Technical Analysis | Portfolio Yoga

Fundamental investing vs Technical investing

The question as to whether Fundamental or Technical is the right approach to investing is as old as the hills with there being no clear answer on which is better ideology to follow. I have blogged multiple times on how random portfolio’s have worked wonders as well and given the laziness of the approach, it makes one wonder whether we are fooling ourselves trying to find the holy grail of strategies when in the long run, just disciplined investing should be good enough. Or maybe, its just that we cannot accept that simple strategies can work and hence the constant need to search for a complex / sophisticated one.

Dr.Vijay Malik is a well known investor / commentator in the fundamental analysis circle who today re-plugged a article comparing his journey which started with technical analysis but how he found it inferior after finding fundamental analysis.

Dr. Malik concludes the article (Why I Left Technical Analysis And Never Returned To It!) by way of 4 bullet pointed answers to why Fundamental Analysis is superior to Technical Analysis.

Before I argue my take on those 4 points, I do think that technical analysis has acquired a name as a vodoo science thanks in no less part to some of its well known practitioners. Switch on the business channels on any trading day and you will guaranteed to be given hundreds of tips of what to buy / sell – everything accompanied by a story and a chart. Most of the advises are for the extreme short term (hours literally) making it feel that maybe a chart has no use for the investor who is prepared to wait for the long haul.

Advisory / Education is a big industry and for most of them, technical analysis fits their needs perfectly. Like the Instant Lottery, they are willing to sell their wares with results being instantaneous and the crowd loves them for it. Given the fact that I neither run a advisory service nor try to educate investors for a fee, I do wonder what is the point in defending technical analysis given that I know it works for me.

But I am digressing. The point of this post was to showcase a alternative perspective on the questions raised as to why TA is inferior, so lets move ahead on that. (Dr. Vijay Malik’s quotes are in Italic / Red)

Technical analysis keeps an investor on a treadmill. You can never relax. Carrying open positions requires guts. No one knows how markets are going to open up or end at any day. Fundamental investors sleep peacefully at night.

There is honestly no difference when you carry positions over-night for risk remains the same. Neither a fundamental nor a technical investor knows how the market will open or close. The only difference is that most of the time, a technical investor has a plan laid out on what he shall do in case of stock moving higher and what he shall do if a stock moves lower. Of course, if he like me is a Systematic trader / investor, even that decision making process is outsourced.

It doesn’t matter what methodology you chose, if you don’t have a plan and have made too big a bet, you will end up losing sleep. I am sure that neither Sequoia Bill Ackman are investors who look at chart to take decisions, but these days, VRX is keeping them awake.

In my own journey, I remember the days when I used to sit and watch Dow till it closes and sleep worrying about how that will impact my position the coming day. But moving to systematic trading has removed those worries and made trading (even when markets are not trading in my favor) much more simpler.

Technical analysts rarely capitalize on big moves. There is so much noise in indicators, everyone giving either buy or sell signal all the time. In fundamental investing, you buy once and sit tight. It lets the large gains come to you. I feel safe to say that an investor nibbles in technical analysis whereas she grabs a big bite in fundamental analysis.

To me, the question is not whether you are capturing a 100 point move or a 1000 point move since the bigger difference will come from how much you are betting. A 1% allocation to a 100% mover is same as a 10% allocation to a 10% move.

When using charts, using long term signals eliminates the issue of not being able to capture the bigger moves while at the same time providing timely exit. Rather than just talk theoretically, lets use a recent example: Page Industries.

If you used a simple 200 day EMA, you would have garnered 10,497 points from 2008 till date while being exposed to markets for only 76% of the time. Of course, you will argue that I am falling prey to Selection Bias and I accept. my point really was to show that if you have selected a stock and are concerned about missing the meat of the move, you may want to be relieved to know that you can participate on the big moves.

In technical investing you need to get most of your decision right (>50%) before you make some money. Significant money is required to cover cost of live data feed, brokerages and losses of wrong trades. In fundamental investing even 10 stocks chosen well over one’s lifetime can make one millionaire. Warren Buffett is a live example. He found Coca Cola, Gillette, Wells Fargo, Washington Post and stayed invested with them.

Once again, the question is not about your success ratio, but about how much you make when you win and how much you lose when you take a hit. The trading system which I use on my own funds for example has a Win:Loss record of 40:60. But since my winners make more that twice on what is lost by losing trades, it makes up and then more.

Yes, trading is expensive but unless you are trading intra-day, costs are much lower and in these days of low brokerage, brokerage is not a major factor anymore. But I agree, if you can select 10 stocks that you think will do big on the long term and then bet big on them, you would not need to go through the gruel of trading. As I have written earlier, I was lucky to buy into at least three 100 baggers (one of which I still hold). But since I did not bet big, despite having those winners, I still am way short of fulfilling any of my financial goals. But if you think, you can identify the next big thing and willing to be big, Good Luck.

Technical analysis is more time consuming. An investor has to continuously keep updating the charts and analyzing new patterns, which keep on appearing, whereas in fundamental analysis, once a quarter reviews seem sufficient.

Once again, the key is that it all depends on what kind of time frame you chose. The longer the time frame, the lower the requirement to look at charts on a regular basis. Also fundamental analysis is not about just relaxing after buying a stock. Both analysis requires constant and continued efforts and if you aren’t prepared to put those efforts, its way better to invest in a Mutual Fund / ETF and hope that the manager does better than you.

I am biased towards Technical Analysis since it has provided my bread and butter for long. So, take my above view with a bag of Salt. What works for me doesn’t necessarily mean it shall work for you.

The Wake up Call for Technical Analysis

Technical Analysis has never been seen as a viable tool for generating income / wealth from the markets and the number of jokes surrounding that are legion to say the least. The Oracle of Omaha once said and I quote ”

“I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.”

While I have no clue as to what chart he saw before making such a comment, I am very sure that if he saw any trending chart, there has to be a different answer if you were to invert the chart.

Today, Technical Analysis made its mark in Dilbert and once again seemed to suggest that technical analysis is no more than Sorcery mixed with Astrology. Before I continue on my tirade, here is the cartoon strip that will remain famous for years to come

One may recall that when Gold saw a steep fall, some one created a chart and aptly named it “Vomiting Camel” pattern. While no technical analysis books carry any details of any such pattern, with one hearing about all kinds of animal patterns, this was not entirely surprising to say the least.

While every strategy, be it quantitative or value investing has its faults, when it comes to technical analysis, one feels that maybe we are beyond reproach. Most doctors consider Homeopathy to be equal to quack medicine though I can line up persons who have been treated successfully, critics are happy to point out that its nothing more than sugar pills that are seemingly disguised as medicine. The act of curing is purely based on our mental strength and this serves only as a Placebo and in a way acts as a catalyst to cure the problem being faced.

The reason Allopathic medicine is not only widespread but also widely used is due to the fact that to qualify as medicine, it has to go through several tests (including blind tests) which try to ensure that the medicine is really effective without the healing happening due to other factors. How many of our Ayurvedic / Homeopathic / Unani based medicine can claim to have such strong test requirements?

Just today, I read that the Government of Telangana Chief Minister saying that it will construct a new secretariat building in Hyderabad since the existing one suffers from Vastu defect. Before you laugh at the ridiculousness of the thought process, do give a thought to the many who claim to have seen changes in their life owning to they shifting the door / window / bathroom / pooja room. You name it and you can find plenty of people whose lives have changed. So, should we start teaching Vastu along with Architecture?

On Google, a search for Technical Analysis is provides one with the following options

Think about it for a second. A way of investing / trading is seen more as something that does not work than something which is a way to investing. Even the second option has reared its head only recently.

I am a strong believer that technical analysis works. Even though Quantitative Analysts would want you to believe that the difference between Quantitative Analysis and Technical Analysis is similar to the difference between Astronomy and Astrology, I strongly differ for the simple reason that not only are a lot of concepts have its foundation in mathematics, a lot can actually be proved much to the dismay of its opponents. Its only recently that researchers have agreed that Momentum in markets are sustainable and can be used to generate returns above what Beta says they would.

While Fundamental Analysts strongly believe in valuing the business, we Technical Analysts strongly believe that human psychology has not changed and hence patterns keep repeating the way it has done for hundreds of years now. We believe that finally, Price is King since there is no point in disagreeing with a price that the market believes to be the true value of a stock / index.

That said, the bane of technical analysis lies in patterns / strategies that seemingly cannot be expressed in mathematical terms and hard coded so as to be able to apply it without the need for a chart.

If you look at the sky, its easy to see patterns in clouds though they are nothing more than random elements coming together to play a trick on our minds. Why is it so difficult to accept then that many a pattern that appears on charts are no more than the coming together of random elements.

A lot of patterns can be hard coded and tested for efficiency and these to me are worth pursuing (if the results when tested blindly on multiple markets yield similar kind of results). In fact, a lot of hedge funds are rumored to use pattern search algorithms in order to squeeze out gains from seemingly random movements in markets.

But not all patterns / strategies are the same and if you believe that the strategy you pursue can never be coded & automated fully, you are failing to distinguish between the real and dream.

The Church for a long time held steadfast to its belief that the Earth was the center of the Universe before finally acknowledging the universally known and acknowledged truth. Similarly, Technical Analysis if it wants recognition and respect needs to accept that there are strategies that can be tested and proven as viable and there are those that are good for selling newsletters and does not actually fulfill the promises it makes about its ability to predict into the future.

Technical Analysis is to me is more than just a way to get probabilities better than what can be achieved using a simple coin toss. We may never get a Technical Analyst with the stature of Warren Buffett but we do have folks like Dunn Capital who have shown strong performance for a very long period of time. I strongly believe it makes sense to learn what CTA’s use for developing their trading models since many of them have shown handsome market beating returns without having to buy stocks / companies.

I strongly believe that long term wealth can be generated using strategies based on the concept of technical analysis. But always have a skeptical mind since its better to be seen as stupid for asking a question than seen as a stupid for having lost money using a strategy that can hold no water.

Let me end here by quoting David Hume from his book, An Enquiry Concerning Human Understanding

“In our reasonings concerning matter of fact, there are all imaginable degrees of assurance, from the highest certainty to the lowest species of moral evidence. A wise man, therefore, proportions his belief to the evidence.”

Howard Marks critique of Technical Analysis

Technical Analysis is a nice punching bowl for most seasoned analysts and fund managers. Howard Marks in his book, “The Most Important Thing” suggests that its not a worthwhile strategy in not more than 300 words.

I myself despite being a follower of Technical Analysis for quite some time do not take at face value all the bull shit that goes by its name. Switch on any television channel and you shall be saturated with calls based on so called “Predictive Technical Analysis” with most analysts trying to predict where the markets / stocks may go from here on the short term.

And almost everyone who comes on TV espousing technical analysis is either working for a firm or runs his own tip providing company. When was the last time you saw a person who used Technical Analysis but was managing a fund?

What this has meant is that even Quantitative analysts (an area from which we derive a lot) look upon Technical Analysis as some sort of vodoo science fit to be ignored. But is there really any value in Technical Analysis or are we blindly following a belief that is not worthwhile?

Its a question that has been asked several times by several eminent folks and the answer I have found is that while there is merit in some forms of technical analysis, it does not mean that all the non-sense that is peddled in its name has value.

To me, any logic that is based on some sort of mathematics and can be created using a system has value. This is because by using a systematic logical process, one is able to over-ride our inherent difficulty that comes to pass as several biases showcase.

The very fact that there are hundreds of successful CTA’s who use one or the other form of Technical Analysis (Trendfollowing based) again tells me that the science is not Vodoo as many seem to think it is.

Do take a look at the performance numbers of a few of such folks here (Link) and tell me how could they achieve those returns if the market is random in nature.

Coming back to the book I am reading, Howard Mark says and I quote

Another form of relying on past stock price movements to tell you something is so- called momentum investing. It, too, exists in contravention of the random walk hypothesis. I’m unlikely to do it justice. But as I see it, investors who practice this approach operate under the assumption
that they can tell when something that has been rising will continue to rise.

Momentum investing might enable you to participate in a bull market that continues upward, but I see a lot of drawbacks. One is based on economist Herb Stein’s wry observation that “if something cannot go on forever, it will stop.” What happens to momentum investors then? How will this approach help them sell in time to avoid a decline? And what will it have them do in falling markets?

I am yet to read his latest book, but I do hope that he has in the mean time seen the evidence that has come out to showcase the fact that momentum trading has some value to it. (Link for a search).

And as to getting out when the bull market stops? Is it not as simple as just using the reverse analogy of the buy to get out. Should not be too hard, ain’t it?

Like any other form of investing, Technical Analysis is not easy too. The ease at which it captures trends seems great in hind-sight, but without putting the effort required to understand and apply the same, the ability to do that in real time is pretty low.

Technical Analysis like any other form of Analysis asks for thinking out of the box. Just like the probability of gains is low that you shall gain just because a stock is cheap, so is with most known ways of using Technical Analysis to identify entry / exit points.

So, ignore the pundits on TV and put some work to understand the nature of the markets and how you can apply a theory that enables you to capture as much of it as possible without having to take the risks that come with a pure Buy & Hope strategy.

In Defense of Technical Analysis

One of the ways to beat down a strategy is to apply it wrongly and claim since the results does not match expectations, the strategy has to be wrong. Technical Analysis has its faults and there is no denying that. But claiming that those who use technical analysis as the tool of choice tend to have their performances drag down is doing it a bit too far.

That thought is based on a survey which has been done by Arvid Hoffmann of Maastricht University and Hersh Shefrin of Santa Clara University (Link). The key reasons they come up for the under-performance are:

Investors using technical analysis are disproportionately prone to have speculation on short-term stock-market developments as their primary investment objective.

Investors tend to hold more concentrated portfolios which they turn over at a higher rate

Investors are less inclined to bet on reversals, choose risk exposures featuring a higher ratio of non-systematic risk to total risk

Investors engage in more options trading, and earn lower returns.

The biggest problem area for me in terms of Technical Analysis is the confusion whether it’s a science or an art. While it’s nice to say that it’s both a science and an art, it’s plainly illogical that something can be both. Think about Modern Art being said to be an Art (which is true) as also a Science. I am not sure if there is any other field where both Art and Science are seen to be acting in tango.

Now, let’s go back to the four points which the researchers say are the key reasons for the underperformance of investors who use Technical Analysis for their decision making.

The time frame of a trader / investor using technical analysis is way too short compared to an investor who uses fundamental analysis as his tool. While a fundamental investor gets 4 data points in any given year (4 Quarterly Results), guy who uses Technical analysis has a lot more data points based on what kind of time frame he operates in. A investors who looks at Daily chart would have around 240 data points to consider in any given year while a Investor who looks at a weekly chart will have 52 data points to consider in a year. No matter what time frame one chooses, the data points generally exceed the data points available to a fundamental investor

Having more data points is both a advantage and a disadvantage. Let’s take a example where more data points would have worked in the favour of the Technical Analyst – Satyam Computers. Long before the shit hit the fan, most guys using Technical Analysis as their tool would have seen that it made no sense to trade the stock with bullish bias. For a Value /Fundamental Investor on the other hand, Satyam was a strong case of a stock available for cheap.

It is interesting that the survey finds that Investors hold concentrated portfolio’s / bets compared to investors using other methods who may be holding diversified portfolios. A lot of water has flown down the bridge as to whether it’s better to hold concentrated bets or diversify as much as possible. Both have their advantages and disadvantages and I doubt that it can be proven that either concentrated or diversified portfolio is the best bet.

Personally I believe in concentrated bets since the more number of stocks one is exposed to, the closer we get to ordinary performance. The same was proved when I did the test of random portfolio strategy as well. But I strongly doubt that a concentrated portfolio is the key to under-performance since I know of many value / fundamental investors too who use the same approach and have been able to beat market averages by a mile.

This point interestingly goes against the point number 1. If investors using technical analysis as their trading tool are trading more, it goes on to prove that they are betting on reversal s to the existing trend at multiple points and in turn can miss the big rally when it comes.

Option trading as such has nothing to do with Technical Analysis but since Option traders are short term traders and are betting on charts to decide on what stock and what strike to buy, it’s easy to get clubbed with Technical Analysis even though one can search the entire technical analysis vocabulary and find not a single instance of a tool devoted to options.

In an earlier blog post, I had written about how people buying cheap options is not the path to riches and instead will result in ruin of capital in the long run. But then again, options are pretty enticing since unlike stocks, they can double / triple in no time at all.

But Technical Analysis as such has no role in how investors / traders risk their capital in the markets. Option trading is similar to buying lottery tickets (though the odds here are much better) and hence not something that is bound by any strategy other than human greed.

To me the biggest negative is the fact that Technical Analysis as a tool is far from refined and adapted to the world where it’s important that it’s scientifically proved beyond doubts. If I were to buy stocks based on PE, that would not make me a Value / Fundamental Investor but if I were to draw a line on a chart, I am seen as a Technical Analyst. End of the day, it’s the perceptions that seem to matter more than reality.

Over period of time, I myself have debunked multiple strategies that are associated with Technical Analysis and showed how they fail the traders / investors who use those tools. But to claim Technical Analysis as a whole is quack is akin to throwing the baby with the bathwater.

Thoughts on Technical Analysis

The wonderful thing with technical analysis is as Arthur Conan Doyle wrote in Sherlock Holmes and I quote

“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.”

Depending upon our perceived bias, its easier using technical analysis to get the outcome we desire. So, if I want to showcase why the markets may fall (though it may have been rising day in and day out), I would search for indicators that are showing overbought and since overbought in itself may not be a reason to sell, I will also check whether there is a divergence. Of course, once again, divergence is not a reason, but as long as it suits my view point, what the hell.

There exists a lot of bunkum when it comes to technical analysis, but when challenged, one key answer has always been, “it works for me, so there is something in it”. But its not that technical analysis is itself bunkum as many try to project since there exists ways and means to test a lot of theories and come out with valid observations that can be applied elsewhere too.

For example, while patterns are said to be in the eye of the beholder, there has been some serious amount of testing on the veracity as well as the success / failure of each of the patterns by Thomas Bulkowski who incorporated them in his wonderful book – The Encyclopedia of Chart Patterns. Hence while Chart Patterns are in itself subjective, one can guess the feasibility of such a pattern working or failing and hence applying suitable money management / position sizing algorithm to it.

But to me, the best systems are one where there is zero human discretion and charts are definitely not one of them. Once the human element is introduced, its easy to fall prey to try and fit the curve rather than the curve fitting the pattern on its own.

To conclude, the next time someone claims to predict the market with the help of discretionary tools, do note that the possibility of his bias slipping into his analysis is pretty high and that distorts everything.

Share this:

Share this:

Share this:

Share this:

Share this: