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Technical Analysis: It’s Not What You Think

publication date: Apr 11, 2016
author/source: Brian Nelson, CFA

A version of this article appeared on our website May 9, 2014.

By Brian Nelson, CFA

I’ve spent most of the morning trying to figure out who was first to say ‘technical analysis is like reading tea leaves.' After being unsuccessful, I've given up looking and moved on to more important items. However, whoever first uttered those words -- and those that repeat it mindlessly -- may have done (and are doing) a great disservice to the novice investor. Let me explain why technical analysis in some form should be a part of your stock-selection arsenal.

Even if you do not buy into the traditional "pattern" or "breakout" nomenclature that many associate with technical analysis, a stock chart is extremely valuable in a number of different ways: 1) to assess the historical volatility of the equity 2) to evaluate the performance of the equity through the course of the economic cycle 3) to uncover correlations of the equity with other assets and 4) to assess the materiality of historical events that may repeat in the future – these are just four items, and all four of these examples are fundamentally-linked (not cup-and-handle speak, for example). A stock chart is so valuable to some that many buy-siders I know first-hand do not even know how other investors can purchase a stock without looking at one first. A stock chart and its price hold valuable forward-looking information that synthesizes market opinion, and as investors, we want to be cognizant that such information is available, and where appropriate, apply it.

There is a substantial amount of misinformation on the topic of technical analysis in the investment publishing business. For example, there are herds of individuals that repeat the "tea leaves" catch-phrase on technical analysis -- perhaps in many cases without even thinking about it. Many fundamentally-based writers may also misrepresent the concept of technical analysis to support their view that it is taboo, an opinion that they themselves may not be able to support. It may be true that writers that readily dismiss technical analysis are the ones that may have no experience using it, applying it, or even observing it. These individuals may not understand how buy and sell transactions impact a firm’s share price – or how stock prices move. But if these things don’t matter to them, should readers be taking their opinion on a topic they know nothing about? It's a good question.

"Technical Analysis" page shown below

Image shown: Page 7 of each firm's 16-page stock valuation report

I can’t speak for all technicians (nor do I want to) -- as there may be a distinct difference between how traditional technicians apply the discipline and how technical analysis is applied at Valuentum. I view technical analysis (solely) as a window into future buying or selling behavior by market participants on the basis of a firm’s stock price performance, much like value analysis is used as a window into future buying and selling behavior by market participants on the basis of a firm’s intrinsic valuation. The firm’s future stock price is difficult to predict to a degree, and the firm’s future fundamental cash-flow stream is difficult to predict to a degree. Both are mechanisms used to assess future stock price performance, and in this light, they are equally important market drivers -- no more, no less. 

To an unbiased onlooker, for example, there might not be much more to chart-reading other than investors using charts to assess the future price of stocks, and by their own actions, drive stocks higher or lower (via buying or selling) to their target prices. Equivalently, this unbiased onlooker may also conclude that there might not be much more to fundamental and value analysis other than investors using it to assess the future price of stocks, and by their own actions, drive stocks higher or lower (via buying or selling) to their fair value estimates. There is a ‘self-fulfilling’ dynamic to both disciplines – they work because other investors apply them and make them work. Interesting perspective, no?

So why do investors have such a difficult time accepting this law of the stock market as it relates to technical/momentum analysis? I personally think it comes down to the immediate dismissal of the view without independent examination and absent of experience. Thinking back to my undergraduate days, when I first started reading about investing, most of the classically-accepted books I came across made the art of chart reading out to be some kind of witchcraft, often pointing fun at some of its well-supported tenets. For example, some skeptics of technical analysis might say, "Do you really think that a stock is going to advance because it had a bullish moving average pattern?" But let's try this question as well, "Do you really think that a stock is going to advance because it is undervalued?" The answers to both might be, "Yes, because such a characteristic will attract more buyers and therefore drive the stock higher." An undervalued stock may take much longer to converge to intrinsic value than a technical "breakout" to complete, but the conceptual underpinnings of technical and value investing processes are the same: both seek to anticipate future buyer behavior.

There are two distinct ways technical analysis is applied to investment decisions at Valuentum. The first is a systematic representation within the context of the Valuentum Buying Index, the third pillar of the process (following a robust discounted cash flow and relative valuation determination). The systematic technical overlay considers a variety of technical indicators from moving averages to upside-downside volume, relative strength, and money flow assessments and beyond (as shown in the image above). The second way our team applies technical analysis is within the context of add or remove considerations with the newsletter portfolios. Using the Valuentum Buying Index, fair value estimates, fair value ranges, Economic Castle and Dividend Cushion ratio assessments, among may other parameters, we then intently look for opportunistic technical breakouts of downtrends on some of the most undervalued stocks with the strongest business models, and where appropriate, the safest dividends (as in the case of the Dividend Growth Newsletter portfolio, for example). Our technical process is as systematic in the methodology as it is hands-on in the newsletter portfolios.

I hope you found this brief introduction on how we apply technical/momentum analysis at Valuentum helpful. Part of me hopes the skeptics will never come around to accepting technical analysis' conceptual underpinnings, as I believe it is partly because of the pure value investor’s immediate dismissal of technical and momentum analysis that Valuentum stocks generate such great outperformance. If you might imagine, very few pure value investors are anticipating technical breakouts, while very few technicians are doing the depth of valuation work that we are doing. When strategic "gaps" such as these occur, the opportunity to generate alpha becomes considerable. Even if you are not convinced that applying technical analysis is right for you, at the most basic level, please don't ignore the charts, as in doing so, you are ignoring valuable, publicly-available information, a large portion of which is fundamentally-linked. If applying technical analysis in conjunction with a robust valuation process is something that you are already exploring, you are well on your way to reaping the benefits of cross-methodological work.

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