Jan

06

Technical Analysis – What is it?

By Chuck · 11:52 p.m. Jan. 6 ·  Print This Post · Stumble it!

“Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.”

John Murphy, author – Technical Analysis of the Financial Markets

Most people who invest in the market via their 401K, IRA account, or other means select stocks based on fundamental analysis. Fundamental analysis is the study of a particular company, their products, future earnings potential, the quality of the management, reading quarterly statements, earnings reports, and so on. Many of these people, if handed a chart, would only see lines that move up and down and nothing more.

A technical analyst looks at the same chart and draws from it patterns, support and resistance levels, moving averages, and a whole host of tid bits of information that can be extracted from the chart.

For as long as the market is old, there has always been a battle between market participants of which is better, or more accurate. Fundamentalists have always claimed that nothing but a company’s earnings potential and business quality matters, that the stock price will eventually reflect the potential of the company. Fundamental analysis is often associated with people who were brought up to believe in the ‘buy and hold’ method of investing.

During the bear market of 2000-2002 (aka ‘the tech crash’) many analysts were advising their clients to keep buying, or to ‘hang in there’ because they only looked at ‘future potential’ of a company or the quality of the management team, even as the stock prices continued to slide down further and further. On the advice of many Wall Street analysts (and some very high priced) many people kept holding onto stocks even as their portfolios declined precipitously. The biggest flaw with fundamental analysis is that it relies too heavily on ‘optimism’. That optimism comes from the company’s management and the analysts that follow the company.

[Like the Bear Stearns CEO who appeared on CNBC one day to say everything was fine... and three days later was broke]

When the market began to tumble in 2000 many fundamental analysts just wrote off the price declines as temporary. They kept insisting that the stock price will eventually reflect the ‘true value’ of the company and to keep buying as the price came down. The problem is that eventually the stock price DID eventually reflect the true value of the company, and it was much lower than the ‘buy and hold’ investors bought it at. Many of those companies from the ‘tech crash’ never regained their original share price; many also went to zero eventually and faded away along with the investor’s money.

Those that practiced technical analysis escaped the huge losses of the tech crash by using the psychology of the market (chart analysis) to tell them trouble was ahead. The psychology of all market participants is reflected each day in the bars and graphs we call the charts. A technical analyst is not concerned so much with the daily goings on within a company, their management quality, or the quality of products they make. They only care about trends… and when they are changing.

Every instant in time on a stock chart reflects the combined knowledge, fear, and greed for that particular stock, the end result of a battle between bears and bulls is printed on the chart. Each time a new bar is imprinted on a chart it reflects the actions of people making a decision to buy or sell at that instant. As the bars arrange themselves sequentially on the chart (time) they draw a picture of the prevailing trend. Trends stay in force until they are no longer in force, sounds contrite, but it is very simple.

A stock can trade in an upward trend for many years until one day there is a significant change in the direction. If that change in direction persists for an extended period of time (relative to the length of the original trend) then we are able to say very clearly that a significant change in the ‘mood’ of the market participants has occurred. By using trend lines on a chart we can plot the combined mood of the market participants over time and very easily see when there is a significant departure from that mood. And it is during that significant change in trend that raises a warning flag to a technical analyst that says it is time to take profits and walk away.

When studying charts we basically concern ourselves with three time frames; long term (six months to years), intermediate term (3 weeks to six months), and short term (days to weeks). There is some ambiguity in how each technician classifies the length in time for each of the three time frames, but the principle is the same.

Long term technical analysis is the easiest of the three. Spotting a significant trend change that has lasted for many years is simple. The intermediate trends become a bit more complex to work with as the chartist is attempting to study in detail what is often a ‘developing’ change in combined psychology. The short term analysis is the most difficult of all, for the analyst is reading the combined psychology of the market participants in essentially real time. Spotting a trend change is easy when it occurs over many months, spotting a trend change in the short term is akin to determining what kind of creature is hatching out of an egg that you have never seen before.

And there is one situation when technical analysis is the toughest of all… a market with no trend at all. That is the situation we are in now. We are in a state where the psychology of the market is being tossed about from hour to hour. This results in what we call a sideways trading range, a pattern that reflects disagreement in the participants.

Everyone has an opinion of where the market will go next and that is the problem we see in the charts. No one can agree with conviction (conviction is reflected in volume levels) as to buy or sell. So we are currently drifting upwards on what I say is ‘light conviction’. The market participants are waiting for a sign to get in or get out. Essentially this waiting is like saying “you go first, no, you go first”. And until someone makes a substantial plunge in one direction or the other, the direction of the stock market (in the short term) remains questionable at best.

Right now there are still technical signs that a bear market rally wants to carry the market higher for an intermediate period of time, before the primary (long term) bearish trend is resumed once again. Each move of the market is being measured now in finite detail of support and resistance levels, Fibonacci retracement points, and so on. We are in the 9th inning of a tied ball game and everyone is sitting on the edge of their seats waiting for the next pitch to see what happens. That is what we technical analysts are doing right now… we are waiting for the combined market to make its next pitch for us to run with.

How about some charts…

The first three charts are of the S&P 500 and the Russell 2000. The last chart is Marvell Technologies (MRVL). This chart is painting a rather clean inverse head and shoulders pattern (which is bullish). The neck line represents the confirmation point for this pattern. A move above that line would add confidence in the pattern at which time I will take a ‘long’ position with the target price being the resistance level identified by the gray rectangle. Which by the way will be very close to the price this patterns predictive analysis would take it.

With any pattern, there is in many cases a successful confirmation followed by a brief pullback to the test level before continuing. If this were to happen on MRVL then what you might see is a break above the neck line followed by a short pullback to the top of the neck line. And if the neck line holds the price level you have added confirmation of the pattern formation and then that is one more chance to initiate a ‘long’ position. If the price never breaks above the neck line at all then the pattern is negated.

If this pattern does confirm and the price reaches the $10.00 region then that would be your sell point and to turn around and ’short’ the stock for the ride back down.

Looking at the broad market tonight I get the sense that there may be a brief pullback again before the next attempt at any bear market rally. In this economic environment we have to always be on guard for more shoes to drop at any moment.

S&P 500 E-Mini Futures

Russell 2K Multi Year

Russell 2K Daily Chart

Marvell (MRVL)