Technical Analysis

Technical Analysis (also known as 'Charting') is a method used to forecast the future direction of prices by studying past market data, primarily price and volume. Proponents, called technicians or chartists, believe that all the information about a company—from its earnings report to the CEO's favorite breakfast cereal—is already reflected in its stock market price. Therefore, there's no need to pore over financial statements. Instead, they analyze charts, looking for recognizable patterns and trends to predict whether a stock is about to go up, down, or sideways. It’s a world of 'support and resistance levels,' 'moving averages,' and exotic-sounding patterns like the 'head and shoulders.' In essence, technical analysis is the art of reading the market's mood swings. It completely ignores the underlying business and focuses solely on the squiggles of a price chart, putting it in direct opposition to the philosophy of fundamental analysis.

Technicians have a vast array of tools they use to interpret price movements. While the list is nearly endless, they generally fall into three categories: charts, patterns, and indicators. The goal is always the same: to find clues in past price action that might signal future moves.

The foundation of all technical analysis is the chart, which is simply a visual history of an asset's price over time.

• Charts: These are the canvas on which the technician paints their predictions. The most common types are line charts, which connect closing prices over a period; bar charts, which show the open, high, low, and close for each period; and candlestick charts, a Japanese method that visualizes price action in a way that many find more intuitive.
• Patterns: This is where technical analysis gets its reputation for being a bit like financial astrology. Technicians believe that human psychology is predictable and that this predictability creates recurring patterns on price charts. Famous examples include:
  • The head and shoulders: A pattern that supposedly signals a trend reversal from bullish to bearish.
  • The double top/bottom: Two consecutive peaks or troughs that suggest a trend is running out of steam.
  • Triangles: Converging price ranges that are believed to precede a significant price breakout in one direction or the other.
• Indicators: These are mathematical calculations based on price and/or volume, plotted on the chart to provide additional “signals.” Popular indicators include moving averages, which smooth out price data to identify the trend's direction; the Relative Strength Index (RSI), which aims to identify 'overbought' or 'oversold' conditions; and the MACD (Moving Average Convergence Divergence), a trend-following momentum indicator.

The schism between technical and fundamental analysis represents two completely different philosophies of what drives stock prices.

The practice of technical analysis is built on three core assumptions:

1. The market discounts everything. All known (and sometimes unknown) information is already baked into the stock price.
2. Prices move in trends. A stock in motion will tend to stay in that same motion (up, down, or sideways) until a clear reversal occurs.
3. History tends to repeat itself. Chart patterns are believed to be recurring because they are rooted in predictable human emotions like fear and greed.

From a value investing perspective, relying on technical analysis is like trying to drive a car by looking only in the rearview mirror. It tells you where you've been, but not where you're going or, more importantly, whether the road ahead is a bridge or a cliff. Value investors, disciples of Benjamin Graham and Warren Buffett, believe that a stock is not just a ticker symbol to be traded based on chart squiggles. It represents a fractional ownership in a real business. The only logical way to invest is to first determine a business's intrinsic value—what it's truly worth based on its assets, earnings power, and future prospects. If you can buy that business for significantly less than its intrinsic value (with a margin of safety), you have made a sound investment. As Buffett famously noted, “I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer.” The focus is on the business, not the ever-fickle mood of Mr. Market. A chartist might sell a great company because of a scary-looking pattern, while a value investor might use the same price drop as an opportunity to buy more of that wonderful business at a discount.

While technical analysis provides a fascinating look into market psychology and can be a useful tool for visualizing price history, it is a poor substitute for rigorous, business-focused fundamental analysis. For traders looking to make short-term bets on market sentiment, it can be a tempting game. But for a true investor, it is a dangerous distraction. Investing is about owning pieces of productive businesses. Your success over the long term will be determined by the success of those businesses, not by your ability to decipher patterns that look like body parts or geometric shapes. Use charts to see where a stock's price has been, but use fundamental analysis to decide if its underlying business is somewhere you want to go.