More on Technical Analysis

It seems I hit a nerve yesterday: 26 comments and counting here, as well as 18 over at Seeking Alpha, and quite a few more chez Ritholtz both yesterday and today; Barry Ritholtz also has a more formal response here. Adding it all up, it seems that the majority of the comments disagree with me, but they all seem to disagree for different reasons.

Some say that technical analysis is a trading tool which tells you how and when to enter or exit positions which you're getting in or out of for fundamental reasons. Some say that it's a way of quantifying market psychology, and that there are real causal reasons for what it says. Some say that it's a fine art, which only works when used in the hands of the adept. Some say that it's all one big self-fulfilling prophecy, that it works because people believe that it works, creating a herd mentality. And then there's my favorite comment of all:

 TA showed me a seven-year double top last year (2000-2007) and I sold all my stocks on the day in July that the DOW closed at 14,002 and have been in a money market fund ever since...

Evidently for some people technical analysis is so powerful that recognizing a "seven-year double top" can and should be a reason to sell every single stock you own.

And a lot of people decided to take the ad hominem route, asking whether I was a trader, how much money I've made in the market, etc etc. For the record: I'm not a trader, I've made no money in the market, and I would never, ever recommend that anybody ever come to me for investment and/or trading advice. The full extent of my advice on both fronts is simple: don't do it. Don't try to be clever, don't try to beat the market, don't think you're smarter than anybody else. If you're asking me for advice, that's a pretty good indication right there that you're not going to be any kind of outperformer. On the other hand, don't think you're going to outperform through use of technical analysis, either.

The most basic argument against technical analysis is the same as that against any kind of active investment strategy. There are technical analysts, and then there's everybody else. If the technical analysts outperform, then everybody else, in aggregate, must be underperforming. Put aside the passive index performers: they simply track the market as a whole. So who are the investors who consistently underperform the market? Do they happen to be exactly or even mostly the same as the group of people who don't use technical analysis? It seems improbable, to say the least, especially given the fact that celebrated investors like Warren Buffett and Peter Lynch loudly and frequently declare that they think technical analysis is bullshit.

I think the silliest arguments in favor of technical analysis are the ones which basically assume their conclusions:

 Technical analysis is a tool. Like any tool, it needs to be used correctly, or the tool user is likely to sustain injuries... TA expertise takes time and effort... The reading part of a TA education would begin with Technical Analysis of Stock Trends (Edwards and Magee)...that's about 700 pages. Then add more reading, and a few years of daily market observation and price behavior, and then, maybe, you're qualified to make pronouncements on the usefulness of this tool.

The problem here is that the argument is unfalsifiable: anybody who has anything bad to say about technical analysis, and anybody who's lost money using technical analysis, is by definition unqualified to make such a determination. It's worth remembering that given the sheer number of people who use technical analysis on a daily basis, statistically speaking a lot of them will make money quite consistently on say an annual basis for many years. But the existence of such people is no indication that technical analysis is any better than picking stocks based on Super Bowl results.

As for the idea that technical analysis is one big self-fulfilling prophecy - well, I think that's easily disproven by the sheer quantity of disagreement that there is in the field over pretty much any chart.

Barry's take is more sophisticated - but then again he says right off the bat that technicals "are not a way to forecast the future", which does kinda make you wonder what they're good for. He asks what is for me a very easy-to-answer question:

 If you could look at one and only one source before buying your next stock or fund, which would you choose: a fundamental analyst's report (with no charts in it), or any chart of your choosing?

I'm no fan of fundamental analysts, but largely because they spend altogether too much time looking at the share price. An analyst's report which was written with no concept of the share price could, I think, be hugely valuable. The best investments on both the long and short side are where you buy a company trading at a fraction of its value, or where you sell a company trading at a large multiple of its value.

Let's say you have a good fundamental analyst's report which came to a compelling conclusion that a company is worth somewhere in the region of $35 per share. Then if it's trading at $7, you buy. If it's trading at $150, you sell. No chart could ever be clearer than that. The problem is that fundamental analysts tend to be shy, and generally base their valuations on wherever the stock is trading right now. And that's not very useful at all.

Insofar as technical analysis is any better than pure guesswork or astrology, I think it works as a way of gauging market sentiment and psychology. But here's the problem: everything in technical analysis seems to work backwards. No one ever seems to start from first principles and make predictions of what would happen to price-and-volume charts when sentiment does this or does that.

Instead, people start with historical charts, and look at the way prices and volumes have historically behaved during periods of given market sentiment. It's a way of guaranteeing that you're always right about the past, but I'm far from convinced it's at all useful when it comes to being right about the present or the future. As any quant fund will tell you, those kind of models work until they don't. Meanwhile, the technical-analysis crew seems to think that they're dealing with immutable, permanent, semi-scientific probabilistic laws. In the markets, there's no such thing.

Comments

[Andy Cole]

Felix, I'm sorry, but you honestly have no idea what you are talking about.

Let me refer you to the following books where you can educate yourself on the beauty of "technical analysis."

www.amazon.com/exec/ob...

www.amazon.com/exec/ob...

www.amazon.com/exec/ob...

Until you have actually become informed on what technical analysis actually is, you have no place talking about it.

Andy

[Trader Vic]

Perhaps it's time for you to take a long sabbatical and take heed from the previous comment posted. What a waste of time and space.

[User 17459]

i agree!

[p. smith]

If anyone can name a person who has made a sustantial fortune trading stocks by using "technical analysis" then i'll believe it.

years ago, I ran a day-trading firm for about 3 years, there were more than 300 people in and out total, many claimed to be experts in technical analysis.

The result: all perished or badly injured.

Those who said technical analysis were "bullshit" were winners like Warren Buffet and Peter Lynch.

I say those who arguing for the merit of technical analysis are a bunch of "blithering idiots", they just don't know what they are talking about....

[Research123]

Felix, you continue to prove the addage that those who can, do, and those who can't, teach (or write blogs if you will).

Every day I am amazed by stuff on the Web with no substance hiding behind good writing. Thank you for providing me with today's amazement.

[trader717]

Felix,

I have read both of your recent articles on TA and suggest you just stop now. Not only are you clueless on the matter, but you seem to not have put forth any effort in researching TA and how it is truly used by those who are successful. The first article was horrible, and now you come back to defend it.

I am a Jr. Portfolio Manager at a hedge fund and know that technical analysis works. It does take time to learn and takes much patience when applying it. There are also many confirmations that people tend to ignore. Much of the smart money out there knows how to use technical analysis. It is just one factor that must be considered when trading or investing. I use Free Cash Flow models, Multiple Valuations, Regression Models, Financial Statement Analysis, AND Technical Analysis when researching. These are just some of the factors investors consider, and depending on if you are trading or investing you give more weight to certain ones (i.e. if you are looking for a short-term trade you weight technicals more). Technicals also range from analyzing market stats, to chart patterns, to indicators, to looking for short squeezes. Smart money combines all of this research. There is only so much each factor can tell you, for example, a FCF model may tell you the Fair Value of a stock is $20. The stock is trading at $20 on January 1st. You decide not to invest because it is fairly valued, but by June it is at $60. By December 31st, it comes back to $20. Smart money makes 100%, you make none and think you are so intelligent because you knew it was fairly valued. Hopefully point taken.

So in the end Felix, please do not publish anything on TA like this ever again.

[cato]

One of my life's observations: people get angry when their most irrational beliefs are challenged. The more irrational the belief, the angrier they get.

The response to your articles is proof. Be glad that these people don't follow the example of their medeival predecessors, the alchemists, and try to burn you at the stake. ;-)

[Tarun]

What about Black-Scholes? Many an options trader would die without Black-Scholes (even though most of them are too full of themselves to bother understanding the math behind it). Technical Analysis may encompass options trading as well (I am referring to stock options), depending on your definition. Thus, your last sentence ("Meanwhile, the technical-analysis crew seems to think that they're dealing with immutable, permanent, semi-scientific probabilistic laws. In the markets, there's no such thing") is unfounded. The Black-Scholes standard option pricing model mathematically proves the existence of volatility (defined in terms of Ito Calculus as sigma; related to the rate of change of the value of a stock in terms of the Wiener process) and is a quantitative, technical probabilistic law that is mathematically proven (thus it has full logical proofs written that are existential-universal and relies on NO empirical evidence). Granted, Black-Scholes in the real world is often misused because traders simply don't understand the limitations of the model (the 7 assumptions: 1. Either no dividend or continuous dividends 2. Continuous trade of the underlying security 3. no taxes/costs for transactions 4. No Arbitrage 5. Short Selling is possible 6. Fractional securities 7. Risk-Free/0% Interest). However, that doesn't mean that ALL technical analysis doesn't have a solid logical foundation.

[Old Aggie]

I as well as others have benefitted from using BOTH TA and Fundamental analysis for investments. TA is a good indicator of trends and behaviors - but in my opinion, you should never invest in a company that doesn't have sound financials ... and have positive news based on positive actions.

Ignore the TA and you might make money - but add that analysis and increase the amount you make while decreasing the time to do so.

Unfortunately, investing is complex enough to not have "a silver bullet" that is 100% accurate 100% of the time.

[Tarun]

Would you count Black-Scholes as technical analysis? Some might and they would most likely dispute your last point ("Meanwhile, the technical-analysis crew seems to think that they're dealing with immutable, permanent, semi-scientific probabilistic laws. In the markets, there's no such thing."). That's not completely true; we know for sure (i.e. via mathematical proof) that implied volatility is dependent on various characteristics of options trading (assuming the existence of: 1. the ability to short sell 2. no better arbitrage opportunities 3. Continuous trading, which in and of itself is a very unrealistic idea, since there must be some discrete time in which a trade is made and has an effect on option chain pricing 4. No taxes 5. 0% Interest Rate 6. No Dividend 7. Fractional Shares). Surely, Brownian motion (found within most Stochastic models) can be disproved as an always valid methodology (a Universal-Existential proof); however we do know that Ito calculus holds and that there are set scientific rules for technical (option) analysis. Therefore, you may want to be a little more specific in your definition of technical analysis and it's "voodoo" like qualities...because there is some serious mathematical philosophy (this is not experimental proof...this is logical proof which always must hold using the basic axioms of various forms of logic) behind options modelling.

[archman82011]

Ok my 2 cents:

I used both technical analysis and fundamental analysis when buying a stock as an investment. I did not say for a "trade" for I am a lousy short term trader, the worst there ever was.
I use fundamental analysis first to learn everything about the company all its metrics, etc. The comes the T/A. Even if all the fundamental analysis in the world looks good, I wont buy a stock that is falling, falling like a knife, or in a long term down trend. Think about the folks who bought lets say PFE over the past 5 years. Regardless of drug patents other problems, etc, they were still minting billions a year, yet the stock keeps falling. Why? T/A tells you it is in a long term downtrend, etc, etc. Sure you can take a flyer on it, but why not wait until it breaks that downtrend?
T/A got me into BSC back in early 2003, and got me out in early 2006, when the stock went ballistic above its upward trending channel. Did I know it was gonna eventually go bust? Ofcourse not. I would have ended up selling anyway once it broke its upward trend channel anyway long before it ever got below $130 at the time.

Bottom line: IMHO T/A is used in conjunction with fundamental analysis. Luck also plays a role in it, for there is no way anyone can anticipate an unforseen bad news release etc. I think respect should be paid to both fundamental analysis and technical analysis, and both should not be dismissed outright. Again I am not a trader so I am not knowledgeable on using T/A for short term, swing or day trading.

[BS Detector]

To the True Believers:

If you haven't read Malkiel, or if you haven't read Taleb, shame on you for attacking a critic as uninformed regarding technical analysis. Or, to paraphrase a famous line, "voodoo stock picking."

[mark mchugh]

The real victims here are, of course, us stock astrologers, who get bashed by everybody.

Suffice to say, I think it's just mean.

[ItsJustMe]

Felix, I loved your Cramer video and I greatly admire Warren Buffett. However, Buffett and Lynch are long-term investors. They have to be because they manage billions and you can't trade short-term with billions. Technical analysis is of little use to them.

I would never put my 401k with a short-term trader. Give me Buffett. However, I have a smaller percentage of my investments that I trade short-term because unlike Buffett and Lynch, I like playing the market a lot more than "buy and forget." It's just my personality.

For years, I knew nothing about technical analysis and thought it was bullshit too. And to answer your question on who are the "under-performing traders," I was for about 4 years. I lost a LOT of money following the crowd.

But then I discovered that there were technical analysts who were reasonably good at predicting which way the crowd was about to go before they went there. Not precisely, mind you and they're occasionally wrong, but they're right enough that I now make a LOT of money investing in ETFs and index funds for a couple of months following my own "crowd indicators" as well as theirs.

Most of the technical analysts I follow advised their clients to go short between the middle of May and the first week of June (I went short May 15th) and they're still advising short but a potential turn is coming this week or next.

That was awesome advice Felix and it flies in the face of yours. How did they do that? How did they know to advise me to go long the day after Bear Stearns? I asked myself that same question 5 years ago and it's been a very profitable revelation...

[Wall Street Weather]

Felix: Beyond the silliness of how astrology is portrayed in the media, I believe that just as geophysical forces can influences the tides, so can they influence human behavior. And we all know that human behavior is the greatest force in the stock market. Deborah

[pochovilla]

I guess I'm from the old school. I lick my finger to see which way the wind is blowing and then use gauges to tell me wind direction and wind speed. Unfortunately this method of forecasting using a combination of fundamental and technical analysis has a few limitations too.

[Xyrus]

The only way for all forms of technical analysis to be useless would be if and only if the market consisted as a series of independent events. In other words, the market is like flipping a coin.

But as anyone who watches the market can attest to, that is hardly the case. Decisions by traders are governed by numerous factors and they vary trader to trader. New market information can take X amount of time to make the rounds. The markets are governed by behaviors and information, not random coin flipping.

TA, along with any other market analysis, attempts to quantify the effects of behavior and information on the market. While I personally don't like some aspects of TA (I disagree with chart "patterns"), other aspects provide good indications of what the market thinks.

Is it prediction? No. Can it? No. But what it can do is give you some ideas on where the market could be heading.

TA can be wrong. All signs could be pointing down but some unexpected good news can snap the market back. That's one of the reasons why rapid trading, even with a whole suite of TAs can sink an investor. But using a couple of TAs to determine when a good buy point might be for longer term holding can be useful. At least that's how I use.

As Tarun pointed out, even the market is subject to the laws of probability.

~X~

[User 215137]

Fishy,

You are amazing good at proving what you do not know by spouting what you think you know.

Lets just go with one case - the psychological determination of volume at a support level.

When a large (hopefully very large) number of shareholders own a stock at a certain price - a concentration of trading volume - and the stock trades higher, a larger percentage of the stockholders are happy as they are in the money and less likely to sell. They think they picked a good stock and are more likely to hold onto it as, the only reason you buy a stock is to see it go higher, this stock has moved higher and they are having a good, profitable experience with this stock - they will be less likely to sell, offer the shares out, etc... which in effect takes shares off the market and give the stock an upward bias - especially near support. Thus, in the prices above support there is an upward bias.

On the other hand - should the stock be below that price they are not happy and more likely to pull the trigger. This means the stock hias a hgher propensity to go down as more owners of the stock have a higher propensity to sell as they are displeased with the performance. This is the basic concept of support - which is that level about where the volume traded and a large number of shareholders are bought in. Thus, is the areas below support there is a downward bias.

Now this is a very simplified explanation of support and on factor of the importance of technical analysis using just the trading volume indicator - but the audience I am writing for is YOU. Simple.

Learn anything today?

[echotoall]

"everything in technical analysis seems to work backwards"

true, but your ignoring principals surrounding the historical data. Your ignoring the value in that data. We can not ignore the importance of regression analysis and Six Sigma simply because these principals primarily use historical data.

Technical analysis, when used correctly, is unbelieveably valuable. Markets change, so how u use technical analysis must change as well. Just like Quant models must change with market conditions to be truly effective. (if you can not understand this, you will not understand the principals of TA, hence u will continue to bash it.)

Stocks have no memory, but the prinipals of human behavior do. Markets are driven by people, and people have psychologies. The psychologies are driven by patterns, logical principals (ie scientific) and/or unknowing principals (ie the 'golden ratio' being so important far reaching applications of life, in engineering/science and markets).

anything exposed to a market has a behavior because of the human element driving the market entity, and TA facilitates in understanding that behavior. ignoring it is careless.

in any case... it works for me, and i list the trades (with charts) on my blog to back up the value in TA.

[squashnut]

Technical analysis is of course complete bullsh*t. Complete. But it can appear to work. Why? Because so many fools actually trade on it, it becomes self-perpetuating! Or 50% of time through luck. Until the fundamentals catch up with reality and everything crashes!! Which will happen within six months. A Placebo Effect can make you feel much better in the short run. Then the cancer grows too big.

[User 215137]

Here is ONE BIG REASON why the self-fulfilling nature of Technical Analysis is true - i.e. the more trades that use this appoach, the more it works...

What do you think computers use?

[User 215137]

Squashnut...

those that use technical analysis 1) usually are not in for 6 months and 2) their technicals will tell them when 'the fundamentals' are catching up and to exit the trade (if adhered to properly)

[Ken225]

No indicator, fundamental or technical, works on all stocks at all times. It makes no sense at all to say that technical analysis "doesn't work". If it truely didn't work then you could simply reverse the signals and buy when it says sell and sell when it says buy, then it "would work" right? The key to making technical analysis (or any analysis) "work" is to use statistics. You have to backtest the signals on historical data and see which indicators work best for which stocks.

-Ken
Todays Breakout Stocks and Statistics
pages.sbcglobal.net/ac...

[JJ Dupree]

Remember this is the guy who uses Jim Cramer, the Anti-Technician,
as his technical frame of reference. TA won't work for everyone
(fundamentals don't work best for me). Especially for folks who haven't studied or committed to it. Please stop referring to Warren Buffet..the guy is a deep value investor..of course he doesn't believe in TA. For the record Paul Tudor Jones and Stanley Druckenmiller use technicals..last time I checked those guys are
doing a ok. Err, is the Forbes list not good enough? At the end of the day its all about returns..so who really cares.

[Ken225]

Yeah, and also James Simons at Renaissance Technologies who manages oh about $30 billion uses technicals and statistics and has a long term track record of 38%+ annual return (and thats after 40%+ fees!!).

A funny thing about Buffett, his number one rule when buying companies is that they have to have long and stable operating histories. Well companies with long and stable operating histories have long and stable price trends. Stocks with long and stable price trends have good technicals. So in reality is he is buying stocks with good long-term technicals.

[Moral Hazards Amok]

98% of TA is garbage! It's the other 2% that's making me very good money -- even now.

[GKM]

Technical analysis works BECAUSE there are those who don't use it. So to those who follow TA, just let the nay-sayers win - it will be much more profitable that way. EOS.

Salmonites, please go and hold hands with the Cramericans and sing Kumbaya. I wish both of you all the best and I'll see you again tomorrow in the market ;^)

[fallond]

Its not simply a case of one or the other; technicals or fundamentals. Collective intelligence works better than the individual sum of their parts. My (lengthy) response is given here:

zignalsblog.blogspot.c...

Best wishes,
DJF

[yogatrader]

fascinating comments.

my question is: if you have a successful process such as TA, why be so eager to defend and explain it's merits, instead of quietly trading against conventional wisdom?

For example, I trade against Black-Scholes users, and I'm ecstatic when I see it advocated.

Cheers. Happy Trading.

[francis schutte]

Technical Analysis is an art that needs to be learned, and asks for a lot of discipline. As with any profession in life, some people will master it and some will never. It takes a life time of experience to become a good technical analyst. I have 25 years of experience, made a lot of excellent calls, also made some mistakes...but I am learning each other day!

[satellite radio is dead]

The number of potato heads on these message boards defending TA is game, set, match AGAINST it. All of you dunderheads: the only reason you can defend TA as authentic is because you've made money using it in this bull phase of the market cycle that has long exceeded its normal life. You clearly haven't been investing very long, because if you did, you'd realize that the length of this bull phase is very atypical. For this reason, you can't use TA to achieve returns that beat the market over the long-term. It's called weak-form efficient market hypothesis, and history proves that you're dead wrong if you think you can rely upon it in any phase of the market cycle. Those of you who are defending TA: be looking for a job, because your black swans, cups & saucers, and point-figures won't work in the bear phase that approaches.

[Ken225]

yogatrader, we could ask you the same question. Why are you telling us you trade against Black-Scholes? Why not just continue trading quietly? Why does warren buffett talk about how he trades?