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 MARKET REPORTS |
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Analyst report - shares
Why technical analysis matters
July 30, 2007
Brendon Lau, ShareAnalysis
 Fundamental analysts have long been suspicious of technical analysts (people who use share price charts to decide when to buy or to sell stocks) and have often regarded technical analysis (TA) as alchemy. Research undertaken in the US supports the view: that when well-known chart patterns (such as head and shoulders) are consistently applied across various markets for substantial duration, TA does not work. Is TA a waste of our time?
We do not believe so, as critics often forget that TA (and fundamental analysis for that matter) is as much an art as a science. If you blindly apply the same template analysis (technical or fundamental) across various stocks, you are likely to get most of your calls wrong.
What TA does well, which fundamental analysis cannot, is to gauge market sentiment through share price action. When a share price behaves outside the “norm”, it usually marks a change in market psychology. As such, there are strong links between TA and behavioural finance (a discipline taught at universities and practiced by investors such as Warren Buffet). For example, the theory on why former price resistance levels become levels of new support is likely because investors see it as a second-chance buying opportunity as the price drifts down. These are usually the people who were kicking themselves for not having bought before the price jumped and are now buying as the price is roughly back to where they could have last purchased.
As with any analysis, you should try to use a few technical indicators or a valuation matrix in deciding any course of action. For instance, technical traders might use volume in conjunction with a stochastic indicator and trend lines, while fundamental investors may use PE ratios and discounted cash flows (DCFs) to decide what is really good value and not just cheap.
Perhaps where TA and fundamental analysis work together is when investors use the latter to decide whether to invest in or sell a stock and use TA to better time the entry and exit. After all, TA is about sentiment (which can turn on a dime), and not value.
One possible reason why TA is regarded with suspicion is that technical analysts sometimes forget that correlation is not causation. For example, there is the story of the little town in Europe that lies under a winter migration path for storks. One winter, a record number of storks were landing on roofs in the town, and the town had a record number of pregnancies among its population. Conventional “wisdom” might suggest that storks really do bring babies into the world!
It was later discovered that because it was an especially cold winter, the storks had to stop and rest more often. The weather also prompted the townsfolk to stay indoors to cuddle up... hence the pregnancies. So remember, the next time you see a stork on your roof, it could bring you more than a “stork” tip.
Brendon Lau is the Editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. For more information on these stocks and for a free trial of its web-based investor research services, please go to the ShareAnalysis website.
More articles from this week's CompareShares newsletter:
International investing: Chinese whispers
Uranium & Iron ore: Unfashionable metals back in vogue
Resident trader: Learn from your losing trades
Commodities: Which is the most popular to trade?
US plunge: Markets around the world are marching in lock step
Super: Young savers need to rethink super
Stock of the week: ADO
Warrants: Instalment pricing explained
Shares: Chief ratios for stock hunters
Shares: Earnings yield an omen of doom?
Super: The Y2K of super in 2007
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
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