Some months ago I spent a splendid day in the French city of Lyon. For me, as a card-carrying foodie, it was a gourmet’s nirvana. There was one street, just near the river, in which every business seemed to be a restaurant. How could I possibly choose which one was to relieve me of some hard-earned euros?
In investment terms, a fundamental analyst would go to each one, study the menu for the quality and range of food on offer, and look at the prices and whether or not service charge was included. They might even peer through the windows to see what the meals looked like on diners’ plates and, being really thorough, peek into the kitchen. And after all that, they would carefully study their Michelin Guide and Google ‘Restaurants in Lyon’. In short, they would make a decision based on all available fundamentals.
By contrast, a technical analyst would sit on a nearby wall and watch people go into each restaurant. Disregarding the intrinsic value of the product, the technical analyst’s decision would be based on the patterns of activity of people going into (or not going into) each eating place. If a particular restaurant was full it must be good and the reverse would also be true. And if there was a queue outside, well, say no more. Of course, both systems could be said to have their merits.
Technical analysts believe people behave like sheep. They act predictably when faced with human emotions, such as greed or fear of loss. They buy or sell just because they see others doing so. These behavioural patterns can help the technical analyst to predict other people’s predictions of where a share’s price may be going.
The chief principle of technical analysis (is that an oxymoron?) is that a share’s price reflects all relevant information, so it looks at the history of a security’s trading pattern rather than external factors such as economic, fundamental and news events. On the premise that all relevant information is already reflected in the price, technical analysts believe it is important to understand what investors think of that information, known and perceived. To a ‘technician’, the emotions in the market may be irrational, but they do exist. Because investor behaviour repeats itself so often, technicians believe recognisable (and predictable) price patterns can be mapped on a chart and used to earn superior profits.
Whether technical analysis actually works is a matter of controversy. Methods vary, and different technical analysts can sometimes make contradictory predictions from the same data. Many investors claim they experience positive returns, but academic appraisals often find that it has little predictive power.
The chart below shows the theory. It represents the share price of a particular stock over a period of time. It could be days, weeks or even months. As the price starts to rise, with a corresponding increase in the number of shares traded each day (the volume) the technician, or ‘chartist’, will expect the trend to continue until all demand has been satisfied and the market starts to think that the price is getting too high (the resistance level).
The chartist will buy the stock as soon as that upward trend has been identified. It does not matter what the intrinsic value of the shares is, how well the company in question is being managed or whether or not it is particularly solvent. As the peak approaches, volumes will start to reduce. The chartist sees this sign and will then sell. The price starts to fall – only a trickle at first, as volumes are low. Then the herd instinct sets in and others decide to do the same. The sheep have transmogrified into lemmings by now. Why? Because everyone else is selling, so that must be a good enough reason to jump off the cliff as well. Volumes increase as more people exit and the price falls further. Gradually the volumes diminish and the price fall peters out as the support level is reached. And then, say the chartists, off we go again.
Going back to my fundamentalist gourmet (or even investment guru), the downside of that approach might be that by the time they have completed the thorough enquiries and run them through computer models to find precisely the best place to eat, the ideal restaurant may have closed for the day!