technical analysis in the 21st century

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.

 

 

 

 

Tesla (TSLA), me and momentum investing

Why should a company fundamentals-driven investor have a problem with momentum investing?

Two reasons:

–momentum investing is a reactive strategy, and

–one that focuses on the past price movement of the little pieces of paper (or electronic impulses) that trade in the secondary market.

In contrast, fundamental investing is a predictive strategy based on the idea that the price of the paper/bits will ultimately be determined by the value of the underlying company.  Among fundamental investors, value investors believe that the key is the worth of the company as presently constituted (but perhaps running more smoothly than it in fact is).  Growth investors think the key is in early recognition of novel and unexpected profit positives that will fully emerge only in the future.

 

What kind of a thing, reactive or predictive, is my formula for TSLA of:   buy at $180 and sell at $250?  In a sense, I’ve got some fundamental underpinning.  My back-of-the-envelope figuring suggests nothing is likely to happen inside the company Tesla over the next couple of years that could possibly justify more than a $250 price.  And I’m willing to sell at that price even though the stock is still exhibiting positive price momentum.

But how did I get the $180?

What I’ve really done is to take a chart of the stock and draw a line that runs through the lows of the past four years or so and to conclude that this line forms the bottom of a channel (with something like $250 as the top) that TSLA has been navigating itself through since late 2013.  Yes, at $180 I have better potential for upside than I do at $250.  But that’s more a fact about arithmetic than a deep insight into corporate operations at Tesla.

In sum, then, the fundamental underpinning of at least the buying are pretty lame.

So I guess I have to say that there’s a healthier dose of momentum in my fooling around with TSLA than I might like to admit.  On another non-fundamental note, though, this ensures that my California son and I stay in regular contact.

catching a falling knife

what they say

American stock market sayings tend to be earthy and fatalistic, like “what goes around…”, or to refer to ursine gustatory “sometimes you eat the bear…” or waste evacuation practices.  Colorful, maybe, and consoling, but otherwise not very practical.

British financial clichès, on the other hand, are somewhat more high-tone but equally useless in practice–think:  “jam tomorrow,” or “horses for courses.”  One exception:   trying to catch a falling knife.  It’s a gruesome and appropriate image.

catching a falling knife

Catching a falling knife means buying a stock that’s going down in flames, while the downward spiral is still in progress.  It’s never a good idea.

On the other hand, however, if the stock in question has any intrinsic merit, there must come a time when it’s right to buy it.  And, in my view, that certainly shouldn’t be only after it has recovered, say, half of a 30% decline.  So there should be–remember, I’m an aggressive investor–a time when it’s right to behave in a way that looks a lot like grabbing for a blade in freefall.

To my mind, there are two aspects to any substantial stock/sector/market decline.  One is valuation, the other emotion.

valuation

This is the realm of fundamental analysis and is the more straightforward of the two.   Many times, stock declines begin when valuation is stretched and end when valuations are more reasonable.  This is what market corrections are all about–to provide some financial incentive–say, the possibility of a 10% gain over the coming year–for new buyers to act.

But valuation isn’t enough.

At the very beginning of my Wall Street career, I talked with everyone I could find who had experienced the market collapse of 1973-74 first-hand.  One of the portfolio managers I worked for in the late 1970s told me of buying stocks in mid-1974 for less than the net cash on the balance sheet, only to see them continue to fall, by another 10%-20%, over the ensuing six months.

Look at price charts of just about any stock today to get a more current example.  Look at their prices at the market low in March 2009.  Many were changing hands then at under 10% of the current quote.  How so?  People were scared out of their wits–something that always happens at market lows–and unable to function objectively.

emotion

This is all about technical analysis, gauging the level of investor fear/greed.

For me personally, a stock has to be trading at an attractive price on fundamentals before I’m willing to start the very subjective, voodoo-ish process of trying to figure out whether negative emotion surrounding a stock/sector/the market is mostly exhausted.

I look at:

time, since fear always takes longer to abate than I’d expect

trading volume, since sometimes downdrafts end with a final high-volume rush to sell

–the extent of the decline

–hints that the stock is finding a level below which it doesn’t want to go (this is risky, since the stock may only be two or three steps down a flight of stairs).

why write about this now?

I think the selling of “concept” stocks that we’ve seen over the past couple of months is over, and it’s time to sift through these names carefully in a more than nibbling kind of way.