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Profit from charts
Jul 06, 2006
Is it really true that financial prices move in trends? And if so, can technical analysis - the art of trend spotting - really help investors to make more effective investment decisions?
The investment world has long been split down the middle by an almost religious schism. On the one hand are the fundamental research analysts who believe that you can only forecast which company’s shares will do well by gaining an in-depth knowledge of their businesses and then valuing their growth prospects. The other view - that of the technical analysts - is that financial prices move in trends: investing success is about identifying these trends and spotting when they are about to turn.
So who’s right? As usual, when there is such a passionate and extreme dichotomy, both are. Both methods have their uses. If you were about to enter the Roman arena and someone asked you ‘do you want a sword or a shield?’ the correct answer would be ‘both’. It’s the same with investing: you need all the tools you can get.
Closer than they think
In my view, the fundamental and technical camps are really coming at the same argument but from opposite sides. Like extreme left and right-wing political agendas, they are much closer to each other than they would like to believe. Fundamental analysis aims not just to take on board a company’s story, but also how to figure out how much of that story is already reflected in the price. Meanwhile, because price movements betray participants’ actions (new buyers push the price up, sellers push it down), chartists are often effectively analysing the actions of the fundamental analysts. As one chartist once explained it to me, a fundamental analyst is effectively saying that he knows something that (he hopes) no one else knows, and which will affect a share price. A technical analyst, on the other hands, looks for evidence in share-price movements that someone else knows something he doesn’t - and he can benefit from anyway.
Whatever people’s initial views on the debate, one thing is for certain: regardless of their starting point, I have never known anyone become less technically minded as their career advances. Technical analysis too often reveals in price charts what the market is thinking long before the consensus has been written down for that to be the case. The wise investor learns to use the best of both resources: he uses fundamental research to help him decide what to do and technical analysis to help him decide when best to do it.
How technical analysis works
There is an old saying in the market, ‘the trend is your friend’. And it is these trends that technical analysts are engaged in identifying. They want to identify prices that are rising and will keep rising, and prices that are falling and will keep falling. But this is harder to do than it sounds: trends can look fairly obvious after the event, but it is often hard to spot them at the time. Some traders jump on any old move in the hope it’ll turn into a trend, but the danger is that it won’t and they’ll end up buying near-term highs (as prices rise, they think it’s a rising trend and buy, but then it just stops rising) and selling at the lows (the price falls, they think it is a falling trend and sell, but then it stops falling). That’s not the best strategy. This is why you will always hear that a trader’s number one mantra is to ‘cut losses’ fast: if it turns out that what you thought was a trend is not one, then you have to get out quickly. Only once a trend is clearly established can you have the confidence to run with it. But even then, no trader should be without the safety of a stop-loss.
Spotting the turn
Turning points, or inflection points, as George Soros calls them, mark the point where a trend ends - and a new one starts. That’s the point to get out of a trade based on the old trend and into one based on the new. Soros has been quoted as saying that he bases his investment scenarios on the assumption that the market is always wrong, rather than always right (the academic approach). The inflection point for him is when the rest of the market realises its mistake.
If trends are hard enough to spot, inflection points are harder. That said, markets often exhibit certain characteristics at the end of major trends. The most common is ‘acceleration’. As a trend becomes mature and hence more obvious, more people buy in, so the rate of ascent (or descent) accelerates, often bursting above (or below) the trend’s natural borders (known as tramlines). Acceleration in an entire sector or market is more usually known as a bubble. After acceleration usually comes a sharp sell-off, often followed by an extremely volatile period of major up and down moves. This whole process can happen over the course of days, weeks, or even months. After the bubble burst for America’s technology-heavy index, the Nasdaq, it took over a year.
The FTSE mirrored the US developments but showed that a dramatic new trend can be triggered by very un-dramatic old-trend breaks. Although the trend break was very late in 2000, the index had been going sideways for a couple of years beforehand, something that normally might lead you to expect a rather muted sell-off. However, the weight of all those years of uptrend that had come (especially the accelerated surge since 1995), meant a major sell-off was due. This in turn accelerated in 2002 and started getting very volatile through 2003 before breaking the downtrend to kick-off the present uptrend. This should be expected to continue to run for the next few years, unless and until the lower supporting tramline is broken, or a major multi-year double top is reached at the old 2000 highs. To me this makes press talk of imminent sell-offs look premature.
It isn’t always dramatic
The trouble with technical analysis is that the market is rarely having one of its dramatic turns. Hence most technical analysis is involved in the rather more humdrum exercise of trying to decide whether any particular move amounts to a new trend or not, and if so, what its parameters are (this was pretty obvious with the bubbles discussed above, but is not so easy to spot most of the time). Without establishing where the parameters or borders of a trend are, it’ll be impossible to know further down the line whether the trend has been broken and an inflection point has been reached.
Once you have spotted a trend, however, you can assume at least four things with better than random probability. You can assume the trend direction will occur more often than not; you can assume that the tramlines are more likely to hold than not; you can safely assume that a tramline break - in the opposite direction to the trend - is seriously bad news; and finally you can assume that the longer the trend has been running before it cracks, the more significant the next move will be. When the S&P 500 broke its eight-year uptrend in late 2000, it was quietly drifting sideways, but the sheer size of the turning point after such a long uptrend meant an equally sizeable correction was due.
One important rule to remember though: if you break a tramline in the same direction as the trend, it is not a break, it’s an acceleration. This can sometimes be a warning signal that things are over-heated, but just as often it heralds a whole new aggressive surge in the trend. However, tramline breaks in the opposite direction to the trend, especially if it’s a long-running, mature trend, are always bad news, even if they occur without much fanfare. Let’s look at five share-price graphs to see what they are telling us today.
GlaxoSmithKline
Glaxo has been suffering a declining share-price trend since 2001, but this accelerated sharply in 2002, and since then it has been trading sideways but in a very volatile range. The stock price had already exhibited almost all the classic characteristics of a turning point discussed above when, in 2004, it ‘double bottomed’ with the early 2003 low. The scene was then set for a new trend and by the early part of this year that nascent uptrend had already broken the three-year downtrend. Considering how much bad fundamental news has assailed the stock this year, this is both remarkable and a powerful confirmation of the technical approach.
Rio Tinto
Rio Tinto’s chart is a textbook triangle formation with a horizontal top line and a rising support line. The share price has just broken out into what they call ‘blue sky’ territory after five years of trying to break resistance above the £15 mark. This means that there are no new levels where long-term holders may be lying in wait to sell the stock and get out flat. Instead, every holder is now in profit. Good news too is that the fundamentals look excellent as commodity prices continue to surge, so the upside could be spectacular.
Shell Transport & Trading
Like Glaxo, Shell had been stuck in a three-year downtrend since 2001, and like Glaxo, it ‘double-bottomed’ in 2003-2004. This created a very solid platform to reverse the trend if only it could break the downtrend tramline, which it did about a year ago. Since then, it too has been assailed by the worst newsflow ever, so many fundamental analysts would therefore have expected the share price to fall. Instead, the almost unbroken upward march of the share-price chart has shown no indication of the management turmoil that has forced several high-level resignations and a change to the way the whole companyis run. That means we can expect further gains.
Legal & General
Legal & General’s (L&G) downtrend had been going on for four years before a classic acceleration and a cathartic exhaustion spike in early 2003 signalled that a major, multi-year low had been reached. Since then, the uptrend has been steady if not spectacular, but the reason I have included the chart is that, after such a run, if the story had been looking a little tired, the resistance from the six-year downtrend would have proved too much. However, the fundamentals are really exciting for L&G and the share price has just waltzed straight through the line. I expect the share price to continue to do great things for the next two to three years.
Unilever
Unfortunately, it’s not all good news for UK shares. Unilever has enjoyed three decades of fairly uninterrupted growth and that’s been reflected in the share-price performance, at least until the 1998 double-top. Since then, every rally has foundered on the rocks of £6 a share. Eventually, in 2003, the continued sideways movement brokethe multi-decade uptrend. The stock tried a final rally, but failed to get above the long-term trend-line. Technically, years of disappointment beckon. Although the fundamentals don’t yet signal as much, the chart is showing the market believes that the household giant has gone ex-growth. A slower future rate of earnings growth will only justify a lower multiple for the sort of double-whammy that no stock can absorb. You have been warned!
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