Technical Analysis: Is it voodoo? Or does it work?

[MightyMouse 12]

^^ That's the problem right there. It's an accurate description of technical trading, and also an accurate description of why it's a bad game to play in.

 

The returns to investors ultimately derive from the value created by the companies that receive their capital. On average stocks would not grow if the underlying companies were not, on average, growing. So if you're not trading the markets then you do not have those returns available to you. Instead you are competing in a win/lose zero-sum game - quite literally, you are gambling, and the rake taken by the brokers is pretty steep.

 

In fact I'd go so far as to say that any trade with a horizon less than a year is likely to be a form of hunt-the-sucker. I know there are a lot of A-types out there, but the truth is that statistically half of them will be the suckers. Not great odds.

 

There is truth to what you say. Active money does tend to pay passive money in the stock market.

[BlueHorseshoe 10]

Interesting article today.

 

Oil crash pits floor veterans versus computer algorithms | Reuters

 

Pit oil traders are pissed that us new "technical traders" have an advantage over them. (I consider myself a pure technical [algorithmic] trader). I created my own algorithms just like they could have and I consider myself no smarter than any of them or have access to any more resources than they do. That breaks my heart. Just like any industry; keep up with technology or suffer for it ignoring it. I know many many pit traders that have migrated to the charts, the open minded ones that is. Of those, some succeed and most fail.

 

Still waiting on that email Josh.

 

I think if you consider an algorithm to be any set of rules for completing a task, then most successful floor traders will use simplistic algorithms in their trading. So I don't think the technology has opened up the possibility for algorithmic trading, so much as opened up the possibility for more complex algorithms. Hence, as you say, it's a case of "keep up with the technology or suffer".

 

BlueHorseshoe

[joshdance 10]

Ha ha, yes, very funny. Actually I've only ever been a top-down investor and occasionally a stock picker, and I've done pretty handsomely - especially after trading costs are accounted for.

 

Anyway the basic truth remains - investing is about buying good companies at good prices.

 

David, you are certainly not the first investor who has said that trading is gambling, and the like. I agree with your last sentence David; but investing is not trading. Some people simply aren't cut out for trading. Usually the ones who talk about how it's gambling, a losers' venture, a "bad game," are the ones who have been burned by it, or who have never actually done it. There are plenty of "weekend investors" who open an e*trade account and dabble with markets who would like to think they know what trading is, but they have no idea, not a clue. If you have had handsome returns, I congratulate you, and advise you to stick with what you're doing well, and to stay away from that which you have no actual experience with.

[DavidTurner 10]

Some people simply aren't cut out for trading. Usually the ones who talk about how it's gambling, a losers' venture, a "bad game," are the ones who have been burned by it, or who have never actually done it. There are plenty of "weekend investors" who open an e*trade account and dabble with markets who would like to think they know what trading is, but they have no idea, not a clue. If you have had handsome returns, I congratulate you, and advise you to stick with what you're doing well, and to stay away from that which you have no actual experience with.

 

Good advice, and I'll ignore the slightly condescending tone of the earlier part. Trading is very much like poker - it boils down to an emotional game. In a good market, the rising tide lifts all players and generates enthusiasm. But never forget that what you're doing is swapping money with people who made the wrong call. On average, the long-term profit of high-volume traders is less than the return on the index because of the fees they're paying. Yes, you might be the WSOP champion for four years running, and if you're smart you'll retire after that. But I think most TAs end up like like Jesse Livermore on a smaller scale: made it, lost it, made it again, ultimately lost it all.

 

This is not criticism or even a general "stay away" statement - I play poker too. I'm simply pointing out that you have to recognize the reality of the game and know when to get out.

[BlueHorseshoe 10]

Good advice, and I'll ignore the slightly condescending tone of the earlier part. Trading is very much like poker - it boils down to an emotional game. In a good market, the rising tide lifts all players and generates enthusiasm. But never forget that what you're doing is swapping money with people who made the wrong call. On average, the long-term profit of high-volume traders is less than the return on the index because of the fees they're paying. Yes, you might be the WSOP champion for four years running, and if you're smart you'll retire after that. But I think most TAs end up like like Jesse Livermore on a smaller scale: made it, lost it, made it again, ultimately lost it all.

 

This is not criticism or even a general "stay away" statement - I play poker too. I'm simply pointing out that you have to recognize the reality of the game and know when to get out.

 

Hi David,

 

I was intrigued by your statement:

 

"investing is about buying good companies at good prices."

 

Would you ever sell a bad company at a not-so-good price?

 

Would you sooner buy a good company at a better price than just "good"?

 

If a company seized to be good, and you were then holding it at a not-so-good price, would you then sell your holding?

 

In spite of Josh's points, your realisation that active traders have to be very successful just to overcome costs puts you leagues ahead of most active traders.

 

BlueHorseshoe

[DavidTurner 10]

I was intrigued by your statement:

 

"investing is about buying good companies at good prices."

 

Would you ever sell a bad company at a not-so-good price?

Would you sooner buy a good company at a better price than just "good"?

If a company seized to be good, and you were then holding it at a not-so-good price, would you then sell your holding?

 

Hi BlueHorseshoe - I was actually being somewhat precise: investing is about good companies at good prices, whereas trading is about buy-when-it's-going-up, sell-when-it's-going-down (if you'll forgive me for simplifying horribly).

 

While I dabble in trading, the majority of my investments follow a simple value-oriented strategy: evaluate a band of confidence around a target price, then buy when the price is sigma-below and sell when it's sigma-above. These rules actually trigger only once or twice a month, and generally I hold onto a stock for a very long time. The crucial thing (and very much the hard part) is obviously the valuation, for which I use a mosaic of forecasts and Monte Carlo techniques.

 

One problem with this approach is that it's biased towards mid-caps. Another is that it occasionally signals a buy of a perennial loser or a sell of a stock with huge growth potential. So as with all methods, it requires careful thought and judgement on top of the quants.

[MightyMouse 12]

Good advice, and I'll ignore the slightly condescending tone of the earlier part. Trading is very much like poker - it boils down to an emotional game. In a good market, the rising tide lifts all players and generates enthusiasm. But never forget that what you're doing is swapping money with people who made the wrong call. On average, the long-term profit of high-volume traders is less than the return on the index because of the fees they're paying. Yes, you might be the WSOP champion for four years running, and if you're smart you'll retire after that. But I think most TAs end up like like Jesse Livermore on a smaller scale: made it, lost it, made it again, ultimately lost it all.

 

This is not criticism or even a general "stay away" statement - I play poker too. I'm simply pointing out that you have to recognize the reality of the game and know when to get out.

 

I really liked the way you started and then you took a random walk down Wall St. You will be able to make money trading or playing poker as long as fresh money continues to enter either arena. Dumb money either leaves or learns. Either is a problem for a trader or a poker player. Not trading is a great trade if there is no money to be taken by you. If you are going to trade when there is no money to be made, then what you are describing may come true, but then you are not using trading skills to trade and are instead just incessantly hitting buy or sell on your DOM until all your money is gone.

[karoshiman 10]

 

...

 

The returns to investors ultimately derive from the value created by the companies that receive their capital.

 

...

 

 

I assume, by "value created by the companies" you mean profits or cash flow.

 

If so, I disagree... the value of an asset and hence the return to investors is derived from what others are willing or not willing to pay for it. Even, if one takes a long-term view (3 years and more) a company that has increasing cash flows has still to do a great job in investor relations in order to explain their story and convince the markets about its value and by thus driving their stock price up. And that's the key, you have to convince people... cash flow alone will not help.

 

And by the way, the markets reflect the future expectations. That's why it is more important what others think about the future of a company than what the company actually produces in cash flow. The latter is only relevant for the valuation when there are major deviations from expectations, hence, changing the view of people on the future of that company. But, my point is, it's the aggregate view of people about an asset that is the driving force.

 

I've started this game as a fundamental trader. Was right about the internet bubble and lost a lot of money as my timing was crap (I think I was the only one at that time who lost money... lol).

 

I've worked for years in M&A and evaluated private companies in these transactions. Although, you have a fundamental basis for your negotiations at the end of the day it's the buyer and seller agreeing or not agreeing on the price. Often you get to see in these private transactions "irrational" prices.

 

Later, when I've switched to a corporate career I've worked intensely with the board of directors and evaluated also our own company. I saw, that the valuations by the stock market just did not make sense most of the time (not talking cents here, but major deviations).

 

These experiences led me finally to technical analysis... and it works as I am not trying to impose some views on the markets but try to understand the markets intentions. It's irrelevant whether I think the markets are over- or undervalued.

 

Now, if you've meant with "value created by the companies" good investor relations work, then I agree with your statement.

[SIUYA 11]

karoshiman - you almost seem to be arguing against your own point.

Often the markets dont recognise value or overshoot on value....hence a value investor is likely to always be getting into a stock when its in a downtrend, or out when in an uptrend.

 

you then have the issues of even if a good company is well run it may be in a declining industry, or the company is making good money now but has road blocks ahead, or the management have a poor history of reinvesting that cash flow and profits.....etc;etc

 

The best approach surely is to combine the two - work out what is good value and then let the market price guide you as to how best to extract that value......so how then do you value gold, oil, currencies ???

[DavidTurner 10]

I assume, by "value created by the companies" you mean profits or cash flow.

 

If so, I disagree... the value of an asset and hence the return to investors is derived from what others are willing or not willing to pay for it. Even, if one takes a long-term view (3 years and more) a company that has increasing cash flows has still to do a great job in investor relations in order to explain their story and convince the markets about its value and by thus driving their stock price up. And that's the key, you have to convince people... cash flow alone will not help.

 

Hi karoshiman

 

Really good post - sounds like you're a fan of the Austrian school - and it absolutely reflects my own experiences.

 

I can't possibly do justice to this topic in a post, it really deserves a book (and several books have been written on the topic as you no doubt know). But basically I do take the view that a rational investor should base his value estimate upon the expected cashflows and their timings. However this is complicated by amongst others: subjective utility, choice of discount rate, extreme sensitivity to growth estimates, control premiums, and above all, risk factors.

 

The bottom line is that there is a very wide range on any valuation, however the important point to realize is that the probability of making a profit increases as the deviation from the "rational" range of valuations becomes more extreme. The market is not that stupid that it will continue to place a high price on an asset that hasn't delivered big growth or margin improvements for several years. I have seen good companies consistently undervalued. however with these it's often enough to pick up the dividend yield.

 

Anyway this is all drifting way off the topic of technical analysis, so to bring the conversation back around: I think TA should be classified under behavioral economics.

[DavidTurner 10]

Dumb money either leaves or learns. Either is a problem for a trader or a poker player.

 

There's one born every minute? I don't disagree.

[karoshiman 10]

karoshiman - you almost seem to be arguing against your own point.

Often the markets dont recognise value or overshoot on value....hence a value investor is likely to always be getting into a stock when its in a downtrend, or out when in an uptrend.

 

you then have the issues of even if a good company is well run it may be in a declining industry, or the company is making good money now but has road blocks ahead, or the management have a poor history of reinvesting that cash flow and profits.....etc;etc

 

The best approach surely is to combine the two - work out what is good value and then let the market price guide you as to how best to extract that value......so how then do you value gold, oil, currencies ???

 

 

Hi Siuya,

 

I don't see me arguing against my own point... Maybe I don't understand your point fully but your examples do not oppose what I have written earlier from my point of view.

 

As a value investor, I've shorted the internet bubble. Unlucky for me, the bubble lasted longer than I thought. Problem was that I did not take into account what the market's view was.

 

Markets have their own view on value. The moment you say "they don't recognize value" or "overshoot", you are imposing your view on the markets. And that's fatal from my point of view, if you plan to make money in the markets with an envisaged holding period of 2 years or less. I mean, you can make money if you assess value correctly (and you can make a lots of it), but you have to be able to wait for years until markets change their perception of value... like Keynes said: "Markets can remain irrational longer than you can remain solvent."

 

And the other company examples fit to what I have written regarding future expectations. Whether it's expectations on the industry or management or other road blocks, it does not matter.

 

Regards,

k

[MightyMouse 12]

karoshiman - you almost seem to be arguing against your own point.

Often the markets dont recognise value or overshoot on value....hence a value investor is likely to always be getting into a stock when its in a downtrend, or out when in an uptrend.

 

you then have the issues of even if a good company is well run it may be in a declining industry, or the company is making good money now but has road blocks ahead, or the management have a poor history of reinvesting that cash flow and profits.....etc;etc

 

The best approach surely is to combine the two - work out what is good value and then let the market price guide you as to how best to extract that value......so how then do you value gold, oil, currencies ???

 

You can add that a profitable and well run company in a perfectly fine industry can decline in price if money is the market is flowing to stocks in a different industry with much hotter prospects. Such was the case in the late 90's during the .com and ecommerce craze. The tradition industries lagged badly, but people still consumed healthcare, toothpaste, soda, etc.

[YertleTurtle 10]

The OP states basically defines technical analysis as trading price patterns and claims doing so doesn't give a trader an edge. He then states that trading based on volume analysis or tape reading will give a trader an edge. Of course these are still technical analysis techniques.

[Roger Felton 10]

Ha ha, yes, very funny. Actually I've only ever been a top-down investor and occasionally a stock picker, and I've done pretty handsomely - especially after trading costs are accounted for.

 

There's an interesting study (sorry, too lazy to look it up but I think it may have been HBR) which says that if you'd simply picked the market index or bonds at the beginning of each month for the last forty years (and been right), you'd have managed a CAGR of something like 40%. Now that is something that I think I could at least have a crack at from an analysis perspective.

 

Anyway the basic truth remains - investing is about buying good companies at good prices.

 

OMG! I feel so embarrassed...I thought I was supposed to buy Enrons and Worldcomms at high prices. Question: How do you determine it's a good company and a good price when you have no way of knowing when they're cooking the books and when they aren't?

[SIUYA 11]

yes Karoshiman - poorly worded by me (I am not feeling myself the last few days)....we are agreeing.

There can still be value in a company, even if its not recognised by the market initially. Eventually unless the management stuffs up, or the industry is in decline etc; that value is usually released at some stage via dividends, a take over, or the market recognising it.

Companies can still grow assets such as plant, cash, inventories that are not recognised by the markets for a long time.....ideally we wish them to recognise it immediately after we purchase, or we manage to get on board as soon as the market recognises the value in a company.....but then as you point out the market is more inclined to want to try and recognise future value, not present value.....and in the case of a bubble fantasy sucker value

 

Your point --- The moment you say "they don't recognize value" or "overshoot", you are imposing your view on the markets, I would disagree on......I can still clearly put an idea or measure of value on something and use that as a filter to attach probabilities to. How to act on it then is a different measure. (I am reading the latest market wizards book and one of the guys (cant remember his name off the top off the head) talks about this.)

The markets it could be argued never recognize value.....and they most certainly will not recognise your own personal measures, but they are still valid to be aware of what at some stage will become unsustainable, or eventually will be recognised.

 

 

As per all these things, timing is important....hence the value of TA.

If you are not using leverage, not requiring to answer to investors, or to live off the proceeds of trading, then you probably would have made money from shorting the internet bubble.

Personally I have always been a broad brush fundamental investor...eg; never invest in airlines or mining stocks....but its ok to trade them. With the internet bubble, I did not touch it....no value to buy it, no measure at the time for when to short it. (I did have one stock that i bought and rode - very small amount, for fun....bought at 30c, went down to 8.5c, rose to $7.02, i exited at $2.50....it was called sausage software, and you know what at the time sausages were selling for 6.99 a kilo.....thats how you measure value could have picked the top and been a genius)

 

When it comes to stocks and long term investing, there is a whole other set of things that need to be taken into consideration - ie; is the management going to invest excess cash flows better than you, or should they return it as a dividend.....I think most of the fads that get passed through the corporate world are more about lining investment banker pockets than releasing true value. eg; share buybacks, dividend reinvestment plans, takeovers....generally occur at the wrong times....Maybe that could be a measure of value for a company - increased use of investment bankers reduces value

[Fudo 10]

Understanding value is a big part of this business, being able to read a map is equally important.

 

If you don't trade TA when you're young, you have no balls, if you don't trade fundamentals when you're old, you have no brains.

 

 

 

^^ That's the problem right there. It's an accurate description of technical trading, and also an accurate description of why it's a bad game to play in.

 

The returns to investors ultimately derive from the value created by the companies that receive their capital. On average stocks would not grow if the underlying companies were not, on average, growing. So if you're not trading the markets then you do not have those returns available to you. Instead you are competing in a win/lose zero-sum game - quite literally, you are gambling, and the rake taken by the brokers is pretty steep.

 

In fact I'd go so far as to say that any trade with a horizon less than a year is likely to be a form of hunt-the-sucker. I know there are a lot of A-types out there, but the truth is that statistically half of them will be the suckers. Not great odds.

[karoshiman 10]

 

yes Karoshiman - ....we are agreeing.

 

...

 

 

 

Good

 

 

 

...

 

Your point --- The moment you say "they don't recognize value" or "overshoot", you are imposing your view on the markets, I would disagree on......I can still clearly put an idea or measure of value on something and use that as a filter to attach probabilities to.

 

 

 

You mean, like ranking the companies by discrepancy between your calculated value and the current stock price (like Warren Buffett says, he tries to buy companies that are worth 1$ for 50 cent) as you assume, the bigger the discrepancy, the higher the probability for the market price to move to your calculated value?

 

If you are very confident in your analysis and have very deep pockets and lots of time one can do that.

 

 

 

...

 

How to act on it then is a different measure.

 

 

 

So true...

 

 

 

 

...

 

The markets it could be argued never recognize value.....and they most certainly will not recognise your own personal measures, but they are still valid to be aware of what at some stage will become unsustainable, or eventually will be recognised.

 

 

...

 

 

 

Yes, for instance, the stock price of the company I've worked for was very volatile. It fluctuated in a one year period between about 20 and 55 Euro, without any changes in fundamentals or projections by us or by analysts. It had more to do with general market sentiment and associated risk appetite of investors/traders. When I saw this, I just thought to myself "this is all so crazy... the stock market has nothing to do with what happens in the real world... it's all investor psychology"... okay, that was also a very volatile period in the markets, but still...

 

 

 

...

 

If you are not using leverage, not requiring to answer to investors, or to live off the proceeds of trading, then you probably would have made money from shorting the internet bubble.

 

 

 

 

The problem was that I've bought put warrants (similar to options), as at that time in Germany, shorting of stocks was not possible for retail traders (now is). The time value of the warrants were the problem... otherwise I would have made a killing... woulda coulda shoulda... :doh:

[TEAMTRADER 10]

TA can be very good indeed to assess the direction of a chart, and importantly, when to buy, sell or hold.

Does TA work?

Of course it does. It is the search for the nearest to a 100% successful system that drives the trading community.

It is when all of the changes are taking place that creates bad TA assessments.

TA will never give 100% over a long period of time, but it will cut out a lot of bad trades.

TEAMTRADER

[SIUYA 11]

The problem was that I've bought put warrants (similar to options), as at that time in Germany, shorting of stocks was not possible for retail traders (now is). The time value of the warrants were the problem... otherwise I would have made a killing... woulda coulda shoulda... :doh:

 

that reminds of some guy in Australia years ago (details are hazy and this was told to me so who knows...but general jist is the same) - he had sold his company for 30mil or so....was so adamant that the stock market was going to crash he ploughed a large proportion of his money into put options over the index. Told everyone on TV that was what he had done......lost the lot - that was in September 1987)

[karoshiman 10]

that reminds of some guy in Australia years ago (details are hazy and this was told to me so who knows...but general jist is the same) - he had sold his company for 30mil or so....was so adamant that the stock market was going to crash he ploughed a large proportion of his money into put options over the index. Told everyone on TV that was what he had done......lost the lot - that was in September 1987)

 

 

One month to the October crash is pretty close... how do you say in English... a miss is as good as a mile?

[BlueHorseshoe 10]

For anyone interested in the lengths to which good fundamental analysts go, I recommend "Evil's Good - Book of Boasts and Other Investments" by the famed bear-raider Simon Cawkwell. Highly anecdotal but very entertaining.

 

BlueHorseshoe

Edited June 19, 2012 by BlueHorseshoe

[SIUYA 11]

One month to the October crash is pretty close... how do you say in English... a miss is as good as a mile?

 

Close but no cigar comes to mind!

 

interestingly enough if you subscribe to the whole, we get what we want from the markets, and the gamblers idea that a near miss on a win gives just as much mental reward then I guess he was still just as happy. I would have preferred to have a smaller amount in Sept, then Oct, then Nov, Dec,.....

[Lornz 10]

Trading is about finding value, but, for most traders/investors, the only hope is to find expected value.

 

(30? I'm out)

[SIUYA 11]

Trading is about finding value, but, for most traders/investors, the only hope is to find expected value.

 

(30? I'm out)

 

30? I'm out - is that like some Logans run reference (circa 1976), or the number of posts, or both - you are on the run now?

 

Interesting idea of value.....I understand the first part - for most traders we are looking for value trades - ie; those with positive expected returns, or whatever makes you money, long or short.

For the second part "the only hope is to find expected value" especially linking traders and investors together - what do you mean by that?

 

I would think we would hope that

a....the market is currently pricing the instrument with a different value to the expected future value, and

b....we can then manage to caputre that difference

 

thanks