Tuesday, July 13, 2010

Technical Analysis (Part 1)

A Standard Setup of Technical Analysts:
The PSEi 6-Month OHLC Chart with Bollinger Bands and Volume
Image from Bloomberg.com

Back in April, our good friend Ange talked about a well known investment approach called fundamental analysis, which involves comparing a company's true or intrinsic worth to its current market value and making the appropriate investment decision based on this comparison. The estimate of the company's intrinsic value comes from an analysis of the firm's fundamentals, reflected by key financial measures like profitability and operational efficiency, and the economy and industry within which the firm operates.

In contrast to fundamental analysis, technical analysis involves the use of historical market data to predict future prices, which leads to making buy and sell decisions at the appropriate time. Unlike fundamental analysis, technical analysis exclusively uses direct market information like past price and volume trends and shies away from macroeconomic, industry, and firm-specific variables.

Some of you may have witnessed the eternal debate that has been going on between Ange and I all across this blog, with her and active investing on one side, and me and passive investing on the other. In these discussions, I have emphasized my skepticism about technical analysis, based on both traditional and recent findings in the field. But as I was gathering materials in preparation for this post, I have discovered that I might have irresponsibly made some premature conclusions about technical analysis, a lapse which I hope to redress in this post.

Underlying Assumptions

Technical analysis is founded on these core assumptions:

1. The market value of any good or service is determined solely by the interaction of supply and demand.

2. Supply and demand are governed by numerous rational and irrational factors, including economic variables and opinions, moods, and guesses of investors and other market participants. The market weighs all these factors continually and automatically.

3. Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time.

4. Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.

The first two assumptions are actually consistent with fundamental analysis, which also uses the market-driven value of an asset like common stock in making investment decisions. And since the market price of any asset reflects both rational and irrational factors, it's natural to assume that this value and the asset's theoretical, "rational" intrinsic value should diverge at some point.

The next two assumptions imply that past price movements tend to repeat in the future, which is exactly the opposite of what this recent finding of Standard and Poor's suggests. This belief is partly based on the idea that new information about a particular stock does not come to the market instantaneously at one point in time, as what the efficient market hypothesis prescribes, but rather over a period of time. The argument is that information comes from different sources in "chunks" that are released at different times, and that different kinds of investors would have different degrees of access to these pieces of information; it makes sense that institutional investors and market professionals would have better and more timely access to new information than average investors who rely on secondary sources like mass media. This implies that to the technical analyst or technician, price adjustments based on new information would be more gradual than abrupt, and that this lag or delay could be exploited by an appropriately timed investment decision.

Click here for Part 2
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