Implications of Technical Analysis for Investors

The methods used by technical analysts attempt to predict future prices in the markets and individual stocks and to determining when to buy and sell. The number of new methods touted by technical analysts keeps growing.

What is the rationale for the success of technical analysis in identifying future prices of stocks and the markets? First, technical analysts believe that the crowd of investors will always react in the same way. When a pattern of rising prices occurs, investors will want to jump into the market (buy stocks). This action then pushes prices higher as more investors join in, causing a self-perpetuating increase in prices. As prices rise, so do the enthusiasm and fervor with which the buy recommendations of the technical analysts are touted. Technical analysts recommend stocks only when there is a price trend. In essence, they are encouraging you to buy stocks when prices have already gone up, after an established breakout or an upward trend has taken place. In other words, investors are encouraged to buy stocks when the prices have already risen. If these stocks do not continue their upward trend, investors find that they have bought stocks at high prices when the stocks have turned around to fall to prices below their purchase prices. On the downward trend, technical analysts then initiate their sell recommendations. You are then encouraged to buy at high prices and sell at low prices. (This situation does not sound like a winning formula to make money, let alone get rich.) The other problem is that stocks may take sudden turns in price, which could mean that technical analysts could “miss the boat” in their timed buys and sells.

Academic research has shown that technical analysts have not been able to outperform the results from a buy and hold strategy in the market. An astute reader will question this conclusion because most brokerage firms employ at least one technical analyst. What about that? Some good reasons exist for having technical analysts on staff. They read their charts and issue many buy and sell recommendations within short periods on the same stock, advocating active trading of stocks. This situation generates commissions for brokers and their brokerage firms. A buy and hold strategy, on the other hand, generates only one commission per stock when it is bought and held.

From the investor’s point of view, a buy and hold strategy may not be exciting, but it does economize on paying taxes. The perpetual trader, who is in and out of stocks in periods of less than a year, pays taxes on capital gains at ordinary income tax rates. The investor whose holding period is longer than one year pays taxes on gains at the lower long-term capital gains rates. The buy and hold investor does not pay taxes on the gains until the stock is sold. By following the advice of technical analysts, you are bound to generate more commission costs and greater amounts of income taxes.

Take a look at some of the holes in technical analysis. The argument put forward by technical analysts is that if an established upward trend in a stock takes place, the momentum from buyers in the market will continue to fuel the stock upward, to even more dizzying heights. No attention is paid to the fundamentals of the stock or to other reasons that the stock is rising in price and whether it is overvalued. It does not matter, in fact, what the name of the stock is or what type of business the company is in. For example, if the stock prices of two different companies in two different industries have the same chart patterns with upward trends, there would be no differentiation in their buy recommendations. Yet most people know that the oil industry and the health care industry, for example, generally do not perform in the same way and that some fundamental factors could affect different companies in the same industry. What about company management? One management team might be more efficient and effective than another. The charts and chart patterns do not differentiate these factors, and neither do they take into account the possibilities of change. People might react differently in the future from how they reacted in the past, and events can change. If randomness exists in the market, past patterns have no effect on future prices.

Technical analysis encourages timing of buying and selling stocks and the markets. To do so profitably requires a high degree of accuracy. Although many famous technical analysts have predicted many bull and bear markets successfully, they have not been able to do so consistently. Elaine Garzarelli successfully called the “Black Monday” crash of 1987 but remained bearish thereafter while the markets went up. To get back into stocks and the market, the reentry points were much higher than if investors had merely stayed in the market and held their positions during the crash. To time the buying and selling of stocks and the markets successfully, you have to be accurate in your decisions, and you almost need clairvoyance.

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