Technical Analysis is a nice punching bowl for most seasoned analysts and fund managers. Howard Marks in his book, “The Most Important Thing” suggests that its not a worthwhile strategy in not more than 300 words.
I myself despite being a follower of Technical Analysis for quite some time do not take at face value all the bull shit that goes by its name. Switch on any television channel and you shall be saturated with calls based on so called “Predictive Technical Analysis” with most analysts trying to predict where the markets / stocks may go from here on the short term.
And almost everyone who comes on TV espousing technical analysis is either working for a firm or runs his own tip providing company. When was the last time you saw a person who used Technical Analysis but was managing a fund?
What this has meant is that even Quantitative analysts (an area from which we derive a lot) look upon Technical Analysis as some sort of vodoo science fit to be ignored. But is there really any value in Technical Analysis or are we blindly following a belief that is not worthwhile?
Its a question that has been asked several times by several eminent folks and the answer I have found is that while there is merit in some forms of technical analysis, it does not mean that all the non-sense that is peddled in its name has value.
To me, any logic that is based on some sort of mathematics and can be created using a system has value. This is because by using a systematic logical process, one is able to over-ride our inherent difficulty that comes to pass as several biases showcase.
The very fact that there are hundreds of successful CTA’s who use one or the other form of Technical Analysis (Trendfollowing based) again tells me that the science is not Vodoo as many seem to think it is.
Do take a look at the performance numbers of a few of such folks here (Link) and tell me how could they achieve those returns if the market is random in nature.
Coming back to the book I am reading, Howard Mark says and I quote
Another form of relying on past stock price movements to tell you something is so- called momentum investing. It, too, exists in contravention of the random walk hypothesis. I’m unlikely to do it justice. But as I see it, investors who practice this approach operate under the assumption
that they can tell when something that has been rising will continue to rise.
Momentum investing might enable you to participate in a bull market that continues upward, but I see a lot of drawbacks. One is based on economist Herb Stein’s wry observation that “if something cannot go on forever, it will stop.” What happens to momentum investors then? How will this approach help them sell in time to avoid a decline? And what will it have them do in falling markets?
I am yet to read his latest book, but I do hope that he has in the mean time seen the evidence that has come out to showcase the fact that momentum trading has some value to it. (Link for a search).
And as to getting out when the bull market stops? Is it not as simple as just using the reverse analogy of the buy to get out. Should not be too hard, ain’t it?
Like any other form of investing, Technical Analysis is not easy too. The ease at which it captures trends seems great in hind-sight, but without putting the effort required to understand and apply the same, the ability to do that in real time is pretty low.
Technical Analysis like any other form of Analysis asks for thinking out of the box. Just like the probability of gains is low that you shall gain just because a stock is cheap, so is with most known ways of using Technical Analysis to identify entry / exit points.
So, ignore the pundits on TV and put some work to understand the nature of the markets and how you can apply a theory that enables you to capture as much of it as possible without having to take the risks that come with a pure Buy & Hope strategy.