Sorting The Mumbo From The Jumbo

Foreword from ShareInvestor

This article “Sorting The Mumbo From The Jumbo” by Cai HaoXiang was first published in The Business Times on 11 Nov 2013 and is reproduced in this blog in its entirety.

In technical analysis, what’s exciting is that trends can be identified immediately and action taken.

Technical analysis looks fancy and rather daunting.

There are plenty of bars, charts, trend lines, moving averages and exotic theories and indicators that bedazzle and befuddle the casual observer.

Just to name a few: you will be watching RSIs and MACDs, throwing on Bollinger bands and drawing parabolic SARs, checking out the clouds in the Ichimoku chart and surfing Elliott waves while crunching Fibonacci numbers.

You squint at charts, scanning for golden crosses, glancing at flags and pennants, cups and handles, wondering if that was a head and shoulders pattern you saw, or some other body part. (Oh hey, double bottom!)

Rather horribly, there is also a trading term called the “dead cat bounce”, the idea behind which is that even a dead cat will bounce if it falls from a great height.

Similarly, even a stock with no viable business will rebound slightly after a great crash. Sounds familiar? Just ask penny stock traders about that one.

If one is without any deep knowledge of technical analysis, trying to use it is akin to venturing out to the Atacama Desert in Chile armed with only a star map and no prior training.

You would see thousands upon thousands of stars, more than you can ever imagine. But try as you might, you will not find any constellation. There are just too many stars for you to match to the patterns on your map.

You can imagine what a bull or bear might look like, but you will not be able to find Taurus or Ursa Major anywhere.

So you give up and make up your own patterns. But true knowledge will elude you.

Some people swear by technical analysis. They take expensive courses purporting to teach them the most advanced techniques, and buy the most sophisticated computer software that will give them an edge in the market.

Others would bet their houses, wives and kids on fundamental analysis. Raised on a diet of Benjamin Graham and Warren Buffett, they cannot imagine relying on anything but financial ratios, dividend discount models and industry analyses for their stock picks.

Who is right? Which method is more reliable in generating stock returns?

The truth, as always, is probably somewhere in between.

There is no short cut to knowledge. Get-rich-quick seminars prey on the greed and laziness of investors who think that they need to spend money before they can make even more.

Technical analysis is more short-term in nature and perhaps fits that greed and laziness inherent in human nature better.

You do not need to bother with what the company does, the countries in which it operates, who sits in its key management, who its customers and suppliers are or what its cashflow situation is.

You just need price and volume data. Technical analysis is, at its heart, an analysis of the supply and demand factors affecting a stock’s price movements.

It is perhaps most useful for assets with no visible cashflow, such as currencies, commodities and gold.

Users also need to understand human psychology to figure out why stocks sometimes trade at nice, round numbers or multiples. They then manage their risk by developing a system to cut losses whenever things do not go their way.

The exciting thing about the technique is that trends can be discerned immediately and action taken, just by glancing at charts laid out on a computer. Yet, technical analysis can be wrong. Signals can be false. And because it depends on liquidity, it is not as useful for illiquid stocks when a small trade can easily push up the price.

Meanwhile, those relying on fundamental analysis have to deal with a different set of concerns altogether.

A stock can trade below its supposed intrinsic value for years. Not many of us might think about holding a stock for 10 years, much less 30 or 50 years.

But the disadvantage to fundamental analysis – the need for patience and long-term thinking – is also an advantage.

If, after doing your research, you still believe in the fundamental value of a stock and that it is currently undervalued, you do not need to be worried about short-term fluctuations.

Your calculus is straightforward: buy in steadily according to your cashflow, buy more if it goes down further, hold if it shoots up beyond what you can invest – and never sell.

Different as they may sound, there are ways to integrate the two techniques. An investor with a weakness for gambling might want to dabble in some technical analysis in trading currency pairs, but can still have a long-term portfolio of cashflow-generating blue chips.

If you have an eye on a stock that you have researched using fundamental analysis techniques, you can wait for its technicals to point to an oversold situation before opening a position in it.

If technical indicators point to an uptrend, fundamental analysis can add support to the trend, giving you conviction to trade.

Those poised to reap the greatest benefits will understand both techniques deeply and practise often, while retaining a sceptical and open mind.

Ultimately, whether using technical or fundamental analysis, you are following a set of rules.

Understand them, have control over how you use them, tweak them to your advantage, and they will serve you well.