I don't blame you if you have never heard of technical analysis (“TA”). Many people in our industry don’t understand what it means or, worse, actively deride it. What follows is an explanation of the fundamental tenets of this analysis method and how I use it in my investment approach.
What Is Technical Analysis?
At its core, TA is the study of supply and demand as expressed through price. Without needing to take an Econ 101 course, most people understand the basic idea of supply and demand. Where supply and demand meet, we arrive at what price gets paid at that moment in time for a stock, bond, commodity, etc. There are humans on both sides of the transaction, so the study of price also incorporates a lot of human behavior tendencies.
Price is the most critical data point in investing. In fact, it is the only thing that matters to our clients because our success is based on eventually selling for a higher price than we bought. Think about your quarterly statements. Do you care what the return on invested capital is for the investments in your portfolio? No! You care about what the current price is. Only price pays! There are many ways to analyze price, but I will only touch on what is most pertinent to my work.
What Type of Tools Are in My Toolbox?
- Trends – From acid-washed jeans to cryptocurrencies, humans tend to herd their behavior over periods of time. Specific to financial markets, we like to buy what is going up and sell what is going down – it is just our nature. The old adage “buy low and sell high” is incompatible with our internal operating systems. This is because when the price is low, there is usually a reason for it being low, which scares away investors—on the contrary, selling high means potentially missing out on potential future gains. For these reasons, once a trend is established, the odds of it continuing are higher than the odds of a reversal, and there is quite a bit of academic literature to back this up.
- Probability – We live in a world of probabilities while wishing things were certain. Literally everything in life is in flux to varying degrees. Studying price behavior allows us to embrace what is more likely to happen based on prior evidence but does not guarantee those outcomes. Our goal is to be aligned with these probabilities over time and to be compensated for positioning appropriately.
- Current State of the Market – The “Stock Market” is a general term that can refer to different segments of stocks depending on to whom you are speaking. Examined from a different angle, it is a market of stocks where the individual components drive the whole. TA will examine these underlying components to assess the general health of the market itself, much like a mechanic will pop the hood of your car. Doing so allows us to get a better sense of what is happening instead of looking at the daily returns of the Dow Jones.
- Risk Management – Let’s face it, nobody is right 100% of the time, not even close. When we are wrong, what do we do? Do we dig our heels in and say, “no, everybody else is wrong?” Unfortunately, many do this because they would rather be right than make money. We constantly remind ourselves that there is a difference between being wrong and staying wrong. TA allows us to identify when the market does not agree with our investment thesis, cut our losses, and move on to the next thing.
- Intermarket Analysis – Financial markets exist in a web of connectivity. The rates on government bonds affect the performance of stocks, which affects the willingness of investors to spend money, which affects the price of oil…and on and on. Studying these relationships allows us to analyze trends further and position money accordingly.
- Anti-Narrative – One of my favorite quotes is from Alexander Hamilton: “I have thought it my duty to exhibit things as they are, not as they ought to be.” If that is not a perfect description of what TA tries to do, I don’t know what is. We humans like to think of how things *should* be based on our preconceived notions of how the world works. The problem is that our minds cannot comprehend the complexity of our world. We want everything to exist in a neat narrative. Studying what prices are doing rather than opining on what they should be doing allows us to check our ego at the door and align with the prevailing trend.
Certain segments of financial professionals will deride TA as “voodoo” or “arbitrary lines on a chart.” People fear what they don’t understand. It also has to do with expectations, in my opinion. If you expect TA to give you a glimpse into the future, you are mistaken. None of us have access to data from the future, so we must work with data from the past and present to help guide our decisions. By analyzing price movements and applying the frameworks discussed above, one can make more informed decisions as part of the process.
Author: David Rath, CMT, CFA
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