Chart Patterns

Chart Patterns are distinctive formations that appear on a graph of a security's price over time. Proponents of technical analysis believe these patterns are not random but are instead visual representations of investor psychology in action. By identifying recurring shapes—like triangles, flags, or the famous “head and shoulders”—traders attempt to forecast future price movements. The underlying theory is that human behavior, driven by fear and greed, is predictable and that these patterns reflect the historical tug-of-war between buyers (bulls) and sellers (bears). However, from a value investing standpoint, relying on these “squiggles on a chart” is akin to navigating by reading tea leaves. Value investors argue that a company's long-term success is determined by its business fundamentals—its profits, assets, and competitive strength—not by the ghostly shapes its past price movements happen to form.

It’s easy to see why chart patterns are popular. They offer a seemingly simple, visual shortcut to complex financial decisions. Instead of poring over dense annual reports or trying to calculate a company's intrinsic value, one can simply look for a familiar shape and place a bet. This provides a comforting sense of control and a clear “if this, then that” rulebook for trading. This approach promises action and quick results, a siren song compared to the patient, methodical work of fundamental analysis, which often involves long periods of waiting for the market to recognize the value you've identified. The appeal is in its simplicity, but as investors know, what is simple is rarely easy, and what is easy is rarely profitable in the long run.

Analysts have cataloged dozens of patterns, generally sorting them into two main categories. While a value investor should view these with extreme skepticism, it's useful to know what other market participants are looking at.

These patterns supposedly signal that a prevailing trend is about to change direction.

• Head and Shoulders: Perhaps the most famous bearish pattern, it consists of three peaks, with the middle peak (the “head”) being higher than the two on either side (the “shoulders”). A break below the “neckline” (the line connecting the troughs) is seen as a signal to sell. An Inverse Head and Shoulders is the bullish opposite, signaling a bottom.
• Double Top and Double Bottom: A Double Top looks like the letter 'M' and occurs when a price hits a high point twice without breaking through, signaling that bullish momentum is exhausted. A Double Bottom looks like a 'W' and suggests a bear trend is reversing.

These patterns are thought to be brief pauses in an ongoing trend, after which the original trend will resume.

• Triangles (Symmetrical, Ascending, Descending): These form as the price range between highs and lows narrows. The theory is that pressure is building for a “breakout.” An ascending triangle (flat top, rising bottom) is considered bullish, while a descending triangle (falling top, flat bottom) is bearish.
• Flags and Pennants: These are short-term patterns that appear after a sharp, steep price move. They look like small rectangles (flags) or triangles (pennants) on the chart, representing a brief consolidation before the price continues in its original direction.

The value investing philosophy, pioneered by Benjamin Graham and championed by Warren Buffett, is fundamentally at odds with the premises of chart pattern analysis for several key reasons.

Many academics and investors subscribe to a version of the Efficient Market Hypothesis (EMH), which suggests that stock prices follow a random walk. This means that past price movements have no bearing on future movements, as all known information is already reflected in the current price. From this perspective, trying to find predictive patterns in a price chart is a futile exercise—like trying to predict the next coin toss based on the last ten. The “patterns” are simply illusions created by randomness.

A chart shows you the price; it tells you nothing about the value. A value investor is focused on the underlying business—its earnings power, its balance sheet, and its competitive advantage (or moat). A stock price falling isn't a “descending triangle”; it's a potential opportunity to buy a wonderful business at a fair price, if and only if the business itself remains sound. Charting focuses on the effect (the price) while ignoring the cause (the business performance).

Chart patterns are remarkably clear in retrospect. Looking back, you can always find a perfect “head and shoulders” that preceded a market crash. In real-time, however, the signals are ambiguous and often fail. For every pattern that “works,” many more dissolve into meaningless noise, leading to false signals and costly trades. This is a classic cognitive trap where our minds impose order on past events, making them seem far more predictable than they actually were.

Does this mean a value investor should never look at a price chart? Not necessarily. While a chart should never be the basis for an investment decision, it can be a useful, albeit minor, tool.

• Visualizing History: A chart provides a quick overview of a stock's historical volatility and how the market has perceived its value over time. It can help you see when a stock has fallen out of favor, which is often the starting point for a value-oriented investigation.
• Context for Opportunity: Even Benjamin Graham used charts to screen for stocks trading below their net-net working capital. The chart didn't tell him the business was good, but it did tell him the price was low, prompting him to do the real work of fundamental analysis.

Ultimately, the chart tells you the price, but your analysis tells you the value. The goal of a value investor is to find a significant gap between the two. View chart patterns as a reflection of market sentiment and crowd psychology, but base your own investment decisions on the solid ground of business facts and careful valuation.