Does technical analysis even work?

Rick is skeptical about the value of technical analysis:

I would be very skeptical that technical analysis works- here is a link discussing the controversy:
http://en.wikipedia.org/wiki/Technical_analysis#Empirical_evidence
I’ve never heard of anyone getting very rich from technical analysis. Plus neither Peter Lynch nor Warren Buffett believes in it.
A web site that tells you when to buy/sell stocks strikes me as too good to be true. Let’s say that you had a stock purchasing system that WORKED- would you
A Make it available to the world on a website/write a book and make $1M
B Keep it secret, start your own hedge fund and make $1B.
I’m guessing A wouldn’t be too likely… Also if you did have a system that really worked then making it widely known will cause the system to be useless. Why? For every transaction there must be a buyer and seller. If many potential sellers see a “buy” signal at the current prince they will demand a higher price to sell driving the price up. Similarly, if many potential buyers see a “sell” signal at the current prince they will demand a lower price to buy forcing the price down. The final result is that the pool of believers in the system will force the actual price to agree with the system’s prediction of a fair price.

Rick might be a little surprised to know – given my recent posts, apparently condoning technical analysis a lá Phil Town – that I tend to agree with him!

Firstly, keep in mind that I am on record as stating that I am not the ‘go to’ guy on any specific form of investment (perhaps some on business, less on real-estate, even less on stocks, and so on) … my ‘expertise’ (more like ‘passion’) is in the overall strategy of wealth-building, and showing how these individual pieces fall into place.

Also, I am a ‘value guy’ … I love to sniff out a bargain – be it a business, property, or stock – and pounce, and am a fan of Phil Town’s valuation methods (although, I will point out my ‘issues’ with his methodology in a future post).

And, I agree in principle that if you COULD:

a) Identify a stock that was under-priced, and

b) Avoid the market dips by selling out (then rebuying)

… you would increase your returns and – MUCH more importantly – avoid holding onto an under-priced ENRON … one that you thought was cheap but some disaster strikes that the ‘big Boys’ get wind of early.

In principle, that is 😉

Look:

1. There have been successful traders, but none that I know of with longevity; it’s a speculation / business … so, if you are prepared to take the chance on the big run up – then sell off – PERHAPS, just perhaps, you can make it big? Jesse Livermore did it 4 times (before putting a gun to his own head when he crashed for the 4th time).

2. Phil Town suggests that the ‘big guys’ (the huge mutual funds) put so much money in/out of the market that they have to make their move over a number of weeks to avoid the sudden price movement that you suggest. IF this is true and IF you can use technical signals to tell you when the run up/down is occurring, then Phil says that the smaller investor can use these signals to move instantly (in 8 seconds, v the ‘big guys’ 6 weeks).

… and, I have certainly used Phil’s methods to suffer ‘only’ a 15% loss when the rest of the market soured by 50+% (and, you need to remember that I have been actively trading since the crash UNTIL it bottomed and have been in cash since for reasons unrelated to the market), so my personal experience is that the ‘3 indicators’ ARE useful.

The catch is, I don’t know why, because they are all PRICE indicators, not VOLUME … in fact, volume only tells you of an increase in activity, there can be no net buying/selling because there are two parties in every trade (the ‘hint’, I guess, is in the price … it goes up/down according to market sentiment).

So, I am a fan of ‘value investing’ (if you can find the right way to reliably value a stock and can then find one that is way under priced … I believe that this happens often enough to make it useful) and am experimenting with the technical indicators to get in/out, but am – like you – skeptical, but not complaining while I am getting positive results …

… but, please DON’T read this post, I am planning to start my own hedge fund 😉

This week’s Carnival of Personal Finance is out; we’re buried in their list somewhere ….

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10 thoughts on “Does technical analysis even work?

  1. The concept of getting in the middle of a big mutual fund’s move is the only good reason for technical analysis like this that I’ve heard… it would be interesting to compare the aveerage holding of a large fund with the daily volume of the stock to see if it’s valid.

    Of course this can’t be happening too much or I feel sorry for the unitholders in those funds 🙂 And of course you have to wonder what could come up that would have a stronger effect on the stock price than a fund manager (ie, real news).

    In the end it’s nice to think that you can somehow sell and rebuy every time a stock goes down, but you might as well ask “why can’t I just buy the walmarts and microsofts when they’re small?”.

  2. @ SiliconPrairie – I must admit, that this ‘theory’ has worked for me; but, I am a small sample of ‘1’ … however, the theory also states that the ‘Big Guys’ know about the news upfront: no insider trading as such, but when they have lunch with the chairman of the board a hint as to how the figures are looking may appear … who knows, maybe these fund managers are also great poker players because they can read people? 😉

  3. Personally, I believe Technological analysis can be a helpful tool, but only after you have Identified that undervalued stock your looking for. Then it usually will tell you the best times to get in,But I think we need to use our own judgment as to when to get out , as this depends so much on your ( risk tolerance (willingness to lose a bit).

  4. Adrian,

    If you don’t believe it works why risk using it? Have you ever bought or sold a property based only on some analyst’s opinion of the price? What about an analysis’s that you didn’t trust? Also, just because it works a few times doesn’t prove it really works, it could just be luck. Here is an interesting article that talks about how luck could be responsible for managed mutual funds beating the market:
    http://www.obliviousinvestor.com/2009/04/skill-vs-luck-in-mutual-fund-performance/

    @ SiliconPrairie – My question would be how can you differentiate a large firm’s change in position vs. a simple rebalancing before its too late? It seems to me that the large firms would have a lot of money at stake and would NOT want the general public to know about any major sale or purchase.
    -Rick Francis

  5. @ Rick – Your point to Silicon explains Phil Town’s strategy: the ‘big boys’ (usually the major insurance companies and funds) try to move in/out of positions slowly (often over many weeks) in order NOT to unduly influence the stock price. Phil says that the ‘trading signals’ that he uses indicate that activity …

    … since I don’t know whether this is true or not but (a) like the concept/theory and (b) unfortunately am not the type of investor to just sit on his thumbs, I gave it a try with a small % of my portfolio (if you call USD$1 mill. … 100% borrowed ‘small’). Nothing sensible in my approach, at all! 🙂

  6. Rick: I wouldn’t know how to get into that (part of the reason I wouldn’t attempt any of this) – but a simple “backtest” to see if this could be a valid indicator is to check at what level a fund’s move would have had an impact on the share price. If any fund over $200M taking a position that’s too small to make it into the reports would give clear signals, then this could yield a lot of opportunities. On the other hand if it’s only the top 10 holdings of $10B+ funds that are traded this slowly and you’re getting signals every day you might ask a few questions.

    Adrian: It’s not hard to imagine all kinds of communication that aren’t part of the insider trading and disclosure rules. On the other hand, this would imply that all these fund managers should do quite well with their information advantage. That largely isn’t the case – unless the fund sizes, trading costs can actually guarantee mediocrity even when you know the news before it comes up. You aren’t investing in these funds or even necessarily trying to identify whether a stock is overpriced or underpriced, so as long as you just want to see when you should get in and get out within a couple of weeks this may work until it’s used too widely (maybe some of the banks would like to recapitalize by buying a $20 book and making some smart trades?)

  7. @ SiliconPrairie – I guess my point is it may work or it may not; I’m not a purveyor or promoter of trading systems (or any other ‘get rich quick’ system of any kind) … my ‘expertise’ (more like a passion) is in the overarching principles of (real) wealth creation/retention. Sometimes, I just share things that I am doing … and, I’ve been ‘doing’ Rule # 1. It’s fun, and (so far) it’s worked for me! I can say one thing for sure, it’s made Phil a lot of money … at least from book sales and speaking engagements 😛

  8. I think that the question is not whether TA works but whether the TA strategy one is using works. Furthermore I don’t understand Rick’s logic when he says that starting s hedge fund is the best option when one has a TA system that works. Some TA strategies would not lend themselves to a hedge fund and some traders would not want to uproot their lives to start one. They may however find creating an additional stream of cash flow through a web site or book enhances their lifestyle and provides additional money to invest.

    Outside of arbitrage strategies making a system widely known is unlikely to reduce its effectiveness. This is because following a system requires emotional discipline that the vast majority of market participants lack. Most people in the market could not make money even with a good TA system because of their tendency to change the trading rules and their inability to stick with a system after a string of loses.

    How people can argue that TA does not work when there is so much evidence that it does escapes me. It is not difficult to find people who have become very rich through TA, many of them are even on the Forbes Rich List. Check it out – http://etfhq.com/blog/2010/02/17/top-technical-analysts/

  9. I believe Technical Analysis can be a helpful tool, but only after you have Identified that undervalued stock your looking for. Then it usually will tell you the best times to get in.

  10. @ Virenda – A nice idea, very well implemented by Pete Town in his best-seller: Rule # 1 Investing

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