While several investors keep trying to look at the company earnings and the macros to make sense of the the future direction of the stock market prices, a curious category of investors pour over the charts and keep looking for evidence in the apparently random squiggly lines that the charts of stock prices over time make. This group of analysts are known as the technical analysts. So what exactly do the technical analysts look for in the charts of the the stock prices and why do they even attempt to predict the markets when essentially every academician on earth deems the price movements to be nothing but a random chance and any attempt to predict it as an exercise in futility?
Well, having been an investor for more than a decade and going through the drudgery sometimes of stock picking and building a portfolio, I have often used Technical Analysis as a tool to help me make what I believe are some very important decisions at the overall level of a portfolio or even decisions pertaining to the asset allocation. Some people would frown at the idea of using technical analysis to make such decisions but I have found them to be incredibly useful and in this article I will show a few places they prove to be absolutely indispensable.
Technical Analysis is an excellent tool when used on a long term time-frame to get an idea of what the market participants are up to. Markets are made up of participants who have different expectations and different objectives from the same market. While the seemingly different expectations and objectives would lead one to believe that the market participants would not act in a manner which would re-enforce a possible direction the exact opposite is the truth. While the statistical analysis and the academicians go to great lengths to prove that the prices have no correlation with the past prices themselves, what they tend to overlook is the fact that the behavior of investors in a stock market is often impacted strongly by the behavior of the other participants. For example several investors are often found waiting for the stock prices to stabilize or for it to start moving up before they make any commitment to the particular stock. In essence what they are actually saying is that they are waiting for the other investors to make a call before they themselves take any decision. In other words they are likely to follow the investors who will take the lead and invest first. Surprisingly even the investors who use fundamental analysis to make the investment decisions are often seen talking in this language. They often attribute this behavior to the irrational fear in the market and the fact that such irrational behavior can continue for a lot longer than the amount of risk that they are willing to take in their portfolio. Its' precisely these deviations from the rational market behavior that underpins the principles of technical analysis, which looks at the market from a simplistic lens of one where the demand and supply decide the eventual price rather than the valuation metric proposed by certain academicians. The tools that the various technical analysts use vary widely and its very possible that two different analysts disagree on the future course of action of the prices based on the charts they see in front of them. Yet, there are several indicators which are objective in nature and can be used to decide on the action that an investor should take without getting into any debate. One of them is the moving average. A moving average is calculated based on the most recent price data. For example a 10 day moving average is going to have the average of the most recent 10 day closing prices and plotted onto the chart. Similarly you can plot the moving averages of the various time-frames. Now since the moving average is the average of the prices, any time the prices are above the averages one concludes that the prices are in an uptrend and when the price is below the average the interpretation is that the price is in a downtrend. By using the average of different duration one can conclude what the stock is doing for the given time-frame.
For example, a 50 day moving average is considered to be a good measure of the medium term trend while a 200 day moving average is considered to be a good measure of the long term trend. Theoretically speaking there are infinite number of cycles that exist at any given point in time. What we need to do is isolate the time-frames and look at the ones that make the most sense for us. Essentially what we want to do is invest when the different cycles point in the same direction and not when the different cycles are pointing at different trends. Just imagine swimming with the tide versus swimming against the tide. If the two trends are in the opposite direction what we get is a choppy market and when they align what we get is a trending market. Now let is look at some charts and identify the various choppy market trends and the ones where a very smooth trend whether up or down is existing.
The above chart makes it pretty simple to identify the choppy market and a sideways market. The key thing to remember is that the trending market will be known to us when the trend has already been in effect for a while. There are several people who try to identify the trend right at the beginning, but in my experience such an approach is fraught with danger. You will end up getting whipsawed too often and by the time the trend does come into effect you will perhaps be already looking at another scrip out of sheer frustration. Notice the blue line in the chart- that is the moving average. The moving average during a choppy market is flat whereas during the trending market the moving average is sloping downwards. That's an important point to notice. So now we have understood the trending and the sideways market, and are also able to spot a long term trend. Now we go back to the earlier discussion regarding the various cycles. We are looking for an entry and now that we know that the larger cycle was pointing downward we want to now look for an entry using a shorter cycle, for that we can use the 50 period moving average.
The above is the daily chart with the 50 period moving average which is drawn as the red line. The shaded area represents the part where the 200 moving average is sloping down. We know that the down trend is in effect by observing the longer term moving average sloping down. In this chart we use the 50 day moving average to further fine tune the entry and exit of the position. As we can see the 50 period moving average gives us a pretty good exit and then we get a false sell near August. By September another sell signal is initiated and that one gives us a modest profit. If we notice the 50 moving average during the sell signal in August(which is triggered by the prices moving below the 50 moving average), it happens when the 50 moving average is sloping up. This brings us to the point that we were discussing earlier regarding the different time-frames aligning when we take a position. As expected the sell signal when the 50MA was sloping up proved to be the one which ended up in a loss. The sell in September happens when the 50MA was flattening out and had just started to point down. The trade ended in a slight profit. The strategy here was to take a trade in the direction in which the larger period moving average was sloping. Essentially that defines the trend. Then we use the smaller moving average to make the actual entry and exits. The entry is when both the longer term time frame and the shorter term align. The exit is when the prices close above the shorter time frame moving average in this case. This shows that the short term price trend is now bullish whereas the longer term was bearish and we could expect some whipsaws or false signals or simply put trades where we are likely to suffer a loss.
A simple strategy like the one described here probably will not be sufficient for the savvy investors who would look at the plethora of market evidence before making any commitment to any given stock or commodity. But majority of the investors after having looked at the broader market data would also look at the evidence on offer with regards to the individual stock. It is here that the technical tools prove so very helpful when concerned with analyzing the markets which are most impacted by the frailties of the human nature of fear and greed. Markets always seem to get stretched on the upside when the cycle of greed plays itself out and always ends up overshooting on the downside when fear in the minds of the investors leads them to dump their holdings only to regret the actions later on.
When faced with the markets which are often behaving irrationally and in this decade the number of times that we have experienced the shocks have only highlighted the need for a tool that enables us to read the mass psychology with a greater understanding and then also allows for objective rules to enable us to trade with clarity. The charts do just that, give us an understanding of the mass psychology and rules on how to go about trading or investing using them. The moving averages do not worry about whether the markets are rational or not, but simply provide a means for you to react to whatever the market is doing. Eventually profiting from the markets is what we are looking at and the discussion on whether the market is rational or not while maybe excellent for intellectual gymnastics do very little for our fortunes in the stock market.