Technical analysis

Take a look at this chart – figure 1. 

It shows the price action in the Euro/US dollar exchange rate between 2019 and 2022. In some investors’ eyes, though, it displays more than that. A lot more. 

According to these folks’ school of thought, this chart contains potentially important clues about where the market at that time was going, where it might eventually reverse and where it might fall to. 

Welcome to the world of technical analysis.

Technical analysis is the study of price behavior for making investment decisions. 

Its disciples believe that all the relevant information about any financial market is already neatly distilled into current and historical price activity. All you need to know is right in front of you.

According to technicians – as technical analysts also may call themselves – prices also tend to move in predictable patterns over time. 

They claim this is so because market action is driven by investors’ behavior, which never really changes. By identifying patterns, therefore, technicians seek to anticipate prices going up and down – and when to get in and out of markets.

The way that most technicians work is by looking at price charts on a computer screen. They highlight the patterns and trends they see by applying lines, averages and a toolbox of indicators. 

Up until the 1980s, they drew their charts by hand on pieces of paper. Indeed, another name for technical analysis is “charting.” 

The alternative to technical analysis is fundamental analysis. The mainstream approach, fundamental analysis helps investors make investment decisions based on the specifics of the asset in question, be it a company’s business outlook and cash flows, global oil production or central bank interest rate movements.

Whereas fundamental analysis requires understanding of the ins and outs of the investment in question, technical analysis is a one-size-fits-all approach. Technicians use the same methods for any liquid market, be it equities, fixed income, commodities, foreign exchange or digital assets. 

Technical analysis has many varieties, from the straightforward to the esoteric.

Price charts can be displayed in a variety of different ways, examples being simple line charts to bar charts to Japanese candlesticks – figure 2 – to point-and-figure charts – figure 3.

The simplest technique involves spotting uptrends and downtrends. An uptrend is usually defined as a series of highs and lows, where each is higher than the last – figure 4. A downtrend is a series of lower highs and lows. 

Technicians may often say, “the trend is your friend.” In other words, find something that’s going up or down and latch on to it on the assumption that it’ll keep going for a while. We’ll come back to this concept a bit later. 

Another technique is identifying levels where prices have often stopped falling or rising in the past (These are called “support” and “resistance” in techie speak). Investors may look to buy and sell around these levels.

Next, there is more complex pattern spotting. 

Probably the most famous of these is the “head-and-shoulders” formation, so called because it consists of two lesser peaks or troughs (the shoulders) on either side of a higher peak or trough (the head.) 

And the meaning? A head-and-shoulders pattern is said to potentially foretell a reversal in a market. If the price breaks through the “neckline” – a red line connecting the shoulders, see chart – it is a signal to sell. (There are many, many more price formations worth checking out!) 

This brings us to the more curious nooks of technical analysis. W.D. Gann¹ and R.N. Elliott² both relied on numerological methods, including the frequency of number’s appearances in the Bible, in Gann’s case.

And a tiny minority of technicians even look for clues about price behavior from planetary movements sunspots and the signs of the Zodiac. You get the idea.

If you’re feeling a bit skeptical about technical analysis so far, you’re in good company. 

Many of the world’s leading financial academics have long been downright dismissive of this approach.³

The concept of technical analysis goes against one of the cornerstones of modern financial thinking. According to the “Efficient Market Hypothesis,”⁴ past price action contains no useful information for the future.

That’s the theory, but how about the practice? There is no large body of academic evidence suggesting that technical analysis works.

Compare this to fundamental analysis, where countless studies have highlighted the potential performance from, say, investing in cheap stocks, in high quality companies or avoiding firms with accounting red flags and so forth.

Technical analysis seeks to ride uptrends and dodge downtrends. That is, of course, market timing. 

Over the long run, such attempts have typically ended up in missing out on the sharp, early-stage gains that have followed bear markets.

As such, market timers risk foregoing returns at the very least. The effect of missing out on potential dividends and capital gains grows with the more time sat out.

All that said, certain technical principles may indeed have some value.

Remember the saying “the trend is your friend”? Well, academics and real-life investors have found this to be true. 

Momentum investing – systematically buying equities that have risen strongly of late and avoiding those that have fallen – has been shown in numerous studies to have return generating potential.⁵

Other simple techniques – such as staying in the market when the price is above its 10-month average and selling out when it goes below – have also helped to improve risk-adjusted returns in certain studies.⁶

Nevertheless, many investors do keep an eye on technicals, even if their focus is on fundamentals.  

So, as an example, they might identify an equity they believe to be cheap based on its book value but only enter a position once the price action turns positive. 

As with much else in life, there’s a strong case for not getting overly complicated when it comes to technical analysis.