Technicals & Charting
Technical Analysis (also known as Charting) is investing based on the assumption that it is possible to predict the future movement of share prices based on patterns in historic price and volume movements (so in reality it is speculating, rather than investing).
You are all likely aware of the disclaimer on any and all financial documents: “Past performance is no guarantee of future results” – not so for technical analysts and chartists. When it comes to technical analysis, past performance IS what determines future results.
There’s no shortage of expensive courses online to teach you how to read the tea leaves and make money from arbitrary shapes in price charts.
Whereas investors study the underlying company beneath a stock, the technical analyst usually just needs two pieces of information to make decisions: the past movement of prices and the past trading volumes. From those two elements, they believe that they can predict the future movement of share prices. They believe that over any time frame, prices move in certain patterns and trends that are both identifiable, and repetitive.
There are then two basic tenants of this: firstly, that prices tend to move in trends, and are more likely to continue on a trend than change direction; and secondly, that the patterns prices trace are representative of market psychology, which is predictable based on fear or excitement.
As part of this discipline, thousands of chart patterns have been established and like star constellations, have been mapped and followed by many. Like constellations they are given imaginative names based on what they appear to resemble: such ‘hammer’, ‘head and shoulders’, ‘cup and saucer’, etc. Some are said to indicate continuations in the current trend, some are said to indicate the reversal of previous price action.
While it would be extraordinarily easy to poke holes in this as an investment strategy based on ‘price shapes,’ there are two legitimate arguments that we accept when it comes to technical analysis:
People are emotional and tend to behave in similar ways to the past when they are greedy/ fearful
There can be a self-fulfilling element to these patterns – if enough people or algorithms recognise a ‘head and shoulders’ as a reversal signal, then they will sell that stock, creating the downward pressure that the head and shoulders implied would occur.
We would argue there is some truth to both of those statements, and therefore some logical support as to why what appears to be a very foolish way to allocate capital at face value, does at least possibly have some value.
Certainly, there are situations in the short term when elements of technical analysis have been shown to work. Without doubt, investor psychology is repetitive – as a herd most investors are both too greedy, and then at other times too fearful. In the past, people would look for the patterns visually; nowadays the price patterns are typically coded into algorithms, which automatically recognize them and can rank them on their ‘strength’.
Don’t forget
As you must always remember, a stock is still ownership of a business. It doesn’t matter how perfect a cup and saucer pattern may be, when something fundamentally changes for the company itself, that will drive the share price. Think about when stocks release their earnings, and Wall Street eagerly updates their model for the next 3 months, or if the company announces they’re acquiring a competitor, or perhaps they’re being acquired by a competitor. All of those things will be far more impactful to the share price and will swamp any price movement suggested by a chart pattern.
Take a recent example: Amazon in 2020 was roughly half a Cloud company and half a retailer – yet the Cloud business barely even existed five years prior. This is a substantial shift in the business and will arguably be the main driver of returns going forward. Whatever the share price may or may not have done in the past really isn’t relevant.
As always, there are no shortcuts. The most important element in deter-mining the share price is simply studying the underlying company itself.