The value of technical analysis

[2/24/07] Randy Harmelink passes on a few websites on technical analysis

http://stockcharts.com/education/IndicatorAnalysis/index.html
http://www.prophet.net/analyze/popglossary.jsp
http://www.chartfilter.com/education/index.htm
http://www.incrediblecharts.com/technical/candlesticks.htm

[10/21/06] [Dr. Sjuggerud writes] [The] topic of technical analysis is a touchy one. But before we dive into this heated debate, we should probably first come up with some sort of definition of technical analysis. How about this: Stock market technical analysis, at its core, is looking at price action alone to determine some course of action.

That said, there are essentially two heated sides of the debate, both with convincing arguments:

On the "technical analysis is a sham" side, the argument (from guys called "fundamental analysts") goes something like this: "The value of a company is purely determined by the fundamentals of that company's business, not by some silly squiggles on a chart. Therefore, the only worthwhile analysis is analyzing the company's business."

On the "technical analysis is the holy grail" side, the argument goes something like this: "Anyone who only looks at earnings and ignores emotions in the market is an idiot. The market is made up of live human beings, who always bid things up beyond any reasonable value, and sell things below any reasonable value. Sticking your head in the sand and ignoring market action is ridiculous."

Both arguments make some sense when you read them, no? As a rule, these two camps are firmly divided - you either believe stock technical analysis is useful or you don't. Generally, there is no in between. So by picking one side in this debate, I'm bound to outrage the other side. But where I stand on technical analysis actually makes NEITHER side happy...

You see, I'm in the "in between" camp - I believe that both EARNINGS and EMOTIONS matter. And therefore I like to mix and match the two. Here's what I mean...

I like to buy good values - cheap stocks. You find those through fundamental analysis. And I don't like to try to "catch a falling knife" in those stocks - I like to wait until the share price at least starts to recover to give me a margin of safety. I prefer to buy in an uptrend rather than in a downtrend.

The Investors Business Daily newspaper is the most popular example of this. It ranks stocks based on both fundamental indicators (like earnings) and technical indicators, like what's called "relative strength." (Relative strength is just what it suggests - how well a stock is performing relative to the market or its industry. In the case of Investor's Business Daily, this is based heavily on the latest three months action. So if a stock has high relative strength, it's likely beginning an uptrend.

... For one other example of useful stock technical analysis, consider the "moving average" of a stock price. While stocks fluctuate wildly over days and weeks, looking at the movement of the average over a period of time can smooth out the fluctuations and let you grasp the underlying trend. More importantly, moving averages can be a great way to significantly decrease your risk and slightly improve your returns...

Jeremy Siegel, author of Stocks for the Long Run and a noted Finance Professor at the Wharton School (University of Pennsylvania), broke with the tradition of academics and actually tested a simple technical analysis rule - the 200-day moving average - himself. During his test, when a stock's price moved above it's 200-day average, Siegel bought. And if a stock dipped below it's 200-day average, he sold.

What Siegel found is that since 1886, using the 200-day moving average as your indicator, you would have earned 2% points better than someone using a "buy and hold" strategy (11% instead of 9%, I believe), and you would have done so with significantly less risk. You were only in the market about 2/3 of the time. And my own research corroborates Siegel's - I've found that you simply don't make money in stocks when they are below their 200-day moving average.

[after reading discussion at magicformulainvesting]

[8/31/06] Chart your way to Easy Street

[5/9/06] How one contrarian uses charts

[4/24/06] veryearly1 shows an experienced view of technical analysis

[1/28/06] Here's one value investor's view on technical analysis

[1/25/06] I see that Shai has posted a discussion on technical analysis on his blog with interesting viewpoints on both sides.

[1/24/06] Joseph Khattab says technical analysis is not for him. He then proves his case by presenting 12 best-performing stocks of 2004. Four of them went up in 2005 while eight of them went down.

But let me see what these 12 stocks would have returned in total. If you had put in $1000 in each of them, you would have started with $12,000. Crunching the numbers with his data, you would have ended up with $13,500. So despite twice as many losers as winners, there was a profit of $1550 or a return of 13% which would have beaten the market in 2005. Case not so closed.

[11/9/05] Why did Citigroup fire its technical analysis research team?