
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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