Some investment professionals swear by technical analysis. Others swear at it. It has suffered a bad rap for decades, but those who understand it and use it successfully believe that rap is undeserved. So should planners learn about technical analysis and use it as a tool in their investment strategy arsenal?
WHAT IS IT?
Technical analysis is a strategy for evaluating securities by studying the statistics generated by market activity on those securities. While fundamental analysis attempts to determine a security's intrinsic value, technical analysis, on the other hand, uses data to determine patterns and trends related to the security's price. Using charts of stock performance, analysts try first to identify past patterns and trends and then to determine what will happen in the future.
"Technical analysis is the study of price behavior over a designated time period," says Toni Turner, president of TrendStar Trading Group in Irvine, Calif. "We can apply this to any tradable instrument in the stock market that changes price over time, such as a stock or an exchange-traded fund (ETF)."
One tenet of technical analysis is that stock prices directly reflect what investors believe. As a result, fundamental analysis factors, including forward earnings projections, are already "baked into" the price of a stock or an ETF. In other words, technical analysts believe that a stock's price reflects everything that is known about the stock by investors. Therefore, technical analysts don't care whether the market is rational or irrational. They simply accept it for what it is and try to capitalize on the trends.
"Looking at price behavior over time can determine how a stock has reacted to different local, national and global events," Turner says. "This information can be useful in identifying what might happen to that stock in the future."
What value does technical analysis have for financial planners? "You need to know how to deploy your clients' assets properly," replies Michael Kahn, author of Technical Analysis Plain and Simple: Charting the Markets in Your Language and a technical analysis columnist for Barron's Online. "Technical analysis helps you assess the state of the market, such as what everyone is thinking and how news is being absorbed. Stocks go up, and they go down. One thing technical analysis can do is give you clues as to where the market is in terms of its natural cycles."
Philip J. Roth, chief technical market analyst with Miller Tabak & Co. in New York, says you need to be able to control risk in your portfolios. "In an upmarket, everyone will have winners, but you still need a way to avoid the big losers if you want to outperform your competition," he points out.
Technical analysis has different applications too. Some devotees use it primarily to conduct general market analysis. Others also use it to analyze specific stocks or ETFs.
So what are the myths about technical analysis? Can they be debunked?
MYTH 1: IT DOESN'T WORK
While devotees prefer to be called technical analysts or market technicians, critics, who include fundamental analysts and academics, often refer to them disparagingly as "chartists." To them, technical analysis is voodoo economics.
However, the discipline has been around for over 100 years, and it is still going strong. Charles Dow, a co-founder of Dow Jones, first wrote on technical analysis in the late 1800s. Over the past 20 years, technical analysis has gained in popularity, largely due to the increased availability of computer power.
At the same time, academics are starting to discover validity in some of the technical analysis tools. "A lot of universities are starting to teach courses on technical analysis," says Charles Kirkpatrick II, president of Kirkpatrick & Co. in Kittery, Me., author of Technical Analysis: The Complete Resource for Financial Market Technicians and adjunct professor of finance at Brandeis University International School of Business.
MYTH 2: IT'S TOO COMPLICATED
Technical analysis can be complicated, but only for people who live and breathe the discipline. There is value in learning some of the simple basics. In fact, if you become familiar with just four concepts-trend lines, resistance and support, moving averages and moving average crossovers, and overbought and oversold-you can begin to improve returns for your clients. Here's a brief description of these concepts:
* Trend lines. These lines are drawn from a stock's or market's high or low to show the prevailing price direction. A trend line visually represents support and resistance for a given time frame.
* Resistance and support. Resistance indicates that a stock's or market's price has failed to increase past a certain high over a period of time. Support indicates that a stock's or market's price has not gone below a certain floor.
* Moving averages and moving average crossovers. A moving average takes the daily prices of a stock or market over a specific time period and identifies the average price for that time period. The direction of these averages over time shows the momentum of the stock or market. A moving average crossover occurs when the moving average of a shorter time period crosses over the moving average of a longer time period, confirming positive momentum.
* Overbought and oversold. Overbought indicates that a stock or market has experienced an upswing in prices over a short period of time, a potential sell signal. Oversold indicates that a stock or market has experienced a sharp decline in prices over a short period of time, signaling a buy opportunity .
These concepts can be condensed even further, Roth says. "The tools you should use depend on whether you are quantitatively oriented or visually oriented," he says. If you are quantitatively oriented, Roth recommends focusing on tools such as moving averages. If you are visually oriented, he suggests looking at charts and drawing trend lines. "For example, by looking at trend lines and support levels, you can make some guesstimates about risk," he says.
Kirkpatrick believes financial planners should have something that measures sentiment, which is the broad attitude of investors. "Market tops are usually accompanied by gross enthusiasm, and bottoms are usually accompanied by panic," he says "If planners can measure this, it will provide them with a good estimate of what the mood is."
As Kahn sees it, using technical analysis charts involves putting up a picture and determining which way the market is going. He recommends two tools: a trend line and a sentiment measure. "This may end up being informal and subjective, but it will provide you with a sense of the mood of the market," he says.
Kirkpatrick and Kahn both refer to "sentiment." There are numerous technical analysis tools that measure market sentiment. The most popular is the CBOE Volatility Index (VIX). The VIX measures implied, rather than historical, volatility of the S&P 500. This volatility is the amount that S&P prices deviate from the mean price at a particular time, as measured over a specific time frame.
Turner recommends that planners new to technical analysis begin with simple line charts, which show each day's closing price of a stock over time. "Charts can tell you if a stock is in an uptrend, downtrend or moving horizontally," she explains. "Look for prior lows that can act as support, and prior highs that can serve as resistance."
For example, a recent lower high or lower low indicates weakness in a stock, and it may be time to take profits. Conversely, a recent higher high or higher low indicates strength in a stock, so it may be time to buy.
Dean Adams, a Denver investor who has been studying technical analysis since the mid-1970s, says one of the easiest technical analysis tools to begin using is the moving average. It's a good tool to follow price action, while eliminating the day-to-day "noise" and randomness of the market, he explains.
By following moving averages, advisors can determine if we are moving into a bear market or a bull market and shift their clients' money, Adams says. He uses a 20-month moving average of the S&P 500, with monthly charts. "Anytime the price is above the 20-month moving average, we are in a bull market," he notes. "Anytime it is below, we are in a bear market."
MYTH 3: IT' STANDS ALONE
Some investors use technical analysis exclusively to make their investing decisions. But the majority of investment professionals use technical analysis in combination with other strategies.
"Technical analysis is one of three tools that I use in my decision-making equation," says David England, a college finance professor at John A. Logan College in Carterville, Ill., and president of www.thetraderseye.com. "My equation is technical analysis plus fundamental analysis plus informational/news analysis minus greed. Technical analysis shows me what the big money is actually doing, rather than what paid hacks say it is doing."
There is a popular misconception that fundamental analysis should be used for long-term investing and that technical analysis should be used only for short-term investing, according to Roth. "That is ridiculous," he says. "In fact, technical analysis actually works better for the long term than the short term, because long-term trends last longer and are easier to identify."
Turner is also a big advocate of combining tools. "I don't think we should use technical analysis as a mutually exclusive tool," she says. "When used with fundamental analysis, technical analysis provides a much more powerful way of looking at the financial markets."
For example, technical analysis can show when a stock is overbought or oversold, Turner says. "Technical analysis can show you that you may be paying higher than retail for a certain stock."
Turner adds that combining technical analysis with fundamental analysis provides her with a nicely rounded view of what she needs to know about a particular company and its stock. "I can often identify stocks that are on sale so that I don't pay more than necessary. I end up with a better value."
IN REAL LIFE
Scott McClatchey, a financial advisor with Alliance Investment Planning Group in Carbondale, Ill., is one planner who occasionally uses technical analysis in combination with other tools. "It can be especially helpful during volatile markets," he explains. "For example, during the 1990s, when everything was going up, there was probably less need for technical analysis. These days, of course, it can be much more useful."
McClatchey also frequently looks for mutual funds whose managers use technical analysis. "Some of them use technical analysis to help time some of their trades," he says. "Trend lines and moving averages help them determine when to buy, when to sell, what sectors to be in and when to be in them. So while I don't directly do this technical analysis myself, my clients still get the benefits of it."
At least one planner, Mike Moody, a senior portfolio manager with Dorsey Wright Money Management in Pasadena, Calif., relies strictly on technical analysis. "I realized early that I needed to do my own homework," he says. "This led me to technical analysis."
In fact, he uses only one specific element of technical analysis-a concept called "relative strength." Moody and his colleagues have found that high relative strength stocks have historically provided high returns, but they often do not correlate with the broad market. For that reason, high relative strength stocks frequently appear to act as a separate asset class.
From an asset allocation perspective, there is significant value in a high-return asset class that is not correlated with most stocks and bonds. Non-correlated performance can help smooth out the returns in a diversified portfolio.
"The concept of relative strength has been around since the turn of the last century," he notes. "Of course, in recent years, computerization has allowed relative strength rankings to be done much more precisely and across a broader universe of companies. We believe it is the most valuable tool available today, and it has been working very well for us."
Moody has about 850 separate accounts, plus a half dozen or so large institutional clients. Individual accounts range from $200,000 and up. So how did those accounts perform during the recent market meltdown? Moody says it depended on the mandate, but accounts that were fully invested in equities lost as much as the broader market. Many accounts that were hedged were down less than 3%.
William Atkinson, a business writer in Carterville, Ill., specializes in finance, utilities and risk management.