The case against technical analysis

Well,

With the pace at which we folks at valuepickr have started embarrassing a new and sophisticated tool like technical analysis and it’s offshoot techno-funda analysis, this thread was inevitable. Someone has to start this discussion on why, how, where, when, in work. I have started a small thread on why I dislike technical analysis, and the futility of such exercise in my portfolio thread.

To me, seems like we folks at valuepickr have succumbed to what we call the “the magic of sophisticated”. We human, tends to like something which is new and sophisticated as compared to old and what worked, in the process forgetting to ask why it work, where it doesn’t work, what are the risk and what is the success rate. Countless of financial debales have happened because of this herd mentality and open acceptance of un-tested sophisticated tools.

I can list the reasons why it doesn’t work, and why I maintain a comfortable distance from it. But that I think won’t be the correct way to start it. To me, the best way to start it, should be by folks who are deep into technical analysis, explain us in detail on technical analysis, and then we can fire our questions on them. My initial set of queries are

1). Why does technical analysis work ? What are the underlying philosophies?

2). Where can we apply technical analysis, where we can’t apply technical analysis?

3). What are the risks involved in technical analysis. What are the ways to reduce the risk?

4). What are the success rate? May be few academic paper link should do, where these methods are put into test tubes to analyze them?

5). There are countless folks who have made fortune by following fundamental analysis. Are there folks who have made similar fortune by doing tech analysis

6). What about mini-black-swan event like Arshiya/Ajanta. Can they be predicated in advance via tech analysis.

I shall fire my next set of question after someone answer these queries. My aim here is to learn and understand technical analysis in a more fundamental way.

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I think technical analysis works because of the human factor involved in markets.

People are anchored to certain price levels and when a stock reaches that price levels, we see certain strong moves. These price levels can be like 200 dma, 50 dma, 100,500,1000,etc.

Technical analysis bets on the way people have reacted to certain price levels in past.

This is a wonderful article by Ravee Mehta

http://seekingalpha.com/instablog/4575631-ravee-mehta/1033611-why-technical-analysis-works

But this debate can go on and on and thats the reason why there are fundamentalists and technical analysts. And those whobelievein both and “techno-fundoooooo” :smiley:

subash,

regarding your query no 6 esp related to ajanta, we have the answer at this thread:

linkhttp://www.valuepickr.com/forum/techno-funda-picks/237426047

we had predicted targets of 520 plus for the stock when it was around 380 odd.

Problem is that accuracy is not 100%.

Thanks Rohit,

You tried answering my question #1. But it again opens up bunch of more questions. I have read a bunch of books on various investing techniques like growth investing, index investing and so on. All of them starts with aiming at harnessing human behavioral biases by taking on just 1-2 human tendency and making a castle out of it. The problem with that approach is 2 fold.

1). If human psychology is the driving block behind technical analysis, than one should be visiting it every and then in tech analysis. But the fact is, no technical analyst does so. All they care is a graph, with 10s of subgraph, and estoric and exotic sounding names like RSI, EMA, Stocastic, Elliot Wave and so on.

2). There are not just 2-3 human behavior bias, but at least 20-30 of them. Having a castle with just 2-3 idea is same as “one legged man in an ass kicking competition”, in one word, deadly. This is precisely why I love PCA, may be it is difficult to apply in principle, but hey, nothing great in the world is easy to master.

What about answer to rest of 5 questions, and answer to the Ajanta/Arshiya phenomenon.

Hi Subhash,

That is one attention grabbing title. Its one of those touchy subjects. Like growth vs value, Tendulkar vs Lara, Shahrukh vs Salman vs Aamir etc. A thousand and one opinions and at the end of the day nobody changes sides :slight_smile:

So, I guess you need to think about the point of this discussion. Coz I doubt you are going to convert any TA people and vice versa.

To me, a tool is useful if it helps achieve one’s objective. I have picked up the simple techniques of TA thanks to Hitesh/H Gupta/Bala/Tony/Deepak Singh(state of the market blog). For my short term portfolio, its been very useful.

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I am quite neutral as far as technical analysis is concerned [infact aware of very few of its fundas] , but in the last six months seen couple of cases where simple things like focus on delivery volume and average of past 150 days or so, can help you to avoid falling in operators trap who are trying to jack up stock price. Eg. See Halonix price for last six months to a year. In general the spike in stock price is followed by very low delivery and the stock price has fallen within a short time. So generally I stick to fundamental analysis, but I do check delivery volume and stock price for last 30, 90 and 150 days, mainly to find out if the stock price is being jacked up by any operator and not to determine my entry price.

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Hi Hitesh bhai, HG, Anil Kumar,

The reason why I started this thread is that, yesterday I read Oaktree Capital’s July-2009 memo. There he has explained how investor falls for new and sophisticated instruments, without caring much about the fundamentals and risk involved with it. I felt the new trend of asking for technically analyzing stock fitted perfectly with this, and hence started this thread.

Hiteshji,

Coming to prediction of Ajanta matching somehow to the target, we know from fundamental analysis it would hit that mark eventually. Technical analysis didn’t give me any time limit when it shall be hit. So to me it gave me no extra info.

Secondly we shouldn’t get confused good outcome with good process. In short term we might get good result with a bad process, which doesn’t implies that it will be true for long term.

Thirdly we know for sure that technical analysis doesn’t work 100% time. Have we tried to understand what % of time it works (say for fundamentally good stocks, and fundamentally unsound stocks). Don’t you think we should think why it work, when it works and why it doesn’t work when it doesn’t work.

Hi HG,

This thread is not about telling which approach is better technical or fundamental. The aim of this thread is to find out why technical analysis work. Frankly speaking emotions have very less usage in the world of investing. Falling in love with ideas, and stocks is a sure shot way to get yourself shot badly. One need to analyze the process and understand it deeply, modify the process with changing time to sustain in the world of investing. I don’t want to convert TA guys to FA guys. All I want is a intellectual discussion to understand TA deeply.

Hi Anil,

As I said, delivery %/volume is a straight forward, easy to understand concept, and hence worth applying in one’s investing practice. What I want is to get is to get inside the skins of TA and understand it.

subash,

If you want to get into the skins of TA and understand it, you will not get much out of discussion on this thread. I think that will entail reading some good book on the subject which will help you in your objective.

Personally I find TA quite useful and in conjunction with fundamentals tends to give satisfactory results.

If you read all the books by fundamental guys like Buffett, Lynch, and the lot there is always a tendency to give TA a bit of bashing.

But again if you try to get into the skin of TA as you mention it, there will be useful things there as well. But as mentioned above you will need to read the TA books with a lot of concentration.

regards

hitesh.

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Finally it all boils down to what works for us as investors.

If TA helps someone, so be it.

If we can do without it… great.

Why should we make a case against it?

What we can discuss is buying / selling in short term… does that help? I feel this question is more important… whether you arrive at the buy sell decision using TA or FA.

1.Why does technical analysis work ? What are the underlying philosophies?

TA is about predicting future pattern based on historical data. because in the past the price has stopped falling to a level and started raising, there’s a possibility it might work again in the future. the more number of times it behaved in a certain way the more chances it will repeat in future. the underlying philosophy is behaviour patterns. does it mean it will work every time. no. the chances are better. now you build a complete system (with good money management, risk protection (stoploss) ) so that even if it works x number of times out of 100 you can still make money. there are systems with profitability at 25% hit rate

2). Where can we apply technical analysis, where we can’t apply technical analysis?

we need to apply TA within the fundamental analysis. that means first identify what to buy. then apply TA to figure out when to buy. TA gives you better margin of safety. TA works well for large cap stocks. it doesnt work so much in indian equity as there are gap ups/downs and volumes are far far less compared to forex markets. it doesnt work well when the fundamentals are changing. like ajanta rose 50% in 3 days due to fantastic results. in such case no resistence or trends would work. use TA within FA. dont use TA by itself however great you are at it. when everything else is same, then TA would work. that means no news, no results, no govt policy decisions, no major econonic events domestic/global

3). What are the risks involved in technical analysis. What are the ways to reduce the risk?

the risk is we cant guarantee future based on past. so always have a stoploss. try to get more safety margin, get risk reward ratio in your favor, take only the strongest signals. major risk is most of the exotic indicators wont work in indian context, they are researched to work within a certain asset class with some behaviourial pattern. use simple indicators and use them wisely.

4). What are the success rate? May be few academic paper link should do, where these methods are put into test tubes to analyze them?

this is a tool. not a strategy by itself. it is as good as the person using it. you give a best tool to a fool, he can blow up the account in no time. can we asses the success rate of fundamental analysis ? there are lot of knowledgable investors in this forum who have invested in ashriya. can you blame their analysis ? there are so many factors in each analysis and some lay more importance to some factors and sometimes it works and some times it doesnt. how many of the ‘turn around’ stories have really turned around ? how many of ‘short term’ mismatches have actually closed ? giving a number to the success rate is meaningless. giving 100% doesnt make it poolfroop, giving 0% make it worthless. combined with other skills such as proper mental model, proper money management method you can make a losing strategy into a winning proposition.

5). There are countless folks who have made fortune by following fundamental analysis. Are there folks who have made similar fortune by doing tech analysis

yes there are. i have seen some brilliant guys in every field. the common factor among all these folks are they are very simple, they apply simple common sense, have tons of patience, have excellent control over the mind. you hear so many failed patterns because there are more greedy people around. i can say 90% of investors/traders i came across are greedy and want to become rich over night. IBM hires a topper in oceanalogy because a smart guy is smart regardless of what field he comes from.

6). What about mini-black-swan event like Arshiya/Ajanta. Can they be predicated in advance via tech analysis.

no. technical analysis doesnt predict such events. TA takes past data and extrapolates into future. its not a magic wand to see whats in future. can fundamental analysis predict labour strikes and pollution issues in hawkins ? we can only react after the event.

in short, its better to use TA in conjuction with FA and try to increase margin of safety, get more conviction, be ready to face ‘temporary’ road blocks successfully. confluence of several factors (both TA and FA) make it a winning proposition.

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The only challenge I have personally had with TA is it tells me to “stop loss” precisely when I want to double up and buy more because the price has gone down and the fundamentals are intact!!

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In fact, the only person that I have seen use TA effectively for some period of time is Hitesh. I have tracked the performance of some of the stalwarts of TA on CNBC, but find them with fairly poor long term record. On a personal level as well, I don’t know anyone who has made money consistently on TA. But that maybe because of the lack of knowledge, rigour and discipline and may not be a reflection on the discipline of TA per se.

Hi,

Some basic points

  1. Technical Analysis started with mr Charles Dow in 1880-1920. I think the major books on investments came in 1930s. So maybe one can even argue about Fundamental Analysis being a new study.

  2. Technical Analysis is a study of price, volumes , time and is essentially a study of demand supply. Prices are sum of greed and fear if investors were to act only on Fundamentals then there can only be 10-20 trigger days like results, agms, news etc.

  3. Technical Analysis is applicable on every instrument which is widely held. So it may not work on terribly small caps where there are thin volumes and that too circular at times.

  4. The biggest reason for one to apply Technical Analysis is controlling risk with a stoploss or through invalidation of pattern. Fundamental Analysis has no exit plan on the price side but only on business change.

  5. Technical Analysis is used to trade markets with a risk-reward in mind and there are no strict rules and is an art. Many a times its technicals which gives you a better foresight much before fundamentals. 2008 being a very important time has led people to get a bit of technicals.

  6. For all the fundamental folks who have made a fortune have been through multiplying money by 100x or 200x. As a matter of fact a technical trader does not try to do that but make a consistent return with lower risks beating benchmarks and normal returns.

So a story of somebody making 20-25% returns on a moderate capital will never be heard of. Also a technical trader generally bets on his own money.

  1. There are many events of big moves predicted technically before the announcement comes in.

One of the main reasons has been that Technical Analysis as a study has been projected as short term and quick picks rather than for major trend analysis where it usually works the best.

P.S - I am into technicals since last 8 years and also take good interest in deep value picks.

My belief is if an investor would do a bit of technicals will help in asset allocation in a big way and make them spot changes like in 2008/2011 and maybe one more such change in 2014.

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Hi,

Some basic points

  1. Technical Analysis started with mr Charles Dow in 1880-1920. I think the major books on investments came in 1930s. So maybe one can even argue about Fundamental Analysis being a new study.

  2. Technical Analysis is a study of price, volumes , time and is essentially a study of demand supply. Prices are sum of greed and fear if investors were to act only on Fundamentals then there can only be 10-20 trigger days like results, agms, news etc.

  3. Technical Analysis is applicable on every instrument which is widely held. So it may not work on terribly small caps where there are thin volumes and that too circular at times.

  4. The biggest reason for one to apply Technical Analysis is controlling risk with a stoploss or through invalidation of pattern. Fundamental Analysis has no exit plan on the price side but only on business change.

  5. Technical Analysis is used to trade markets with a risk-reward in mind and there are no strict rules and is an art. Many a times its technicals which gives you a better foresight much before fundamentals. 2008 being a very important time has led people to get a bit of technicals.

  6. For all the fundamental folks who have made a fortune have been through multiplying money by 100x or 200x. As a matter of fact a technical trader does not try to do that but make a consistent return with lower risks beating benchmarks and normal returns.

So a story of somebody making 20-25% returns on a moderate capital will never be heard of. Also a technical trader generally bets on his own money.

  1. There are many events of big moves predicted technically before the announcement comes in.

One of the main reasons has been that Technical Analysis as a study has been projected as short term and quick picks rather than for major trend analysis where it usually works the best.

P.S - I am into technicals since last 8 years and also take good interest in deep value picks.

My belief is if an investor would do a bit of technicals will help in asset allocation in a big way and make them spot changes like in 2008/2011 and maybe one more such change in 2014.

1). Like FA is not the holy grail for making money in the markets similarly even TA is not the holy grail. In neither of the attempts you get 100% strike ratio. So asking for examples in every case of crackdown either from FA or TA guys is non-sensible. Both the disciplines work on probabilities.

2). Companies on the long term advance only bcoz of fundamental reason, so it will be right to say TA follows FA.

3). How is TA helpful in investing is it helps you determine the pivot levels and you can decide to buy or sell based on break-out/down from these levels.

4). lots of time many fundamentally good companies keep going down. Any guy buying this script will see his wealth eroding daily and this has a lot of psychological damage on the investor, he starts losing his confidence, but a simple strategy to buy only above 200MA will ascertain you buying into a uptrend if not atleast not in a downtrend.

5). Stoch might be used for add-ons/scaling-in to good stocks already in an uptrend, so as to buy when the stoch comes out from oversold levels.

Also if you havent tried TA its very hard to really debate on the pros & cons. There are a million ways of making money in the markets and you just need to excel in anyone method tosuccessfullymake money from the markets, so you might even let TA pass… nothing wrong in it…

Hi Subash,

I had written the below mentioned article addressed to you in Importance of Cloning elsewhere on this site. Please do read this again. The key to success is to use both fundamental and technical analysis in conjunction to give the best results. This has worked for me and I stand by it.

Fundamental Analysis answers the question of " What to buy", while Technical Analysis answers the question of “when to buy”. In his book Tom Dorsey’s Trading Tips, the author refers to an article written by Gretchen Morgenson in the New York Times (December 31, 2000) titled " How did so many get it Wrong". She poses a question, " How can so many who are paid so much to scrutinize companies have blown it so spectacularly for their investor customers?" The article was not very flattering on the fundamentalist’s work to say the least.

In the article, Anthony Noto at Goldman Sachs sums up the dilemma faced by fundamental analysts, and in doing so, points out why it is important to incorporate technical analysis with your fundamental analysis. Mr. Noto goes on to say " Our research is driven by fundamental analysis and is not influenced by anything else". He went on to explain that the companies he follows saw their stock prices drop last spring not because their operations were failing,but because the market psychology had changed. He downgraded the stocks much later because only then had it become clear through his research that the companies’ results (fundamentals) weredeteriorating. In hindsight he said, " We should have lowered our ratings sooner. We regret that."

Mr. Noto outlines exactly what the problem is with using fundamental analysis by itself. Fundamental analysis is a lagging indicator. In essence he says that the stocks began to break down technically before it became visible to him that the fundamentals were changing. Market psychology is technical analysis.When market psychology changes it means that there are more sell signals than buy signals. Those who are watching can detect this subtle change. Nothing is perfect not even technical analysis, but the trouble will show up in the technical picture before it shows up in the fundamental picture.

Therefore to sum up one can conclude that the true key to success is using both schools of thought simultaneously and continually educate oneself. This has borne me rich dividends. This is how I keep RECREATING myself and cloning.

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One question from my side:

Can someone help me the info about who are the super successful investor who have followed this approach of TA after FA over a long period of time. Like the Charlie’s, Buffet’s & Peter Lynch’s of this school of theory.

And whom i can read more about, to get more insight’s into this theory.

I am bit confused here.

It seems one need to apply TA within the domain of FA to be something out of it. It is seemingly a tool to decide when to buy, which FA doesn’t have.

As per my understanding FA tells us to buy whenever there is undervaluation, and sell it when there is a over-valuation. TA gets the timing from analyzing price pattern, FA tries to get it by analyzing less data, i.e by looking at the ratios, numbers of quarterly data, along with business fundamentals to decide when to buy and when to sell.

Plus how do we merge the stop-loss concept of TA with FA. Both of them tells us to do 2 different thing.

There is another problem with technical analysis too. This is what I call “signal noise problem”, In long term, price follow earnings (provided you haven’t paid a very high pe to begin with), the detail of which comes once in 3 month. So this is what I call the signal. For the rest of 89 days, stock price move here and there, without any solid reason behind them. This is what I call noise. One need to remove these noise from the price movement to get a feel of where the stock is going on. To a layman like me, technical analysis seems to be much more concentrated on the the noise, rather than the underlying fundamental signal.

We all know very well that past data can’t be extrapolated to predict future outcomes. But again we are using same philosophy to do TA, is one of my main concern

My second concern is about lack of research on it. So mathematical this approach is, and still considered an art with no known research on its effectiveness.

My third concern is lack of any big guys who has used this approach.

**Re-posting **the post which i posted in Arshiya International yesterday -

Technically Arshiya was indicating bearish pattern from almost 2 years. It never indicated strong uptrend.

On10/12/10it closed below its 350 ema. Closed @ 219rs.

It never crossed it previous high of 292 rs which it did on 3/12/10.

Again on7/3/11it closed @ 177 rs.( Way below its previous bottom ). Later on it was free fall.

Markets did indicate.

Thanks to Bala Sir & Hemant Sir, have started to look for technical indicators as well.

Was about to invest in Tulip and Arshiya. Debt/equity kept me away.

Was amazed by Tulip’s data center and had read an interview in Times about its founder, some time back.

OK, enough of philosophical talk, let me give you a nice example to understand the issue with TA.

Currently, there is a butchering of few midcap stocks going on in the market, without any change in fundamentals. As per my reading of few comments in MC message board. RS software is breaking all of its support level at available at a mouth watering valuation of PE of 4.7, ROE and ROCE hovering around 40-50%, zero debt. As per FA, this is a screaming buy for me. What about TA?

The same story with Granules/Hikal.