reversals at 52-week extremes in price
    http://www.cxoadvisory.com/technical-trading/trading-after-52-week-highs-and-lows/

    Trading after N-day highs and lows
    http://www.cxoadvisory.com/technical-trading/trading-after-n-day-highs-and-lows/

    I read some of the papers at CXO Advisory a while back. Most of the indicators were found to be ineffective over large periods of time. Long-term moving averages were an exception.

  • Mike C says:

    I think I left a pretty detailed comment on this subject in the past, so perhaps I am repeating myself, but I think the essence of technical analysis isn’t momentum….that is just one tool in the overall toolbox.

    Start with Graham’s idea of the weighing machine versus the voting machine. Fundamental value analysis concerns itself with the weighing machine. What is the “real value” and from there you go to cash flows and all the various valuation methodologies as laid out in something like a Damodaran course.

    Technical analysis concerns itself with the voting machine. How does the crowd perceive the asset? Technical analysis simply attempts to identify the market psychology towards an asset. Momentum is but just one technique for identifying the greed part of the cycle. I think I made this point before, but a stock or asset could score well on a pure raw quantitative momentum metric, yet a skilled chart analyst make the case the trend has topped out and reversed. No one is going to agree 100% on every single chart pattern, support & resistance line, just as no fundamental analysts are going to agree 100% on a calculated intrinsic value based on different revenue growth rates, margin assumptions, etc. I’ve actually worked with some other people either looking at their markups, or having them look at mine, and actually there is probably about 80% agreement on what patterns we are seeing or where to draw trendlines, etc.

    Anyways, I think your perception of what technical analysis “is” is very incomplete because you are bypassing the foundational concept of “analyzing the voting machine” and going straight to a technique/tool such as 6-month momentum. I’d read the 2 books I’ve recommended. Here is the definition from the MTA:

    http://www.mta.org/eweb/dynamicpage.aspx?webcode=what-is-technical-analysis

    Now what it “is” and whether it actually “works” are 2 different questions. The academic support for pure momentum is pretty robust whereas support for pattern analysis is a little shaky but frankly I don’t believe it can really be tested in the sort of academic way that would be satisfactory. I think you have to look at real world traders who use it and see results.

  • RichL says:

    Tech analysis is a tool that, for investors, sometimes works, and sometimes doesn’t.
    It does work for retail brokers, in that they can concoct a story with little work to get trades on the page. I worked at a major wirehouse in the 1970’s, and the tech analyst had a great rep. with the sales force.
    Management tried to quantify the analyst’s record, and the performance analysis found that he was basically spinning his wheels. That analysis went on the shelf!

  • Randolph says:

    After a little more thought, and reading some of the replies, I will offer some additional comments (of unknown value).

    In the broadest consideration, technical analysis as way of approaching investing decisions does appear to be about momentum. Here I am taking momentum to be nothing more than the fact that when a stock price is moving in a direction (up or down), it is more likely to continue in that direction than to change direction (i.e. stock prices often exhibit “serial correlation”). Is there a more exact investing definition?

    The various chart formations and bands and levels are various tools that are supposed to show whether to expect a continuation (in which case you should keep your position) or a reversal (in which case you should close). After accepting that basic premise, it is all about arguing which chart patterns can be identified and what they signify.

    Another way of a thinking about it is that technical investors aren’t studying the financial statements of a company to examine cash flows or debt servicing, etc. They aren’t interested in how much they are getting for the current asking price. They are interested in price changes and making money off those changes.

    I remember reading an analysis that I had a difficult time grasping because its approach was so foreign to my way of thinking. In short, there was a line of resistance and the conclusion was that if the price goes up to X (some number above the resistance level) then BUY, but if it goes down to Y (breaking below the level), DON’T BUY. My way of thinking is that at the lower price, you should be more inclined to buy in the latter case because all else being equal, it’s a better value. That is clearly not the way the technical trader was thinking.

    Of course, technical analysts can look at valuation criteria in choosing particular stocks and entry points, just as fundamental investors can consider moving price averages or other technical measures in making their valuation based decisions.

    Incidentally, another group of investors — Asset Allocators of the Boglehead persuasion — also don’t concern themselves with investing fundamentals. In the purest incarnation, they set target percentage allocations for various stock/bond classes (large value, small growth, international bond, etc) and maintain them, regardless of valuation, maintaining agnosticism about where the various markets will go and contenting themselves with the perfect average performance.

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