Thursday, July 15, 2010

Technical Analysis (Part 2)

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In previous posts, we've seen how I've attacked technical analysis by citing empirical evidence that debunk some of its underlying assumptions or by relying on what I like to refer to as simple financial common sense. After doing additional research for this post, though, I have realized that I may have focused too much on the weaknesses of the method and failed to highlight some of its merits. Again, I hope to remedy that lapse with this post.


1. Technical analysis does not rely on accounting information.

Unlike fundamental analysis, technical analysis exclusively uses historical market prices and trading volumes in making investment decisions and abstracts away from accounting information from financial statements. According to Generally Accepted Accounting Principles (GAAP), firms enjoy a certain degree of freedom in choosing from among several available methods in measuring and reporting important financial variables like earnings, expenses, assets and liabilities; of course these firms can (and do) always choose the approach that shows the best financial results on paper. This flexibility in interpreting and applying accounting rules and principles can be (and is) used by managers to mask the weak financial status of their firms, as we've seen in the cases of Enron and WorldCom this past decade. In the Philippines, it is common practice for firms to have different sets of financial statements for different audiences, usually one for the SEC, one for the BIR, and one for internal decision making. This lack of transparency and consistency in financial reporting thus makes decisions that are heavily based on accounting information doubtful, at best.

2. Technical analysis considers intangible and nonquantifiable factors that don't appear in financial statements.

Another disadvantage of using financial statements in making investment decisions is that these documents rarely reflect the effects of subjective factors that are difficult to quantify, like manpower skill, management expertise, and brand equity, among others. According to technical analysis, asset prices continuously reflect how buyers and sellers view the firm in terms of all possible sources of information; thus, using historical prices in forecasting future stock movements would tend to be more reliable and complete than using accounting data.

3. Fundamental analysis may be able to tell you "what to buy", but it cannot tell you "when to buy."

Fundamental analysis allows investors to identify assets that are underpriced, or those whose intrinsic worth is greater than the price determined by supply and demand. Unfortunately, it ends here, since fundamental analysis cannot say when the best time to buy these underpriced assets is, or when market prices will eventually catch up with intrinsic value.

Conversely, fundamental analysis goes beyond coming up with buy or sell recommendations since it is supposed to able to identify the exact moment when long run prices will change, and thus provide investors with an optimal timing recommendation.


Most of the challenges to technical analysis in literature comes from the efficient market hypothesis (EMH). But since I firmly believe that EMH is just another by-product of the now-defunct school of rational-investor economics (here I go again with my bold and audacious statements), I'll veer away from these arguments and look at more pragmatic points from other sources.

1. Technical analysis is limited to assets that are actively traded in public markets.

Unlisted private firms and the underdeveloped real estate and bond markets in the country would not be able to provide real time prices that technical analysis needs. This is where fundamental analysis comes in, since the concepts and tools used by this approach (i.e. free cash flow projections, time value of money, the cost of capital, etc.) may be applied to to any kind of asset.

2. Technical analysis involves several concepts and rules, some of which contradict each other, that may be interpreted differently by different analysts.

That's why two technicians looking at the same data set may come up with two completely different conclusions. Go figure!

3. Empirical evidence from recent studies show that active investment strategies like fundamental and technical analysis don't work.

Or at least, they are not conclusively or consistently better than passive investment strategies.

Yeah, yeah, you'll tell me about this person you know who knows someone who knows someone who was able to make a killing by picking stocks. You know what, even if this person is able to consistently beat the market index, net of all transaction fees and taxes, for, say, thirty consecutive years using any stock picking method, it's still no evidence that the market can be consistently beaten by active fund management. This is what that write-up about lucky fund managers tell us; it's what that S&P study about past performance shows.

Wait, these arguments sound eerily like they come from the school of EMH... don't they? While we commonly associate EMH with passive fund management and behavioral finance and irrational decision making with active fund management, these connections are not written in stone. While empirical evidence shows that active investment management is not conclusively superior to passive investing, it does not necessarily mean that markets are efficient and investors are rational.

The Verdict

So is technical analysis better than fundamental analysis, or is it the other way around? In my opinion, we cannot really say that one is better than the other, since it usually really depends on the situation, or what kind of asset we are considering to include in our portfolio. In most cases, we shouldn't even be choosing between the two since many active fund managers choose to apply some sort of combination of these two approaches. Still, to me, making investment decisions based on historical prices alone just sounds soooo wrong. Investing in stocks is really just buying a piece of a business, right? Doesn't it make sense to know other things about the business you're buying aside from its price?

One very important thing that I learned from all this talk (and all the reading I've done) is that technical analysis is not completely worthless as some irresponsible personal finance blog facilitators contend. I completely agree that financial statements, especially in developing economies like the Philippines and particularly for micro, small, and medium enterprises, are ultimately unreliable. I've always believed that most investors are far from being rational, just as the market is far from being efficient, and that leaves some room for those who know what they're doing to make a bit more money than passive index funds. I also agree with Martha that past performance should have some bearing in making investment decisions, despite the results of that recent study. In my next post, I'll even try to use some of these technical analysis concepts to figure out and try to explain what's going on in the local stock market right now and why I think stocks are currently overpriced.

Let me end by sharing this little nugget of wisdom from Warren Buffet about technical analysis:

"I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer."

Tell me, how the fuck does one argue against that?

Click here for Part 1.
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