On Technical Analysis
This piece was prompted by a recent post on Value Discipline. I suspect it will be of little interest to most readers. It is a long, plodding piece that contains two extended quotes from dead men. However, if you are interested in the discussion of technical analysis and value investing, you may wish to read it. In either case, you will want to read Value Discipline’s shorter and more interesting post.
Let me first say that I do not now engage in technical analysis; nor, have I ever engaged in technical analysis. I do not believe doing so would be a productive use of my time.
Having said that, I do not claim technical analysis has no predictive value. In fact, I suspect it does have some predictive value. The Efficient Market Hypothesis is flawed. It is based upon the (unwritten) premise that data determines market prices. As Graham so clearly put it in “Security Analysis”:
“…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”
I’ve seen a lot of people cite this quote, without bothering to notice what’s really being said. Graham had a very broad mind, much broader than say someone like Buffett. That’s both a blessing and a curse. At several points in Security Analysis (and to a lesser extent in his other works), Graham can not help but explore an interesting topic more deeply than is strictly necessary for his primary purpose. In this case, Graham could have said what many have since interpreted him as saying: in the short run, stock prices often get out of whack; in the long run, they are governed by the intrinsic value of the underlying business. Of course, Graham didn’t say that. Instead he chose to describe the stock market in a way that should have been of great interest to economists as well as investors.
Data affects prices indirectly. The market is a lot like a fun house mirror. The resulting reflection is caused in part by the original data, but that does not mean the reflection is an accurate representation of the original data. To take this metaphor a step further, the Efficient Market Hypothesis is based on the idea that the original image acts on the mirror to create the reflection. It does not recognize the unpleasant truth that one can interpret the same process in a very different way. One could say it is the mirror that acts on the original image to create the reflection. In fact, that is often how we interpret the process. We say an object is reflected in a mirror. We rarely use the active “an object reflects in a mirror”.
For some reason, when we talk about the market we like to use inappropriate metaphors. We talk about wealth being destroyed when prices fall. Yet, no one talks of wealth being destroyed when the price of some product falls. When the market rises, we talk about buyers, as if there wasn’t a seller on the other side of each trade. Above all else, we talk about “the market” not as a mere aggregation of transactions, but as some sort of object all its own.
The Efficient Market Hypothesis does not recognize the true importance of interpretation. Saying that data (publicly available information) acts on market prices omits the key step. After all, the same data is available to every blackjack player. Casinos just don’t like the way a card counter interprets that data.
The Efficient Market Hypothesis is not the only argument against technical analysis. There is also empirical evidence that questions the utility of technical analysis. However, empirical evidence alone is not sufficient to prove technical analysis has no predictive power. If most knuckleball pitchers had limited success, the knuckleball might be an inherently ineffective pitch, or there might be a better way to throw it. The same is true of technical analysis.
The adjective “random” is a very strange word. Although it is rarely the definition given, the most appropriate definition for random would have to be “having no discernible pattern”. The word discernible can not be omitted. If it is, we will take too high a view of science and statistics. There’s a great introduction to economics written by Carl Menger which begins:
“All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary. Human progress has no tendency to cast it in doubt, but rather the effect of confirming it and of always further widening knowledge of the scope of its validity.”
All things are subject to the law of cause and effect; therefore, nothing is truly random. A caused event must have a pattern – though that pattern needn’t be discernible. Even if one argued there is such a thing as an uncaused event, who would argue that stock price movements are uncaused? We know that they are caused by buying and selling. Stock prices are the effects of purposeful human actions. Several sciences study the causes of purposeful human action; so, it would be hard to argue any such action is uncaused. Furthermore, each of our own internal mental experiences suggests that our purposeful actions have very definite causes. We also know that the actions of some market participants are based in part on price movements. Many investors will admit as much. They may be lying. But, there is plenty of evidence to suggest they aren’t.
If the actions of investors cause price movements, and past price movements are a partial cause of the actions of investors, then past price movements must partially cause future price movements.
Technical analysis is logically valid. Not only is it possible that some form of technical analysis might have predictive power; I would argue it necessarily follows from the above assumptions that some form of technical analysis must have predictive power.
So, why don’t I use technical analysis? I believe fundamental analysis is a far more powerful too. In fact, I believe fundamental analysis is so much more powerful that one ought not to spend any time on technical analysis that could instead be spent on fundamental analysis. I also believe there is more than enough fundamental analysis to keep an investor occupied; so, he shouldn’t devote any time to technical analysis. Personally, I feel I am much better suited to fundamental analysis than I am to technical analysis. Of course, there is no reason why this argument should hold any weight with you. I also believe there is sufficient empirical evidence to support the idea that fundamental analysis is a far more powerful tool than technical analysis.
Even though I believe there must be some form of technical analysis that does have predictive power, the mental model of investing which I have constructed does not allow for such a form of technical analysis. In other words: logically, there must be an effective form of technical analysis; but practically, I pretend there isn’t.
Why? Because I believe that’s the most useful model. One should adopt the most useful model not the most accurate model. I’m willing to pretend technical analysis does not work, even though I know some form of it must work.
Really, this isn’t all that strange. In science, I’m willing to pretend there are random events, even though I know there must not be random events. In math, I’m willing to pretend zero is a number, even though I know it must not be a number.
A model with random events is useful. In most circumstances, a refusal to allow for random events would be harmful rather than helpful. The model with random events is simpler and more workable. The situation is much the same with zero. It isn’t a number. To include zero as a number, you would have to put aside the principles of arithmetic. So, we don’t do that. In school, you were taught that zero is a number, but that there are certain things you must never do with zero. You accepted that, because it was a simple, workable model.
I propose you do much the same in the case of technical analysis. You should recognize the logical validity of technical analysis, but create a mental model of investing in which technical analysis has no utility whatsoever.
Read yesterday’s post: “On Value Investors as Market Timers”
Comments
Thank you again for the links to my blog! As I tried to say in my post,a fundamental DCF model is my primary basis for any analysis. This is followed by a behavioral examination of bias inherent in my assumptions.
Technical analysis, at least as generally practiced, has always seemed far too interpretive as you suggest.Though chartists argue that they see patterns of supply and demand in a chart, quite often their interpretations can be at complete odds with one another. There is complete dissonance with value investing when a technical system suggests that securities become attractive as they escalate in value. That is completely illogical, at least in my opinion.
Consequently, I confine my technical analysis to relative strength but only after a fundamental assessment of intrinsic value has already been made.
You provide great insight in your blog and I recognize and appreciate your analysis and thinking!
Posted by: Rick | January 23, 2006 07:54 PM
I just realized my opening paragraph was terribly unclear. I meant to say my post is a long, plodding piece. However, it's not really clear I wasn't talking about Rick's piece until the last sentence of that first paragraph. Rick's piece is neither long nor plodding. It's not real short, but it is shorter than this one. Please check it out if you haven't already:
http://valuediscipline.blogspot.com/2006/01/value-investors-as-market-timers.html
And thanks for the comments, Rick.
Posted by: Geoff Gannon | January 24, 2006 11:35 AM
A Value Investor admitting technical analysis has value.
That's terrific!
I never understood the "gang wars" between different disciplines; You use what works for you and suits your personality best . . .
Posted by: Barry Ritholtz | March 19, 2006 06:24 AM
Good article. However, I must take exception to your idea that there are no truly random events in nature. Quantum physics proposes that all quantum processes (sub-atomic events) have an inherently random element. These events are not apparently random because we don't have enough information, or we don't have the correct model. They are inherently uncertain. At best, we can assign probabilities. Since all macroscopic events (including human actions, markets, the weather, etc.) are built upon microscopic (sub-atomic) events, this implies that there is an inherent, irreducible uncertainty or randomness to all events. Well, at least, if you believe quantum mechanics.
Posted by: Amanda Gerrish | March 26, 2006 12:22 PM
You make a good point about quantum mechanics, but I have seen it taken too far. For instance, one philosopher argued that an inherently random element supports the case against the existence of God (or a prime mover of any sort). I have a few problems with this argument. The biggest problem is that it favors accepting the existence of an uncaused event over the prudent course of withholding judgment because far too little information is known.
When I say too little information is known, I mean simply this: an inherently random element does not fit with the law of cause and effect. So, we have three options. One, we could throw out the law of cause and effect and assume that the best we can ever do is establish correlative rather than causal relationships. Two, we could throw out the idea of an inherently random element in quantum mechanics. Or, three, we could withhold judgment, because we feel our understanding of these matters is not sufficient.
I favor the third course, largely because I think our understanding of time remains inadequate. In several different places, the study of physics has bumped up against our ignorance of what time really is, and just how it works in the extremes. This gets us into some very strange sounding discussions. However, we will need to address them eventually.
Are there more dimensions than we perceive? Is our perception of time flawed? Can actions occur outside of time? Is any “inherently random element” actually the result of a cause that did not occur in the dimensions we perceive? Simply put, is it possible we can’t perceive the cause, or even the general laws under which the cause operates, and therefore can not conceive of the effect as being anything but random?
I wouldn’t put it into these words, but I think eventually people will say that it’s possible there may be causes operating “outside of time” – simply meaning that there are causes that do not operate according to the principles of time as we know them. As strange as it sounds, I think the logical idea of a law of cause and effect is actually a far more durable model than the empirical model of the four dimensions we perceive.
It’s quite possible none of us will live long enough to know who is right and who is wrong. But, my money is on the law of cause and effect to outlast the simple four dimensional model of physical reality.
So, while I wouldn’t say I don’t believe in quantum mechanics, I would say that we may all have a different view of quantum mechanics as our understanding of time evolves. I believe a universal theory of cause and effect is likely to outlast most of these newer theories.
As I’ve said before, I believe the best model is the most useful model. So, I have no problem with quantum mechanics as a model – even though it is irreconcilable with a model of reality that incorporates a universal law of cause and effect. The fact that the two models contradict each other is unfortunate, but I don’t think it should stop us from using either.
The best course is to simply suspend belief in a strong theory of cause and effect when dealing with quantum mechanics, until physics provides an integrated theory. There have been some movements in that direction. It might happen. More likely, all of this will remain in the realm of pure conjecture for the rest of our lifetime.
Posted by: Geoff Gannon | March 26, 2006 03:46 PM
I agree with your comments. To go a step further, there are interepretations of quantum mechanics, such as the Bohm Interpretation, which restore causality:
http://en.wikipedia.org/wiki/Bohm_interpretation
This interpretation is by no means universally accepted, so the question of a truly random process in nature is currently an open one.
If the Bohm interpretation is correct then it would mean that all processes in nature are not random, but some features (i.e., the "hidden variables" in Bohm's theory) are unknowable, so that they are effectively random, given the limits of our knowledge.
Even in classical quantum mechanics, the concept of cause and effect is assumed to hold "on average", meaning that, statistically, some events are overwhelming probable, or improbable. For example, according to quantum mechanics, there is a some chance that I could walk through a wall unimpeded. However, it is so ridiculously small as to effectively be impossible. This maintains cause and effect at the macroscopic level while allowing probabalistic events at the microscopic level. (Electrons can easily tunnel through matter under the right conditions, but I can't walk through a wall.) Your belief in a strong theory of cause and effect is quite reasonable.
Posted by: Amanda Gerrish | March 26, 2006 06:21 PM
Thank you for the response and the link. You just inspired a blog post. My comments below will appear as a full blog post, because I think they pertain to investing:
The last point you make is very interesting. While I’m sure people have heard that particular example before (it seems to come up whenever someone describes quantum mechanics), it’s worth thinking about. Probability, causation, and observation are all important concepts for an investor to understand.
Investors need to think about exactly what they mean when they use terms from probability. They need to appreciate the role of the observer (and his or her limited knowledge). For instance, if I flip a coin and cover it before you can see how it has landed, is it really correct to say there’s a 50% chance the coin has landed head-side up?
The problem is that we know that the class of (fair) coin flips will be populated by as many instances of heads as tails, and therefore if we know that a coin flip belongs to the class of fair coin flips (but know nothing else about the special case) we may say that there is a 50% chance the coin will land head-side up.
But, there is one somewhat unsettling matter to consider. Once I have flipped the coin and it has landed, we can all agree that it has either landed head-side up or tail-side up. The event has already occurred. But, it hasn’t yet been observed. Of course, I could lift my hand a bit and sneak a peak. Then, I’ve observed the outcome, but you haven’t.
Speaking probabilistically, you might still say there’s a 50% chance the coin has landed head-side up. But, you would now know that there is a difference between the knowledge possessed by different observers. The unsettling part comes when you realize that a probabilistic statement can not be made independent of the observer (and her knowledge).
It may seem a trivial problem when we consider the observer to be a single individual. But, all our knowledge is dependent upon observation, and all our probabilistic statements are dependent upon our knowledge – so, all of our probabilistic statements are dependent upon our knowledge.
That’s obvious, because we only make such statements where our knowledge is limited (we know something about the class but not the special case). The problem for investors is that two analysts with the same data may interpret that data differently such that they arrive at two very different conclusions. Essentially, they will make two different probabilistic statements (largely based on what data they believe pertains to the special case in question).
For instance, you can make a statement about stocks trading at a P/E of 12, or stocks trading below book value, or stocks that have achieved a ROE of greater than 15% in nine of the last ten years. But, that may not be the best class to consider.
I just mentioned Harley-Davidson (HDI) in a previous post. Does Harley-Davidson belong to the class stocks with a P/E of 15? Or, does Harley belong to the class stocks of companies with entrenched consumer brands? After all, some stocks with a P/E of 15 may be in commodity businesses.
The investor needs to reference several different past records at once. She needs to consider the past record of entrenched consumer brands (how many had their earnings power diminished? How many of the brands lost their luster? How many increased their earnings power?).
Harley-Davidson might more properly be classified as a growth stock. Look at the annual rate of increases over the last ten years: Book value per share has increased at a 17.78% annual rate; EPS has increased at a 21.92% rate. Or, we could classify HDI as a stock that has consistently earned high returns on equity while employing very little debt. At this point, we haven’t even considered classifying it by industry. Is that an appropriate classification?
The investor is in the position of performing an overwhelming calculation. She has knowledge of the past records of countless other stocks and countless other businesses that are in some way related to the case at hand. But, how closely related are they? And in what way are they related? What is the proper weight to assign to each variable? And what is the proper estimate for that variable?
Some very smart investors (e.g., Warren Buffett, Peter Lynch, Ben Graham) have pointed out the similarities between investing and gambling, but haven’t gone as far as suggesting there are similarities between the (intelligent) investor and the gambler. Why? Because investing really is a game of odds. But, no sane man would take the gambler’s position.
An investor bets only with the odds in his favor. He has no interest in luck. The investor looks for high-probability events and a margin of safety. He wants to the tilt the odds in his favor; he doesn’t want to play a game of chance. But, his knowledge is always limited. Nothing is certain. So, the best he can hope for is playing the game of odds the way the house does. He begins with a clear advantage that will reduce the importance of the element of chance inherent to the game.
Some time ago, I wrote a short post on intrinsic value. I think it’s worth revisiting:
The intrinsic value of a business can not be determined through clairvoyance or calculus, prescience or projections - for even the best projections sit precariously atop a mountain of complex assumptions. Determining the intrinsic value of a business requires simple arithmetic, common sense, and a careful analysis of the past performance and current financial position of the firm. Most importantly, it requires the separation of those things which are both constant and consequential from those things which are either mutable or meaningless.
When your knowledge is limited (as the investor’s knowledge always is) you’ll do best to rely on those things which are both constant and consequential. Actually, I omitted one key word when I wrote that post on intrinsic value.
I’ve always believed an investor should focus on those things which are constant, consequential, and calculable.
You need to focus on those things that can be both known and weighed. The relative weights assigned to each variable are where most investors make their biggest mistakes. It tends to be the things they know, but can’t weigh, that kill them.
Just remember to be conservative in all your estimates – and, when in doubt, withhold your judgment. Investors have the luxury of inaction. That comes in handy whenever the question posed is complicated. You only need to know the easy answers – as long as you know when not to give an answer.
Posted by: Geoff Gannon | March 26, 2006 10:31 PM