Technical analysis and stock market

Despite all the fancy and exotic tools it employs, technical analysis studies supply and demand in a market in an attempt to determine what direction or trend will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

In this article, we’ll introduce you to the subject of technical analysis. It’s a broad topic, so we’ll just cover the basics, providing you with the foundation you’ll need to understand more advanced concepts down the road.

Many Sri Lankan investors focus on fundamental analysis to pick stocks. They usually verify these findings by employing technical analysis. However, it is disheartening to note how certain individuals attempted to distort findings gathered through technical analysis in order to mislead investors. This was clearly evident during the Bull Run in 2010/2011. Thus, it is vital for investors be diligent about the recommendations they receive.

Technical analysis: Basic assumptions

As stated earlier technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.

Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns while others use technical indicators and oscillators. Most use some combination of the two. In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued - the only thing that matters is a security’s past trading data and what information this data can provide about where the security might move in the future.

The field of technical analysis is based on three assumptions:

1. Market discounts everything
2. Price moves in trends
3. History tends to repeat itself

Market discounts everything

Major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that at any given time, a stock’s price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

Price moves in trends

In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.

History tends to repeat itself

Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyse market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Technical analysis: Fundamental vs. technical analysis

Technical analysis and fundamental analysis are the two main schools of thought in financial markets. As we’ve mentioned, technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals. Let’s get into the details of how these two approaches differ.

Charts vs. financial statements

At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements.

By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries to determine a company’s value. In financial terms, an analyst attempts to measure a company’s intrinsic value. In this approach, investment decisions are fairly easy to make - if the price of a stock trades below its intrinsic value, it’s a good investment. Although this is an oversimplification (fundamental analysis goes beyond just the financial statements) for the purposes of this article, this simple tenet holds true.

Technical traders, on the other hand, believe there is no reason to analyse a company’s fundamentals because these are all accounted for in the stock’s price. Technicians believe that all the information they need about a stock can be found in its charts.

Time Horizon

Fundamental analysis takes a relatively long-term approach to analyse the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years.

The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company’s value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock’s market price rises to its ‘correct’ value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This ‘long run’ can represent a timeframe of as long as several years, in some cases.

Furthermore, the numbers a fundamentalist analyses are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share don’t emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management can’t implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyse a stock is generated much more slowly than the price and volume data used by technical analysts.

Trading vs. investing

Not only is technical analysis more short term in nature than fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools.

Critics

Some critics see technical analysis as a form of black magic. Don’t be surprised to see them question the validity of the discipline to the point where they mock its supporters. In fact, technical analysis has only recently begun to enjoy some mainstream credibility. While most analysts focus on the fundamental side, just about any major stockbroker will also employ technical analysts as well.

Much of the criticism of technical analysis has its roots in academic theory - specifically the efficient market hypothesis (EMH). This theory says that the market’s price is always the correct one - any past trading information is already reflected in the price of the stock and, therefore, any analysis to find undervalued securities is useless.

There is no right answer as to who is correct. There are arguments to be made on both sides and, therefore, it’s up to you to do the homework and determine your own philosophy.