I read a post on the Simple Dollar blog called How To Read a Stock Chart in Just Five Seconds. The post is a great example of the misconceptions and misplaced biases that individuals have with investing in the stock market generally and specifically with technical analysis. An interesting fact is that the post is about technical analysis. It isn’t about Warren Buffett. Yet, Buffett’s name is thrown around in the comments section multiple times. I am a big fan of The Simple Dollar blog (it is on my Interesting Blogger Project list) and I mean no disrespect to Trent Hamm or the individuals in the comment section.
However, I do strongly disagree with many of their statements. I would categorize this post as an attack on fundamental analysis.
I am actually pretty passionate about this subject. I believe there are two basic paths to take when trading and investing in the stock market. There are fundamental traders and technical traders. Those that go down the fundamental path are pretty much wasting their time. Much of it is because everyone hears on CNBC and finds books at the bookstore promoting the theme of “investing like Buffett.” Many investors using fundamentals and claiming success were fortunate to have their careers during a bull market. Everything goes up in a bull market.
I have no reason to have bias. I used to be a fundamental trader because I read the same junk that everyone else reads when they are getting started. If you read my About page, you’ll see that I was actually pretty successful with it. But as I point out, most of that was luck. I hate to see people wasting their time and energy. It takes a lot of time and effort to make money in the market even if you start using technical analysis from day #1. If I can shorten the path for people by having them go down the technical analysis path from day #1, I could be saving people years of wasted time and poor returns (or even worse, people give up).
In this post I’ll respond in a conversational tone to parts of the post and some of the comments. I believe the post and the comments are a good sample of what the average individual with some knowledge of the stock market thinks about technical analysis (as the saying goes, a little knowledge can be a dangerous thing).
Overall, Trent’s article accomplishes its purpose of explaining technical analysis to someone with little or no experience with stocks and I appreciate his post. I’ve blocked the portions of his post that I quoted.
Stock pundits love these kinds of graphs. Not only do they look pretty cool, there’s a lot of data compressed in there. Even more important, many stock pundits believe that you can use this history to predict where the stock is going to go.
That predictive process is known as technical analysis, and people have debated for years over whether it actually works. Technical analysis basically says that you can look at patterns in the past behavior of a stock – combined with basic tenets of human behavior – and predict where the stock is going.
Also, past performance is never a guarantee of future results. Just because a person is able to identify some sort of pattern in the historical data doesn’t mean any of it’s going to hold tomorrow.
It’s true that the patterns don’t have a 100% success rate. But if you could change the odds to 50/50 (I’m using a lowball figure – most patterns have a higher rate of success) by trading a pattern, you can actually be very successful.
Take this chart of UNG (Natural Gas ETF). Using the work of Tom Bulkowski, I identified a pipe bottom at $9. This trade also had a good chance of success because RSI (which measures price momentum) was very oversold at 19 (30 is considered oversold). So I had a chart pattern telling me that this could be a reversal along with a technical indicator telling me that a reversal could be coming. So technical analysis is telling me I have a good potential entry. The next question is how do I manage risk on this trade? This one is very simple. The low on the two pipes was $8.94. So I set a stop order just below that level (In reality I set it at $8 initially on this trade but the reason adds complexity and I won’t bother mentioning it in this post). If price went below that level, it would mean the pattern was no good. If you were able to enter near $9, your risk of loss was very low ($8.85 – unless there was a gap down) and there was a lot of upside potential. Once UNG started moving higher, you could monitor the position by raising your stop or by using a trailing stop. This is where experience factors in but the point is that technical analysis is really about managing risk. If you don’t believe that stocks trade using historical support and resistance levels, I ask that you watch the market for a few weeks before coming to a conclusion. For example, prior support on UNG before it fell to $9 was in the $12-13 area. Notice that UNG is currently bumping up against this price level. This is not a surprise to a technical trader. Also note that I know nothing about natural gas but was still able to trade it. I didn’t have to become a guru on natural gas or the mechanics of how the ETF trades (getting technical, but this is a reference to the contango argument for not owning UNG)
Take, for example, the recent debacle with Apple. A false rumor about Steve Jobs having a heart attack caused the stock price to drop to a 17 month low (a 5.4% drop) very suddenly. Imagine, if you will, if Jobs actually had passed away. It’s an event that no technical analysis could predict – it only deals well with long-term patterns in very stable companies.
Regarding Steve Jobs, I would argue that his health was priced into the stock. Let’s say AAPL was at $90 when everyone knew Jobs was sick but unsure of his return. Well, I bet the stock would have been over $100 but for the Jobs health issue. On the other hand, if Jobs had to leave the Apple (death or otherwise), the market might have valued the stock at $70. So at $85-90, the market was waiting for more data on Jobs. Regarding the rumors, that kind of crap happens. I’m sure some traders had stops taken out on those rumors. But that is part of trading and managing risk. I don’t keep more than 2-3% of my capital in a single stock and on a stock like AAPL my stop would be set for a maximum loss of 5-8%.
Now that it’s pretty clear why pundits like those stock charts, what can you get out of such charts in the five seconds they’re up on the screen on CNBC? This is, of course, assuming you’re following the basic idea of only owning stocks in companies you know and believe in and have a specific reason for owning that has nothing to do with the stock price – which is a very good way to invest. It’s the way Peter Lynch suggests in his excellent book One Up on Wall Street, for starters, and is also described in many other stock investing books.
I am embarrassed to say that I own Lynch’s book and it is huge waste of money. You are going to buy “companies you know and believe in and have a specific reason for owning.” Isn’t this pretty subjective? How many companies can a person get detailed knowledge about? Even if you had a lot of knowledge, would it be knowledge that others in the global marketplace did not have?
I personally don’t believe if Lynch had to run his fund in today’s world that he could be successful again. In his day, there was less regulation, technology and generally it was possible to have an information advantage over others. Besides illegal insider trading, everything is available on the Internet and the regulatory structure (Regulation FD among others) limits private disclosure before information is disseminated to the public. But let’s assume Lynch (and dare I say Buffett) could do it in today’s world using fundamental analysis, they are still equipped with an army of researchers, a corporate jet to visit companies and sometimes even a seat on the board of directors. Meanwhile, you have your Yahoo finance along with millions of others out there. Where is your edge?
What these three things point you towards are signs that something has changed in the company – something that might violate the reasons you own the stock. As I’ve said many times, you should only own an individual stock if you have a specific reason for doing so. You trust the CEO. They deliver a stellar product. Their product has some sort of inherent advantage over the competition. Each of those changes, which you can quickly pull out of a chart, is simply a sign that you need to investigate the stock you hold in more detail to make sure the reason you have for owning the stock is still intact.
Please never invest in a company because you are “trusting the CEO.” See my example of Angelo Mozilo below. Everything most investors know about these individuals is what they are fed by the media. Up until recently, Ken Lewis was a great CEO. Now nobody trusts him. You didn’t trust strangers when you were a kid and you shouldn’t base your investing decisions on trusting CEOs.
Unless you’re investing professionally or doing it as a serious and focused hobby, there’s not much else you can really get out of a glance at a graph, so don’t let yourself get overloaded with data. Just look for the important events, the ones that would change your opinion of the company or how it does business. Leave the rest to the people who do this eighty hours a week.
I agree with Trent here. There is no free lunch in trading stocks. It is very hard and is not something that can be done without a lot of education and experience. If it is not something your passionate about and willing to put the time into, I would likely do the index approach as well. It isn’t a great option, but if you are not willing to take the time there isn’t really a great option. If I wasn’t interested in trading stocks, I would also likely put money in real estate to keep things diversified.
Next up is my response to some of the comments.
#2 Stop Getting Cheated @ 8:24 am October 7th, 2008
Trent, this is a great for getting a quick overview. You provide us with some simple and effective tools. If a stock looks compelling, people can do their own intense research. I’m like you, I never could put much faith in technical analysis. I am really looking forward to your reviews of Benjamin Graham and your perspective on his premise of value investing.
My response: How do you know when a stock looks compelling? Because you feel it in your gut? Large brokerage houses with huge research teams have trouble generating good returns. I find it hard to believe that the average investor has the ability to out research and out think these professionals. Unfortunately, you are also likely going against people with inside information at times. It isn’t legal, but it is reality. At least with technical analysis these misdeeds show up on the charts.
Even if you are educated in a particular area and for the sake of argument you do have an edge, your pool of investments is now limited to that very specific area. Let’s say your an expert in airline stocks (or at least think you are). There could be a long period of time where there is simply nothing to do. The stocks could trend sideways for a long time. Even worse, if you turn out to be wrong you are not diversified and all your eggs are in one basket.
#5 Alan @ 8:48 am October 7th, 2008
I’m going to take the other side of the argument from Trent. Technical analysis is the astrology of stock trading: instead of the stars, it gazes at the charts to infer actions in the real world.
My response: I would say that fundamental analysis is the arrogance in believing that you can uncover the mispricing of a company that other traders do not see. Especially when it comes to highly followed stocks such as AAPL and GOOG.
#11 Jay barnson @ 10:36 am October 7th, 2008
Basically, technical analysis is attempting to analyze mob psychology.
I believe there’s a difference between being able to do technical analysis profitably and having to spend eighty hours a week at it. Yeah, a lot of the really big-time fund managers do this, and they make some really incredible (in the literal sense of the word), consistent returns – and they are obsessive – but there are a growing number of “second-string” traders out there pulling consistent but more down-to-earth results doing the same thing on a part-time basis.
And I think most technicians would agree it is as much art as science. I was reading one interview with a fund manager recently who said his best analyst is only right about 65% of the time. So it can give you a leg up, but it’s definitely not as cut-and-dried as some would have you believe. So I feel it works, but it’s not a crystal ball. More like a meteorologist trying to predict the weather 20 days ahead.
If you are investing for the long term, I really like the combination of using fundamentals mixed with some basic technical indicators like those promoted by Phil Town in his book, “Rule #1.” The fundamentals tell you what stocks to buy (the ones that are both underpriced by a wide margin and growing solidly with good management and a strong competitive advantage), and when to buy them – and when to sell them.
My response: This guy had a nice comment until the last part. I liked his analogy of comparing a technical analyst to a meteorologist predicting the weather 20 days ahead. It is not perfect, but it is the best system out there and it does give you an edge if executed properly.
The bold part I have a major problem with. The thought is that fundamentals tell you what stocks to buy and that you use technical indicators for timing. It sounds good but in practice I don’t see how fundamentals will help. I would be super wealthy if I had a system that objectively generated a list of stocks that:
1. are underpriced by a wide margin;
2. are growing solidly;
3. have good management; and
4. have strong competitive advantage.
#1 is my favorite. This is where you are supposed to “be like Buffett and Graham” and buy stocks that are underpriced. But how do you know when a stock is truly underpriced? This really amounts to arrogance. Again the thought is that you are more intelligent than the rest of the marketplace and that everyone else has it wrong. Moreover, to be successful, you have to do this magic over and over again.
Citigroup is just one example. But how many individuals out there thought they were Buffett at $40, at $30, at $20 and at $10?
#2 is that we’re looking for a solid grower. But everyone has access to the growth data just by pulling up Yahoo finance. Where is your edge? If you are taking a long position, wouldn’t it be common sense to want solid growth. Everyone wants that. It is similar to telling someone buying a house to buy a house in a nice location. Sure, but you pay for that nice location.
#3 is that you are looking for good management. How many individual investors actually know management personally? Up until 2007, many thought Angelo Mozilo at Countrywide was the leader of a great management team.
I remember catching a Mad Money episode where Jim Cramer interviewed Angelo [before I quit watching CNBC] and talked about how he was such a great CEO and that Countrywide would be the last mortgage lender standing. This is just one example. The list could go on and on.
#4 is similar to #2. Yes, it is nice to own a company with a strong competitive advantage just like it is nice to buy a house in a nice neighborhood. But you will pay for it. What happens when a competitive advantage is not enough? GOOG owns the search business. There is no serious competitor.
That is a tough ride from the $700s down to $250. If you invested $10,000 near the top, at the low, you would have been well under $5,000.
#15 David T. @ 2:00 pm October 7th, 2008
To my knowledge Warren Buffet does not invest in index funds although he does suggest that the average Joe invest in them. To really find out how Warren picks stocks (and other investments) read the best investment book ever written “Buffet, The Making of an American Capitalist”. Trust me, you won’t read this in a weekend. It is all about finding value like finding a $100,000 house built with $50,000 worth of material and labor that you can buy for $30,000. Charts mean absolutely nothing except history.
My response: So the expectation is that you can compete in a global marketplace with millions of traders and investors and that you’re going to find a “$100,000 house for $30,000.” It would be a tall task to do this in the real estate market but at least that seems plausible. With real estate, you can buy on inside non-public information and the market is thin compared with the stock market. So at least with real estate it is possible to benefit from information asymmetry like Lynch and Buffett did years ago.
In the stock market, this is not a reasonable expectation. And hey, even if you could do it once, that wouldn’t get you anywhere. You would have to do it over and over gain to actually make a profit.
There are also some good one-liners:
#16 Mart @ 4:55 pm October 7th, 2008
Perhaps interesting to point out this is the complete opposite of Warren Buffett’s philosophy. TA only works when enough people believe it and even then it is more voodoo than science.
#19 Sarah @ 7:46 pm October 7th, 2008
Technical analysis? Seriously, Trent? Maybe next you can tackle snake oil?
#20 Juan @ 11:41 pm October 7th, 2008
I think it was Warren Buffet who said that he realized TA did not work when he flipped a chart upside down and still showed the same results.
To Mart, Sarah and Juan, I hope you survived the crash of 2008-2009.
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