Thursday, January 3, 2013

Uptrend, Downtrend, or What?

The idea that studying graphs of past price movements of a stock or commodity (known as "charting" or "technical analysis") can reveal its future price movements is appealing, since we can't reliably predict the future course of events. 

While there have been prominent "chartists" or "market technicians" on Wall Street who  have had successful careers, I'm skeptical of the value of technical analysis.  

We all have biases as investors.  I favor assets that are unpopular and depressed in price, rather than widely popular assets that are already sharply higher in price (regardless of whether fundamental prospects are favorable).  When selecting stocks, I favor valuation, financial strength, management quality, and contrarian market psychology, rather than business fundamentals or upcoming profit reports.

I do look at some technical indicators while favoring stocks or assets that are depressed or "oversold" (abruptly lower) in price.  However, I have a bias against pure charting, where the name of the company or the commodity is irrelevant to the decision whether to own, not own, or short the asset in question.  

My impression over nearly three decades of following markets is that for every example where charting would seem to work in predicting the future price direction, there is another that would not have worked.  

A case in point is the use of uptrends, downtrends, and "breakouts."  It typically takes so long for an uptrend or downtrend clearly to have reversed direction that by the time it is decisively reversed, the percentage move in the opposite direction is substantial--and often unreliable.  That means giving up a significant portion of profits when an uptrend has been reversed by a sharply falling price, or missing a significant gain when a downtrend has been reversed by a sharply rising price.

I noticed in this week's Barron's that as of last Friday, all three Dow Jones indexes--Industrial, Transportation, and Utility--had decisively "broken down," or fallen below the rising line that connects the daily closing prices of each index.  Given that supposedly clear signal, one should sell--or even sell short--each index.  

But in the first two trading days this week, all three indexes reversed the supposed new downtrend by rising sharply (the Dow Jones Industrials rose 4%).  Which is it?  Buy or sell?  The Dow Jones Industrials declined nearly 4% before clearly breaking down and giving a "sell" signal.  Now it has rebounded 4%--and given a new "buy" signal?

I have noticed similar results when studying moving averages, either 50-day, 100-day, or 200-day moving averages of the price of an asset.  Sometimes when the price rises above--or falls below--the chosen moving average, it signals a trend reversal.  But often it is just price fluctuations that do not indicate a trend reversal.  The result is buying and selling and buying and selling, often buying somewhat high and selling somewhat lower, followed by buying back in at a higher price and selling at a lower price.  It seem to me that the result often is to "buy high and sell lower," rather than what we're supposed to do:  "buy low, sell high(er)."

It may be unfair to assert that charting often causes investors whiplash, as they reverse positions abruptly following broken uptrends or downtrends.  It does seem that when an asset builds a "base" by fluctuating at a depressed level for some time but not falling further, it produces significant gains once it "breaks out" by rising sharply.  And I realize that dedicated "chartists" would tell me that there is much more to technical analysis than I've presented.  Nevertheless, I continue to view technical analysis with skepticism and as only a small input to my investment decisions.

Steve Lehman

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