Technical analysis, which charts market trends, is attracting new interest as financial instruments lose their sheen. Indeed, money managers are unwise to ignore these studies, writes Vanessa Drucker.
The modern history of technical analysis in financial markets begins with Charles Dow, the American co-founder of Dow Jones. As early as the turn of the 20th century, Dow had laid out his basic tenets on analysing financial markets from a technical perspective. He maintained that markets discount everything, and that they move in primary, secondary and minor trends.
“Trend is the magic word,” says Robin Griffiths, a strategist at Cazenove Capital Management. “They appear and persist more often than the laws of chance would allow, driven by economic cycles.”
Technicians, or chartists as they are sometimes called, study the past behaviour of financial markets by analysing prices and volumes involved in their trades. Together, those elements paint a description of investors’ collective mindsets and behavioural impulses. Studying the “tape”, analysts can spot levels of demand from investors and buying pressure in upward sloping trends, or observe flatter lines in consolidations, when bulls and bears engage in a tug-of-war. Psychology is always at work, as investors cannot resist urges to get out even, or exploit a second chance to buy or sell before the market runs away on them.
The popularity of technical analysis goes in and out of vogue. During the roaring nineties, the technique fell into disrepute. Many value investors – essentially bargain hunters – scoffed at chartists, likening them to astrologers and tea-leaf readers. But, a decade on, buying and holding financial instruments has lost some if its sheen, and technical systems are attracting renewed interest. It may take time for the market to reward bargain hunters for looking at the fundamental strengths and weaknesses of financial instruments, rather than technical trading patterns. There will also be volatile environments, like the present one.
During market crises and plunging sell-offs, correlations between instruments converge. Analysis of their fundamental traits generates fewer prescriptions for investors. If investors focus on the effect of macroeconomic risks, for instance, it becomes less relevant to look at the profits of individual firms and price them on a more micro level as a multiple of their earnings. (Cover story continues below)
One appeal of this technical discipline is that it eliminates some of the anxiety of managing money. By adhering to a process, and rebalancing, managers are less likely to let headline news events rattle them in the heat of the moment. “We communicate that process to our clients,” says Michael McGervey, a wealth manger in Canton, Ohio. “When they receive their confirmations or see their portfolios going to cash, it reassures them, too.” (As at mid-September, McGervey’s portfolios invested only 15% of their money in bets on rising markets, leaving the remainder in cash.)
Mark Tepper, a founding partner at Strategic Wealth Partners in Seven Hills, Ohio, describes what he discusses with his own clients. While his robust technical process will not beat the market in every quarter or month, he tells them it serves well as insurance “in choppy years”. Since he implemented it in 2000, during upswings when the averages were rising 12% to 15%, rapid ‘fluctuations in the markets have sometimes caused his system to underperform. It sometimes took a while to put the chips back. In down years, however, he saves his clients from losing their shirts.
David Solin, who acts as a consultant to hedge funds and commodity trading advisers, agrees that technical analysis makes it easier to quantify what rewards investors can expect for the risks they are taking. It also provides clearly defined and mechanical entries and exits.
Solin, who runs technical analysis from Essex, Connecticut, for FX Analytics, outlines further advantages of technical models for those interested in raising capital. “You can say clearly: this is what I do and how I do it. For instance, I might take 2% in profits in a position, and then I’m out. That precision can inspire more confidence than someone who just says, ’Trust me’.”
Increasingly, sophisticated money managers are blending some degree of technical and fundamental analysis in their final decisions as they assemble a portfolio. Ari Wald, an equity strategist at Brown Brothers Harriman in New York, says: “As a technician, I think it unfair that technical analysis has a certain stigma. Nevertheless, the best money managers will not neglect any type of analysis, or fusion, that can add value for them.”
In fact, they ignore the technical ramifications at their peril, considering the self-fulfilling role these often play. As markets approach widely recognised support and resistance levels, traders pile in, anticipating change.
”Trends appear and persist more often than the laws of chance would allow”
Nor do fundamental analysis and technical analysis necessarily contradict one another. Fundamental analysis suggests what to buy, and technical guidance recommends when to buy it – how to time a transaction, and how to measure turning points in the market.
Dan Morris oversees two commission-free mutual funds, focused on large core and large growth holdings, at Manor Investment Funds in Malvern, Pennsylvania. As a starting point, Morris looks for stocks demonstrating strong earnings, capital available for growth, healthy financial balance sheets and the ability to generate cashflow. “In a valuation-driven process, we find companies that can remain attractive over a long time,” he says. “Next we need to look at relative price performance, to be ready to buy when they start to move.” For Morris, the valuation, the overall story and the technical picture should all work in synergy.
Tepper also intertwines fundamental research with a technical component. In his hunt for promising investments, he uses several economics firms and a hedge fund to provide daily research. Those sources help him sift through asset classes, which may range from equities and investment grade bonds to agriculture or precious metals. “It works well,” he reflects. “If I had not included a fundamental aspect in the process to open my eyes to opportunities, I would not have bought gold and silver [as they neared the end of their decline] before 2000.”
Even those who try to blend the disciplines may turn to technical and fundamental analysis in different types of markets. Especially when underlying markets become unusually volatile, it is hard to put a fundamental price on assets. That is when technical prowess comes into its own. When volatility eventually decreases, fundamental aspects become more reliable.
Roelof-Jan van den Akker, a senior technical analyst at ING in Amsterdam, describes how “sudden events can result in a highly emotionally traded market, which is looking for longer-term support and resistance levels to come to a point of arrest.”
”The best money managers will not neglect any type of analysis, or fusion [of analysis], that can add value for them”
A pure focus on fundamentals and reversion to mean values can even disguise or distort what is driving prices. One example is the frequent call that stocks are priced cheaply as a multiple of their earnings and offer bargain values. What do low prices imply? Most mutual funds are mandated to remain almost fully invested in equities, and thus find themselves locked in during market downdraughts. Yet they may be forced to redeem some of their favourite positions to raise cash and liquidity. “Academics don’t always understand that decisions to sell go far beyond value,” says Solin.
The best technicians take their art a stage further. When successfully interpreted, charts and price movements can send a signal about what is driving the real world conditions beyond financial markets. In other words, instead of starting with fundamental premises, and honing the details with technical overlays, the process can also work in reverse.
By suggesting revealing “tells” about market conditions, technical analysis can expose underlying problems or potential, according to Arthur Hill, a senior technical analyst at StockCharts.com. Hill, who is based in Brussels, describes how he might start by dividing the S&P 500 index into its standard nine sectors, and would then drill down within each sector for industry groups. As his chart shows (page 26), on September 16, the three strongest sectors were consumer staples, healthcare and utilities. According to Hill, “since those are all defensive sectors, they tell you the market is on a defensive footing”. In the same vein, Morris cites gold’s decade-long rise and technical strength: “It’s sending a message regarding global financial conditions. Even if you don’t believe in gold as an investment, you can look at it as a measure of investor attitudes.”
Van den Akker, like Hill, analyses the market from the top down. He currently holds less than benchmark indices in equities and commodities and more in bonds. He has also ranked the EuroStoxx 50 sectors in order of preference. Chemicals, healthcare, industrial goods, telecommunications, technology and food and beverage look relatively promising. Banks, insurance and basic resources limp behind.
When it comes to specific recommendations, every technician has some favourite indicators in the toolkit. Despite the plethora of technical measures available, it is recommended to keep the process simple. “I’m mainly looking for gauges of changes in direction,” Morris says. “Too many esoteric overlays cloud the picture.”
Although many analysts continue to seek one indicator that is always right, that holy grail does not exist. McGervey warns that past behaviour regarding a particular indicator does not promise reliability for the future. “It can self-destruct on you,” he says. “If you’re creating your own, or working with well-known ones, or tailoring them, be careful not to curve-fit them to prove out your belief system.”
”I’m mainly looking for gauges of changes in direction. Too many esoteric overlays cloud the picture”
Wald at Brown Brothers Harriman outlines a road map of the main mechanisms he employs. The first step is to determine the overriding trend. Second, he looks at internal breadth, volume and participation. That means testing new highs and lows, and constructing an advance decline line to measure the numbers of advancers versus laggards and to confirm the strength of the current trend. Third, he takes momentum into account, registering how overbought or oversold a position has become and whether that level either confirms or diverges from the price. He then assesses market sentiment, which can be derived from the Vix index of market volatility, or from polls such as Investors Intelligence’s Advisors’ Sentiment survey. (Extremes in sentiment play a contrarian role, signalling that the last bull or bear has given up.) Lastly, Wald looks at seasonal factors, and whether they confirm historical patterns.
Others focus their process on identifying seasonal and longer-term regularities. Griffiths at Cazenove starts with cycles, which he regards as key to decoding the overall technical landscape. The underlying logic is that trends are driven by economic cycles, which operate in long secular patterns, incorporating shorter sequences. For instance, since 1946, the American presidential cycle has functioned as a medium-term predictor, while seasonal deviations tend to exhibit annual regularity. More often than not, you might as well sell in May and go away, as the adage recommends. Griffiths offers a basic rule of thumb: “Anything lower now than it was 10 years ago is in a secular downtrend.” And that would include all western markets.
Moving averages are probably the easiest and most straightforward measure. They filter out the volatility by smoothing out price data with some lag, which helps to identify and clarify trends. Different-length moving averages perform distinct functions. The moving average of the last 200 days of market activity, which is popular for assessing the longer-term picture, does not work as well in a sideways market, and “we could be entering that phase in coming years”, van den Akker cautions. Moreover, different time lengths can be more predictive for the individual price movements of different stocks.
McGervey says: “Growth stocks seem to work better off shorter ones, because they are more volatile”. Investors pay special attention to crossovers, when different averages over different time periods cross one another. The dreaded “Death Cross” occurs when a 50-day average slips beneath the 200-day, signalling a downturn. Traders around the world shuddered when that happened to the S&P 500 on August 11.
What then do the technical indicators augur for the future? The short answer is nothing good, at least for those who invest on the basis that equities will rise. Wald states the case for an ongoing decline, forecasting a possible market floor for the S&P 500 somewhere between 1,080 and 1,120. A test of that floor will probably succeed, leading to a rally within an overall bear market. His argument rests on several legs: increasing bearishness is a contrary indicator; weak seasonal factors coming into October tend to precede strength in November and/or December; and an August overnight low of 1,077 sets a marker. Before investors get too comfortable, Wald cautions that he still regards any potential rally as a counter-trend, and that he is watching 950 as a further leg down.
In any case, markets never move in a straight line. After a first move down in 2009, equities rebounded with a huge bounce. “If you take a step back, over the next 12 months we could return to 667, the 2008 low on the S&P,” says Solin. “As you step back, the bigger picture hasn’t changed.”
Solin adheres to an Elliott Wave framework, which enables analysts to develop potential scenarios for markets. Elliotticians, as they are known, believe markets trace a rhythm of five-wave advances, followed by three-wave corrections, in a repetitive pattern of cycles and longer super-cycles. Critics of the theory point out that, in hindsight, one can always superimpose a wave pattern over any chart, with bullish, bearish or neutral implications. The crux, says Solin, is deciding which is most likely. As Hill – who also predicts lower prices ahead – adds, “in a bear market, most stocks and sectors end up on the losing end. If one must be invested in stocks, I favour strong defensive names, with good dividends, which usually lose the least.”
”Anything lower now than it was 10 years ago is in a secular downtrend”
After a downtrend, technicians look for some time to heal, involving a basing period of sideways pricing and consolidation. One can accumulate within the base, or wait for breakouts to the upside. Bottoms and bases, which usually form in dull markets, are scarce right now. “And this market is anything but dull,” says Hill.
Are there any glimmers of hope on the horizon? Only a few faint ones, respond the technical brigade. Gold, which still offers one of the few positive pictures, has ascended in a relentless uptrend since 2001. Hill also likes exchange traded agricultural funds, and, more recently, the dollar, and treasuries maturing in 30 years’ time. He observes that high-yielding utilities have held up best among sectors in a bleak landscape. Wald is most enthusiastic about technology as a candidate for relative outperformance.
Griffiths looks east. He expects all western economies “at best to bump along with modest growth”. To illustrate his cyclical outlook, he draws an image of world markets divided up like railway carriages, with the length of the train extending over one year. The first market to reach the peak last year was the engine, represented by China and India. This year, the Chindia engine was losing steam, rolling back downhill, while the Western caboose at the back arrived at the top. In the short run, the entire train will be heading lower. But Griffiths reckons Asian markets, which fell more precipitously and sooner, are setting up for a grand buying opportunity in the next round.
Technical analysis takes patience, discipline and hard work. It can also be frustrating. Investors’ time horizons in recent years have shortened, making technical trading more challenging, as markets whip around in changing macroeconomic conditions. If on the first occasion it does not deliver, some users give up on it prematurely.
Yet analysis need not work every time, as long as it can prevent a portfolio from a disastrous plunge – that is when all the hard work pays off. While technical interpretations are not infallible, and can be ambiguous, one only need be right 51% of the time to create a money machine. Charting provides an odds maker, with the edge and advantage of becoming the casino. A robust technical system, steadily applied, can deliver consistent returns.