Chart Pattern

A Chart Pattern is a distinct formation on a stock chart that is created by the movement of a security's price over time. These patterns are the cornerstone of a field known as technical analysis, where analysts and traders study historical price action to forecast future market direction. The theory is that these recurring shapes and formations visually represent the collective psychology of buyers and sellers—their greed, fear, and indecision. By identifying a pattern like a “Head and Shoulders” or a “Cup and Handle”, technicians believe they can predict with a reasonable degree of probability whether a stock is about to rise, fall, or move sideways. These patterns are typically identified by drawing trend lines that connect price points or by observing the relationship between price and other indicators like moving averages. While immensely popular in the world of short-term trading, the practice of “reading the tea leaves” of a chart is viewed with deep skepticism by value investors.

Technicians believe that market prices move in trends, and chart patterns are seen as signals that can either confirm a trend or indicate an imminent reversal. They are generally categorized into two main types:

• Continuation Patterns: These suggest that after a brief pause or consolidation, the prevailing price trend will continue in the same direction. Imagine a stock climbing steadily, pausing for a bit, and then resuming its ascent. The shape the price makes during that pause is the continuation pattern.
  1. Examples include: Flags, Pennants, and Ascending/Descending Triangles.
• Reversal Patterns: These are considered more significant as they signal that a prevailing trend is about to change direction. For example, a reversal pattern at the peak of a long uptrend might warn traders that a downtrend is about to begin.
  1. Examples include: Head and Shoulders, Double Top, and Double Bottom.

For instance, a “Double Top” looks like the letter 'M' and forms when a price hits a high point, pulls back, and then rises to the same high point again before falling. Technicians interpret this as a sign that the stock is unable to break through a resistance level and is likely headed lower.

For a value investor, focusing on chart patterns is like trying to understand a company's health by analyzing the shadows it casts on a wall. It's an indirect, and often misleading, approach. The philosophy of value investing is built on a foundation of fundamental analysis—the rigorous study of the business itself.

Value investors believe that a company's stock price will, over the long run, reflect its underlying intrinsic value. This value is determined by factors like earnings power, debt levels, quality of management, and its competitive position, or economic moat. Therefore, an investor's time is best spent poring over financial statements and understanding the business, not trying to decipher squiggles on a chart. The core questions are: “What is this business worth?” and “Can I buy it for a price that provides a significant margin of safety?” The daily or weekly zigs and zags of the stock price are largely irrelevant noise.

A key critique of chart patterns is that they may be a product of pareidolia—the human brain's tendency to see meaningful patterns in random data (like seeing animals in clouds). Stock price movements contain a great deal of randomness, and it's easy to retroactively fit a pattern to past data. Furthermore, the Efficient Market Hypothesis suggests that all publicly available information is already baked into a stock's price, making past price movements useless for predicting future ones. As legendary investor Benjamin Graham taught with his “Mr. Market” allegory, the market is a moody business partner. A value investor doesn't try to predict Mr. Market's mood swings (charting); they patiently wait for him to offer a wonderful business at a foolishly low price.

While millions of traders use chart patterns, and their collective actions can sometimes create self-fulfilling prophecies, this does not make it a sound investment strategy. For the long-term, business-focused investor, chart patterns are a distraction from what truly matters: the fundamental value and quality of the underlying company. While it can be interesting to be aware of the language of technical traders, your energy, capital, and focus are far better allocated to finding excellent businesses offered at a discount to their real worth. That is the most reliable path to building wealth, leaving the chart-gazing to speculators.