Technical Analysis (updated 27 Feb 99)

There are essentially two ways of analyzing investments: fundamental analysis and technical analysis. With the former, investors try to calculate the value of an asset, asking questions like what is the present value of the likely future cash flows I am going to get from it, and how does that compare to its current price. With the latter, they focus exclusively on the asset's price data, asking what does its past price behavior indicate about its likely future price behavior.

Technicians, chartists or market strategists, as they are variously known, believe that there are systematic statistical dependencies in asset returns - that history tends to repeat itself. They make price predictions on the basis of published data, looking for patterns and possible correlations, and applying rules of thumb to charts to assess 'trends', 'support' and 'resistance levels'. From these, they develop buy and sell signals.

Market timing is a form of technical analysis that aims to identify turning points in the performance of major stock indices. Other methods include filter rules, measures of 'relative strength', line and bar charts, moving averages of prices over various periods, the study of trading volume, aggregate demand and supply analysis and numerous other gauges that measure momentum, valuation, sentiment, leadership or monetary policy.

Technical analysis is based on the assumption that markets are driven more by psychological factors than fundamental values. Its proponents believe that asset prices reflect not only the underlying 'value' of the assets but also the hopes and fears of those in the market (see INVESTOR PSYCHOLOGY). They assume that the emotional makeup of investors does not change, that in a certain set of circumstances, investors will react in a similar manner to how they did in the past and that the resultant price moves are likely to be the same.

Technical analysis guru: Walter Deemer

Stock markets have been around for centuries. But technical analysis as a tool for the average investor has thrived over a much shorter period. It was in the late nineteenth century when Charles Dow, then editor of the Wall Street Journal, proposed the Dow Theory. This view recognized that it is the actions of people in the marketplace responding to news that cause prices to change rather than the news itself, and that once established a market trend tends to continue.

Since the 1960s, the technical approach to market analysis has been greatly expanded in scope and credibility. But in the US market of that time, market technicians were an arcane group. Mostly, they were introverts dealing in the hen scratching and wiggles of lines on semi-log charts posted on sliding wallboards in their offices. Managers and analysts would walk into their environments the way one would approach a reader of tea leaves - apprehensive but hopeful.

In those gunslinging days, as they have been called, Walter Deemer was one of a handful of technician superpros. He started at Merrill Lynch in New York as a member of Bob Farrell's department. Then when the legendary Gerry Tsai moved from Fidelity to found the Manhattan Fund in 1966, Deemer joined him. Tsai would consult him before every major block trade, at the start of a time when large volume institutional trading became the norm and the meal ticket for brokers. Deemer, in his 'war room', could recreate market history on his charts and cite statistics the way a baseball fanatic can reach back into any season for parallels and records. He maintained contact with the group of other pros around then, who shared their insights with each other in a collegial confidence worthy of the priesthood.

But New York living did not suit Deemer. Not only did he not have room for his ham radio equipment and missed communicating around the world for relaxation, but he also liked the country. So he moved to Boston as the head technician at Putnam Funds. He was still doing the same thing, however: examining the market for its clues of future performance.

While technicians were getting a bad name during markets that mostly went up in a straight line since 1973-4, they adopted a title more suitable to their modern function: market strategists. This label referred to their output, not the fact that they used price instead of company and economic fundamental data for their determinations. If you could win by buying and holding a broad group of stocks as in indexing, why would you need a strategist?

But a handful of strategists persisted in their beliefs and formed a worthy industry group, the Market Technicians Association (MTA). Deemer is a charter member of this group, which continues to share information openly to challenge each other and holds very little back under a proprietary cover.

Currently, Deemer publishes market strategy comment and data from Florida. He has new tools that he did not have forty years ago, a broader sweep of international markets but exactly the same questioning attitude and historical perspective that he has always used. As an early adopter of the internet to communicate with his clients, he produces insights to a very elite clientele, most of whom are portfolio managers. And many other advice givers look to his research for their ideas.

Two market phenomena in 1998-9 provide good examples of Deemer's approach to understanding the market, using history to try and illuminate the future. The first followed the global market turmoil in the second half of 1998, where Deemer looked for a time in the past when the market went down big, followed by a big rally turning speculative in a hurry. The best match he found, prompted by research by fellow MTA member Chris Carolan, is a period when there was a decline of 37% in three months (not all that dissimilar to the late 1990s decline in small-cap stock indexes) and a 97% retracement of that decline in the next three months.

That 97% retracement was very speculative, as a quote from the New York Times that was printed just a month after the bottom attests: 'Stock exchange speculation is rampant. There is now a greater disregard of relative values than in usual seasons of excitement.' The date?: 8 December 1873. The market then went down 45% during the next four deflationary years.

The second area in which Deemer has been thinking about historical precedents is the incredible moves in some of the internet stocks in 1998-9 (see INTERNET INVESTING). He offers the following two cases:

'Deja vu I: I recently decided it was time to read The Money Game again - particularly the section on The Kids; the section that tells about The Great Winfield's solution to the boiling market of 1968: 'Kids. This is a kid's market...'. The Kids, you see, were the only ones who could figure out the New Math, the New Economics and The New Market. And what stocks were The Kids buying in 1968? Leasco Data Processing, Data Processing and Financial General, Randolph Computer, Kalvar, Mohawk Data, Recognition Equipment, Alphanumeric, Eberline Instrument, Western Oil Shale and Equity Oil. Ten stocks - none of which are around today.'

'Deja vu II: Go back with me to 1983. You're a money manager. You envision, quite clearly, the great PC boom ahead; a boom that is destined to change profoundly the way we do things. What stocks do you buy to capitalize on this great trend? Regrettably, most of the 'obvious' candidates, back in 1983, never met the test of time. The 'obvious' candidates ranged from IBM, the leading manufacturer of PCs, whose stock was just a market performer for the next two years - and a drastic underperformer for years and years after that, all the way to the PC plays that never made it at all from a longer-term standpoint: plays like Hayes, Prime, Seagate, Tandy, Wang, etc. As things turned out, the two REALLY big winners that came out of the PC revolution were anything but 'obvious' in 1983: the company that made the PC's 'brains' and the company that made its operating system.'

'Time passes: now you're a money manager in 1999. You envision, quite clearly, the great internet boom ahead, a boom that is destined to change profoundly the way we do things. What stocks do you buy to capitalize on THIS great trend? Dare I suggest that most of the 'obvious' answers to that question will also not meet the test of time? Dare I further suggest that the real answer lies in companies that have locks - and I mean LOCKS - on their particular area of expertise, as Intel and Microsoft did?'

Counterpoint

Who needs technical analysis? We have had a sixteen year bull market in the United States and the Dow has gone from 1,000 to 9,000, doubling in the three years to 1998. How would you possibly want to have a tool, which even if successful, got you in and out of the market? The thing, surely, is to be in - ideally in index funds, which have outperformed most active managers who have tried to do better than the average of other managers or better than the average of the market (see INDEXING).

Indeed, technical analysis is much derided as hocus pocus. Critics argue that its claims to offer insights into investor psychology are absurd, and that it has less rational basis than astrology or the study of UFOs.

What is more, technical analysis is in effect what is used by quant analysts (see QUANTITATIVE INVESTING). For example, Long Term Capital Management's market strategy was based on the assumption that historical price relationships between different assets might change but that they will eventually return to normal.

Guru response

Walter Deemer comments: 'Technical analysis is one of the most basic parts of the entire investment analysis process, perhaps the most basic of all. The reason: investors don't buy portions of companies; they buy pieces of paper that represent part-ownership of companies - much different things. Technical analysis is the study of all the factors that influence the price of those pieces of paper, and, in aggregate, the stock market. This means that as long as investors buy stocks rather than companies, technical analysis (or 'market analysis', as it is better called) will be, by default, a necessary part of a complete investment analysis process.'

'In recent years, though, the benefits of technical analysis have been shoved into the background by its increasingly short-term focus. The media are partly responsible for this misguided attention. So too are the mushrooming day trader types, who embrace classic technical trendlines and oscillators in their frenetic financial adventures because 'normal' investment tools are pretty much useless to them. But investors who focus on long-term technical factors - especially those that anticipate price moves rather than react to them - and who then integrate those factors with all the other inputs at their command are well aware that 'technical analysis' adds value to the overall investment process.'

'As far as indexing is concerned, I'll leave it to others to decide whether indexing is 'good' or 'bad' (although I'm unwilling to concede that the most important stockpickers on Wall Street are the folks who decide - in deep secrecy and with no set rules - what goes into the S&P 500). Like all trends in the financial markets though, the current trend towards indexing to the S&P 500 will ultimately create the excesses that lead to its reversal. The growing concentration of assets in one group of stocks will create relative values in other areas of the market that will, at some inevitable point, cause the pendulum to start swinging the other way. And, since the S&P 500 is NOT the only 'index' in the US stock market, one of the biggest investment trends of the next decade is likely to be a gradual but persistent flow of indexed money out of the S&P 500 and into broader stock market indices, especially when performance-oriented pension funds and their consistently-late consultants decide that assets need to be shifted away from a now-underperforming S&P 500 index into better performing broader indices.'

Where next?

Technicians are in the doghouse. And yet, they may have their day. Walter Deemer is one of a number of traditional and extremely good market technicians covering equity markets who have been saying for some time that the US market is getting a little 'toppy'. And other technicians like Richard Olsen in Zurich are using very advanced mathematical techniques and high-frequency data to forecast currencies to great effect (see FOREIGN EXCHANGE).

As more and more information becomes available through the internet, the opportunity arises to apply the tools of technical analysis to a huge range of new data. The technical tools available for today's investor are limited only by innovation and historical data. But for the most part, the indicators are not used to forecast stock prices as much as to identify the major market trends and measure risk. It might be said that the true objective of technical analysis is to determine whether or not the ingredients of a healthy bull market are present - and to watch out for possible warning flags before a major decline or bear strikes.

Dean LeBaron, one of this book's co-authors once went to a fortune teller with friends. The normally dressed seer peered into the tea grounds left at the bottom of his cup and said 'you once flew a red airplane into the ground', a fact no one at the table would have known. He followed with other insights from the past and the future. Was it the patterns of the leaves or was he an intuitive student of personalities? It seems likely that the tea was merely the means to occupy time to get the sense of other intuitions.

Technical analysis may also be an intuitive art form. There is an infinite range of data to look at and a sweep of global market history but the sorting is personal to the strategist. The skilled practitioner looks at the tea leaves, mulls over the past and may see into the future. But if you try to convert the art form into a mechanical, repetitive pattern, then the risk is that the art - and the forecast - is lost. Technical analysis looks more repetitive than it is.

The best forecasts are the ones that challenge conventional wisdom. But to do so requires strong conviction and may not be commercially successful unless one presumes to be right 100% of the time. And even in this unlikely event, telling your clients that they are wrong over and over is unlikely to produce high repeat subscription rates. So a high success rate can be a pyrrhic victory.

To succeed the strategist must have a retentive sense of history, mathematics and graphic skills, a skeptical mind, wit and an ability to express ideas that are difficult to imagine. But most of all, fortitude.

Read on

In print

Robert Edwards and John Magee, Technical Analysis of Stock Trends - the standard work of technical analysis
Elli Gifford, The Investor's Guide to Technical Analysis
Richard Russell's Dow Theory Letters - an example of a technician newsletter
'Adam Smith', The Money Game

Online

www.4w.com/deemer/ - Walter Deemer's website
www.olsen.ch and www.oanda.com - websites of Olsen and Associates
www.ifta.org - website of the International Federation of Technical Analysts
www.mta.org - website of the Market Technicians Association