What exactly is technical analysis?
Photographs: Ken Teegardin Follow/Creative Commons
Technical analysis is the practice of gauging a stock's future price pattern by analysing past activity in terms of price, volume and momentum.
Lesley Beath, a technical analyst from Australia, answered the question -- What is technical analysis? -- on Morningstar's Australia website. It has been reproduced below.
When I began using technical analysis back in the mid-1980s, I was met with a lot of derision by some fundamental analysts. They viewed it, as Burton Malkiel referred to it in his book A Random Walk Down Wall Street, as "sharing a pedestal with alchemy".
What many of them didn't realise at the time was that this form of analysis has been around far longer than most people think. In various forms it dates back hundreds of years.
The Dutch used it in the 17th century, the Japanese have used candlestick charts since the 18th century, and in the US, the writings of Charles Dow in the 19th century, and R N Elliott and W D Gann in the 20th century, are legendary.
If you think about it, these days technical and fundamental analysts both talk about such things as support and resistance, and cyclical and seasonal factors. So they are now merging. The fundamental analyst rarely spoke of those concepts back in the 1980s.
I remember the 1987 crash. I had just come out of hospital after an operation and was going to take time off to recuperate. I can't tell you how many phone calls I received from my work colleagues, most of whom had shown little regard for technical analysis.
"What now?" they would ask. "Could you possibly come into the office and update your charts?" Back then, my charts were updated daily by hand. So off I went.
Again in 2002, I received a phone call from a fellow that I used to work with. He was very well-respected and ran the investment division of a large global funds management company. "Lesley, no one knows when this will end... what do your charts say?"
For a small minority, the technical analyst will still be seen as some form of "crystal ball" gazer, one who reads the stars, and one who cannot be taken seriously. But this view has been slowly dismissed and technical analysis is now widely incorporated into the investment process.
Just as there are many facets of fundamental analysis there are many different components of technical analysis.
I incorporate an array of different factors when assessing the condition of various markets each week and my interpretation of technical analysis is quite broad.
I prefer to call it market analysis -- this includes technical analysis, comparative analysis, intermarket analysis and psychology.
When the technical analyst talks about chart patterns, or price formations (terms such as head and shoulders, tops and bottoms, rising wedges, double bottoms, triangles and key reversals to name just a few), they are often met with a roll of the eyes by the staunch fundamental analyst.
But there is nothing extraordinary about these chart formations. They simply reflect human behaviour -- fear, greed and indecision. They are a representation of the prevailing mood of the market and can indicate whether a stock is in an accumulation or distribution phase.
Some patterns work well at times and not at others. Like anything, they are used in conjunction with numerous other factors.
Trendlines and support and resistance levels are also merely a representation of market sentiment. Breaks occur when the equilibrium of supply and demand changes -- simple as that.
The analysis of price charts has always been open to a lot of subjectivity. This led, many years ago, to the development of indicators, be they volume or momentum-inspired. This was an attempt to change technical analysis, or charting as it was then known, from an art to a science. But there is still a lot of subjectivity.
Momentum indicators can be useful at times, but at other times they give little guidance. It is how you interpret them that matters. A very naive approach, for example, is to look at oversold and overbought levels as buying or selling opportunities.
But that is not the case. For a start you have to know the difference between momentum indicators that work in a trending market and those that work in a ranging market.
There are dozens of momentum indicators out there but I tend to stick with the old RSI (relative strength index) and the stochastic. They need to be analysed correctly if they are to be of any use. They have support and resistance levels of their own and breaks of those can often occur before a break in the price.
The psychology component of "market analysis" goes beyond chart formations and support and resistance levels -- it also includes such aspects as the general market mood, cover stories and consumer sentiment.
A lot of technical analysts use the Elliot Wave in their analysis of the market. I have respect for the theory but don't use it a lot. I do find, however, that the psychology associated with the different "waves" is reliable. So I do take note of that.
Even the cycles and seasonality patterns that I often talk about simply relate to the behavioural patterns of humans. There are two major explanations for the existence of cycles in markets.
The first is fundamental -- the operation of the laws of supply and demand does not happen smoothly and instantaneously. There are time lags between observing a situation and reacting to it.
Moreover, such reaction is often an overreaction, driving the market from one imbalance to an opposite imbalance. This leads to the development of cyclic swings in activity and prices.
Secondly, from a psychological aspect, markets are driven by fear and greed. There is a considerable body of literature describing how this leads to rotating periods of boom and recession in markets.
Yet another aspect as far as psychology is concerned is the investor or analyst's natural bias.
Just as the same fundamental data can be interpreted in a number of ways, so too can the technicals. It is not uncommon to see one analyst put forward a positive outlook on a stock, at the same time as another presents a negative view. Same data, different interpretation.
This is common -- what we see as an individual can often depend on what we expect to see. The investor or analyst who is bullish will "see" bullish technical patterns, and ignore, or play down, any evidence that might contradict his views.
At times we can get too wedded to a particular view and fail to see a change emerging. This is easy to do and we will all be guilty of this at some time.
To get around this, I often invert the price charts of individual indices or stocks. I then apply momentum indicators, or look for price patterns, on this inverted data. This might sound strange but I have found that it does help in the analysis.
I am reminded of the famous optical illusion of the "old woman/young girl" or "my wife and my mother-in-law," in which the brain switches between seeing a young girl and an old woman. Sometimes it is easy to see both, but at other times we keep getting drawn to the first impression and it is difficult to make the brain see the other side.
In the analysis of financial markets, it is a constant battle to see both sides of the equation. By inverting the charts we are forced to look at the opposing side of the story. This is not a common part of technical analysis, but it has served me well over the years.
Sometimes, approaching things from a different angle helps to clarify the issue.
Always remember that as we analyse the markets it is imperative that we are always questioning our view. We can never be complacent. It is at the time we are most confident in our view that we are most likely to be wrong.
The more we agonise over our view, the more we sweat, the more likely we are to be rewarded.
When thinking about the psychology of financial markets I am always reminded that times and events can change, but the one thing that doesn't change is the human reaction to those events.