Preface to Technical Analysis Plain and Simple
Technical analysis is one of the oldest market disciplines, yet the majority of the investment and academic communities consider it, at best, a minor supplement to their own work. At worst, it is disparaged as tea-leaf reading or simply a self-fulfilling prophecy. Look at these two phrases. They suggest that the technical analyst divines the market from some mystical process. This could not be further from the truth.
Consider the fundamental analyst. This person relies on company reports, conversations with company insiders, and macro-economic research in relevant business sectors. All this is indispensable when determining if a company is viable and predicting how its business will fare in the future.
Now consider the source of all the raw data. Much of it is projection and conjecture. How can you rely solely on such raw data when earnings reports and other industrywide data will be subject to revisions?
Technical analysis looks at actual trades in which bulls and bears have put their money where their collective mouths are. There is no revision of data. There is no ambiguity. There is no mystical divining of the future. All market and stock selection is based on current, not past, price performance, the predictable behavior of market participants, and the dynamics between markets over time.
Trends exist. Information is slowly disseminated to the public in an imperfect manner, and as the public acts on the information, the markets move. They continue to move until either the last group has acted or an outside influence, such as news, ends the trend. Sounds a lot like physics, does it not? A body in motion tends to remain in motion.
Look at another aspect of the analysis. Behavior is a key component of the analysis. When similar market conditions occur, market participants react in similar ways. This is how the patterns and measurements within technical analysis are created.
For example, the market holds fairly steady as buyers and sellers adjust their portfolios to meet their specific investment criteria. A stock might trade from 50 to 52 for weeks in this way. Is the stock good? Is the company good? You do not know. All you know is that bulls and bears consider the stock to be fairly valued within a small range. A body at rest tends to stay at rest—physics again.
Now somebody comes into the market to buy a large block of stock. Why? Technical analysis does not know but more important, it does not care. All it needs to know is that money has flowed into the market and increased demand for the stock. Demand? That is straight from basic economics. If demand rises, the price must rise to induce sufficient supply (sellers) to come into the market and restore equilibrium. This does not sound very mystical, does it?
So, now that demand has increased, market activity picks up to provide supply. It also changes in character as people try to decipher what is happening. Here are the familiar concepts of fear and greed, both key determinants of human behavior. Some participants think that something has changed and the stock is now undervalued. It could be a new product or simply a decrease in the company's raw material inputs. Perhaps it is foreign capital coming into the stock. Or a shortage of the stock itself. Whatever the reason, some market participants know something, or think they know something, about improved prospects for the company and they buy. The market breaks out of the trading range, and as it does, more market participants act. The size and scope of their actions is often similar to the size and scope of their actions at other occasions in which the market has broken out of similar ranges. It can be measured and projected.
Technical analysis has an unfortunate name. Perhaps "price action analysis" or "supply, demand, and reaction analysis" might be better. In 1998, great strides were made between market technicians and the academic community in the emerging field of behavioral finance. Now there is a possible name to use.
One aspect of the technical discipline is explaining the difference between valuations and actual market prices. If a stock is worth 75 on paper based on discounted cash flows, projected growth, and overall economic conditions, why is it trading at 90? The difference is in the market's perceptions of the stock. People have pushed the stock up past its theoretical value. Technical analysis is perfectly suited to handle this. Because people's perceptions can change quickly, it is also perfectly suited to reacting equally as quickly. This type of reaction speed is impossible using fundamental analysis alone.
Do you scrap your fundamentals and rely exclusively on technicals? Absolutely not! Although there are scores of money managers and traders that are 100 percent technical and making a lot of money, you, the reader, are not interested in making technical analysis your sole investment discipline just yet. You are reading this book because you are seriously interested in enhancing your returns, not searching for a completely new method. Perhaps one day you will make that switch, but that is beyond the scope of this book.
At this stage, charts give you a clear picture of what your fundamental research is saying. Remember that the fundamentals describe the company. Technicals describe how the stock performs. You are buying stock, not companies.
But why does this book need a third edition? If technical analysis is not subject to revision, then its concepts should have near-permanent shelf life. Unfortunately, the markets are ever–evolving, and analysts are always learning new things about how it operates. After all, wasn't the world considered to be flat at one point by the best minds of the time? Or that leeches healed disease? You get the point. As the markets change, so, too, must the analysis.
Between the first and second editions, most of us experienced our first live bear market for stocks. Between the second and third editions, we experienced a near breakdown of both the financial markets and the usefulness of our analytical tools. This edition incorporates everything new I have learned about the markets and how to analyze them. It is likely not going to be the last edition because the markets will not stop changing. Remember the old saw, "Whenever you find the key to the market, they change the locks."