Technical analysis 3 comments

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One of the perpetually hottest debates among the stock market players is the issue of fundamental analysis vs technical analysis. On one side you have those who believe that share prices are ultimately a reflection of the company's fortunes and therefore the arcane art of stock price prediction must start and end with an analysis of the strength and profitability of the business; on the other you have an equally fervent set of mainly short-term traders who, in the purest form, believe the stock's past price-volume trading history holds the key and a vital set of clues to its future price performance, and even provide a reflection of the fundamentals of the company that are as yet not publicly known. And of course, there are the so-called hybrids who try to combine both in their investment/trading approach.

The case for technical analysis has not been helped in the sometime religious/astrological fervour to which its practitioners try to interpret buy/sell signals from their charts, and the shallowness of thought process as well as groupthink that seems to infect the most vocal of them. But at its root, there is no denying its usefulness in price prediction. The doyen of fundamental investing himself, Ben Graham, had said famously that the market was a voting machine in the short-term and a weighing machine in the long-term. And what is technical analysis, but an attempt to assess the technical position of a stock (including things like market technicals, traders' optimism, stock price momentum, buy-sell balance) in the short-term? If one takes the position that it pays to know what the average investor is thinking (although that probably also means having to guess what this average investor thinks what his counterparts are also thinking --- a never-ending paradox), then technical analysis provides a route to gauging the pulse and psychology behind a stock, never mind the underlying reasons.

The fact that most, if not all, self-respecting brokerage research houses have their technical analysis division suggests that they believe in the value of gauging market sentiment and tendencies. It is possibly a self-fulfilling prophecy: enough people believe in an idea and it becomes mainstream thinking. Ultimately it influences the price that it is attempting to predict in the first place. Of course, nobody wants to cede any advantage they could get. If one thinks generally about the market, technical analysis is similar to the comparative valuation techniques used in assigning suitable PEs, P/NTAs etc to companies by cross-referencing to peer companies in the same sector: things are ok if the trading band/general PE multiple remains the same over time, but what if the industry undergoes a downturn suggesting a deterioration in prospects and hence PE multiples? That's where the second valuation technique comes in, techniques like discounted cash flow etc ---- analogous to fundamental analysis. In short, technical analysis could be seen as the waves, fundamental analysis as the general water level.

On the other hand, what use might it be if everybody uses it? It is equivalent to the situation where nobody gets a viewing advantage in a stadium if everybody stands up to get a better view. The usefulness of technical analysis, ironically, lies in its not being too popular that the market becomes efficient in this respect, but also not being too obscure that nobody practises it and hence reducing the effectiveness of the abovestated self-fulfilling prophecy. Talking about efficient market, there are three versions: weak, semi-strong and strong. Weak-form efficiency suggests no excess returns can be earned by using investment strategies based on historical share prices or other financial data, hence implying that technical analysis is useless. Semi-strong form and strong forms postulate that share prices will adjust quickly to new information, suggesting that fundamental analysis is useless. That weak-form efficiency does not deny the usefulness of fundamental analysis while discounting the efficacy of technical analysis also shows clearly the leaning of academicians.

Basically the choice between fundamental and technical analysis for me boils down to two issues: relative effectiveness and focus. Most would agree that technical analysis is most effective over the short-term, while fundamental analysis, over a longer term. But if the market is even remotely, approximately efficient (read my views in "Is the market efficient"), then such market efficiency effects should intuitively be more prevalent over the short-term. Which suggests it makes sense to focus on longer-term techniques (ie. fundamental analysis), if one sees market efficiency as an enemy to market outperformance. Secondly, while accepting that both schools of thought are useful and possibly could even be complementary in their approach, one has only limited amount of time resources to do his "stock research". More time spent on technical analysis means less time available for fundamental analysis --- the substitution effect. So, the choice is really whether to overweight technical analysis and underweight fundamental analysis, or the contrary. But it pays to keep an open mind and to never completely deny the usefulness of technical analysis. Just as technical analysis preaches "no smoke without fire", it also makes sense to apply this cliche to technical analysis as a practice in itself.