A reader asked last week what I think about technical analysis.  This is my answer.

what it is

Technical analysis in the stock market is the attempt to predict future stock prices by studying current and past patterns in the buying and selling of stocks, stock indices and associated derivatives.  The primary focus is on price and trading volume data.

Technical analysis is typically contrasted with fundamental analysis, the attempt to predict future stock prices by studying macro- and microeconomic data relevant to publicly traded companies.  The primary sources of these data are SEC-mandated disclosure of publicly traded company operating results and government and industry economic statistics.

what the market is

The stock market as the intersection of the objective financial/economic characteristics of publicly traded companies with the hopes and fears of the investors who buy and sell shares.  Fundamental analysis addresses primarily the companies; technical analysis primarily addresses the hopes and fears.

ebbing and flowing

To be clear, I think there’s an awful lot of ridiculous stuff passing itself off as technical “wisdom.”  The technical analyst’s bible (which I actually read a long time ago), the 1948 Technical Analysis of Stock Trends by Edwards and Magee, is now somewhere in my basement.  I’ve never been able to make heads nor tails of most of it.

On the other hand, in the US a century ago–and in markets today where reliable company financials aren’t available–individual investors had little else to guide them.

the old days–technicals rule (by default)

What individual investors looked for back then was unusual, pattern-breaking behavior in stock prices–because they had little else to alert them to positive/negative company developments.

I think this can still be a very useful thing to do, provided you’ve watched the daily price movements of a lot of stocks over a long enough period of time that you can recognize when something strange is happening.

the rise of fundamental analysis

Starting in the 1930s, federal regulation began to force publicly traded companies to make fuller and more accurate disclosure of financial results.  The Employee Retirement Income Security Act (ERISA) of 1974 mandated minimum levels of competence in the management of pension plan assets, laying the foundation for the fundamentals-driven securities analysis and portfolio management professions we have today in the US.

past the peak

The rise of passive investing and the rationalization of investment banking after the financial crisis have together reduced the amount of high-quality fundamental research being done in the US.  Academic investment theory, mostly lost in its wacky dreamworld of efficient markets, has never been a good training ground for analytic talent.

The waning of the profession of fundamental analysis is opening the door, I think, to alternatives.

algorithmic trading

Let’s say it takes three years working under the supervision of a research director or a portfolio manager to become an analyst who can work independently.  That’s expensive.  Plus, good research directors are very hard to find.  And the marketing people who generally run investment organizations have, in my experience, little ability to evaluate younger investment talent.

In addition, traditional investment organizations are in trouble in part because they’ve been unable to keep pace with the markets despite their high-priced talent.

The solution to beefing up research without breaking the bank?  Algorithmic trading.  I imagine investment management companies think that this is like replacing craft workers with the assembly line–more product at lower cost.

Many of the software-engineered trading products will, I think, be based on technical analysis.  Why?  The data are readily available.  Often, also, the simplest relationships are the most powerful.   I don’t think that’s true in the stock market, but it will probably take time for algos to figure this out.

My bottom line:  technical analysis will increase in importance in the coming years for two reasons:  the fading of traditional fundamental analysis, and the likelihood that software engineers hired by investment management companies will emphasize technicals, at least initially.