Monday, January 23, 2006

The Value of Technical Analysis

Warren Buffett recently remarked that he does not wish to know the price of the stock prior to his analysis. He would rather do the work and estimate a value for the stock and then compare that to the current offering price. In particular, he opined that knowing the price in advance may influence his analysis. In short, Buffett values the company first before checking against its price to ascertain whether to buy into the company. What about technical analysis? It is using price as a starting point to determine if it is attractive to buy into the company. Hence, technical analysis turns Buffett's consideration on whether to purchase on its head.

Furthermore, does valuation of the company come into the picture of a chartist? Apparently not if you are looking purely at indicators such as moving averages, Japanese candlesticks, momentum etc to make your assessment. By extension, the next question to ask oneself is whether valuations matter?

Graham once famously remarked that the stock market is, if I may paraphrase, a weighting machine in the long run while it is a voting machine in the short run. His profound statement succinctly suggests that the true valuation of a company will shine through only in the longer time frame. It recognizes that the short term fluctuations are dependent on the whims and fancies of the herd who may base their decision on chart patterns or other such indicators. My sense about the value of technical analysis is that it should be looked at as a tool in the broader context of behavioral finance to understand prices in the short term if one wishes to ride its ups and downs.

Technical analysis relies on many assumptions which one may easily poke holes at. For one, it relies on the historical data to predict the future. It requires past prices to be a prologue to the future. In essence, it is driving forward while looking in the rearview mirror. Do you have a stomach for it?



Anonymous Anonymous said...

I think there is a healthy degree of bias built into your post. I find challenging my deeply held opinions to be a truly worthwile experience mostly.

I sometimes think 'indicators' in technical analysis (TA) should be more aptly called 'reflectors' as they are simply reflecting the past. Indicators are not really to predict the future so much as to help identify higher probability trades than those chosen at random. Take for example areas of supposed resistance on a chart that can be used for a stop. Interpretative yes but far from simple reading of chicken entrails.

It's well know that there is a bias to trend in most things in the financial markets, simply said there is a role for TA as markets just aren't efficient, even the sage acknowledges this. I personally get my edge from TA and quant analysis of my trading vehicles.

I find this a much easier path for myself as a retail trader than trying to emulate a company assimilator like the sage.

Interesting blog.


6:34 AM  
Blogger Mr Market said...

Andrew, thanks for your comments. Had also spend a while immersing in your thoughts at your website. Several posts offered much food for thought.

Please indulge in me as I attempt to expound my thoughts a little more.

I am not discounting the study of technical analysis as completely groundless or flawed. As there are many roads to Rome, there are probably many ways to finding investment manna.

But I see technical analysis as one of the aspects which one must comprehend in the wider context of behavioral finance if one is keen to get a handle on short term price movements.

I must, however, confess that I am inherently biased towards fundamental analysis.

For one, I cannot quite comprehend the validity of a "resistance" or a "support" line if sound fundamental analysis suggests that it is cheap at this particular price. Also some have argued that marrying technical analysis with fundamental analysis allows one to time their entry into a fundamentally sound counter.

I offer differing views. Fundamental analysis, if performed correctly, allows one to value the company. If the price quoted by Mr Market represents a comfortable margin of safety to the valuation, it is simply a signal to back up the truck. I do not see the need for technical analysis in such an analysis framework.

Another gripe is the intensity of resources required to engage in technical analysis. Personally, I cannot devote extensive time to reviewing charts on a daily basis to see if the faster moving average has cut across the slower moving average or an "engulfing bull" pattern has emerged for me to capitalize on. What is more acceptable to my schedule is devoting time during weekends to catch up on industry reports or company specific news.

Having said that, I am a strong advocate that the investing strategy must be a reflection of oneself. So it is imperative that one seeks out a strategy that is in harmony with one's characteristics.

11:33 AM  
Blogger NO DooDahs said...

There is no *one* “mister market” but several individual actors, each with their own methodology for determining price. Assume for argument’s sake that all are fundamentalists, and each one has their own estimation of intrinsic value (and discount to same) that makes a stock price attractive. As the stock price moves up or down, there will be various mixes of people who desire to buy vs sell. If the price at which sellers predominate the market persists for some period of time, it will clearly show what appears to be “resistance” to climbing above that price. See this chart of GE and note Feb-May of 2005.

Similarly, it appears that $20 has been cheap enough for AEOS to be attractive to more buyers than sellers, hence “support.”

The validity of a "resistance" or a "support" line is precisely *because* the “sound fundamental analysis” of various individuals directs the price to a level where buyers and sellers are not significantly out of balance. Keep in mind that the last price of a stock is not a point of agreement on price, but is rather the nexus of a disagreement about price – I sell for $20 because I think it ain’t worth $20, you buy for $20 because you think it’s worth more – if we both thought it was worth $20, I would be indifferent as to my preference – since I sell, I clearly value $20 more than the stock.

You state “technical analysis relies on many assumptions which one may easily poke holes at. For one, it relies on the historical data to predict the future. It requires past prices to be a prologue to the future.” Interesting, because fundamental analysis relies on *several* assumptions of historical data predicting the future. First, you rely on historical profit, balance sheet, and cash flow statements to predict a future earnings picture. Second, you rely on this assumption about future earnings (really just an approximation based on past earnings) to be a prologue to the future price of the company. While there are studies that back the value investor’s claims, there are also studies that show value in TA.

I would say that if the price quoted by “Mr Market” represents a comfortable margin of safety to the valuation, you should wait until the technical analysis shows evidence the price has stopped falling, or started re-ascending. You could save yourself a lot of capital that way. It takes no great amount of resource to do this – if you have 5-10 attractive value stocks but capital for only 2-3, instead of backing up the truck for the most likely ones (and likely catching a falling knife), just put all on a watch list, look at them every weekend, and buy the first ones that show signs of life. Not capital-intensive at all.

I agree that the investor has to be comfortable with the strategy they employ. But pushing through some initial discomfort may lead to higher profits, making you even more comfortable in the future.

3:44 AM  
Anonymous Henry Lu said...

nodoodahs and I have been debating on Technical Analysis verses Value Investing. Welcome to join us at:

7:27 AM  

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