Charts Are Pretty, But Not Predictive

"The S&P 500 Fell Below Its 50-Day Moving Average. What Happens Next?" Well, what happened next were rallying stock prices putting the index back above that allegedly meaningful moving marker. But rather than sounding the all clear, all this does is remind us clearly that basing your strategy on technical indicators is a faulty approach.

This week's coverage of technical analysis shows just how futile it really is. On Tuesday, the S&P 500 fell below its 50-day moving average-typically considered bearish. The same day, the 52-week high/low spread (the difference between the number of NYSE stocks that hit their 52-week high and 52-week low) flipped from bullish to bearish. Headlines rightly pointed out that the S&P 500 falling below the 50-day moving average hasn't accurately predicted returns over more than a day or so during this bull market ... yet they went on to guess at what it means for the next day or week anyway, arguing it's a bullish contrarian short-term indicator. This, of course, is largely pointless-what stocks do in any day or week is insignificant in the long run. Moreover, like all technical analysis, it also assumes past performance predicts the future-which is never true.

Now this episode is extremely myopic and has the relevancy lifespan of a gnat. But it's illustrative of all technical indicators' shortcomings-whether they're aimed at short- or long-term movement. Here's a sample:

• The Hindenberg Omen-named after infamous ill-fated Zeppelin-uses the NYSE's 10-week moving average and one-year high/low spread (and some other mumbo jumbo) to predict market crashes.
• The Golden Cross is bullish when a stock's 50-day moving average breaks above its 200-day moving average.
• The Death Cross is the reverse-the 50-day moving average crossing below the 200-day.
• Ichimoku clouds, the Japanese game-show version of technical analysis[i], track averages of 26-day highs and lows and 9-day highs and lows on a rolling basis, drawing conclusions from the midpoints of the average of those averages and the 52-week high and low.
• Candlestick charts plot the opening, closing, high and low prices of stocks each day-and supposedly can form all manner of bullish or bearish patterns.
  • One, the Bullish Homing Pigeon, says a stock is about to rebound when its negative candlesticks get smaller (the gap between the lows and highs shrinks)
  • Another, the Stick Sandwich, is bullish when an up candlestick is sandwiched between two larger down candlesticks-and bearish when the bologna is down and the bread is up. In English, it's bearish when a small down day happens between two big up days and bullish when the opposite happens.

None of this stuff works. It all has the same problems, relying on past movement and assuming patterns hold true always. But if markets followed perfect, repeatable, predictable patterns, these indicators would always work, everyone would follow them, and no one would lose money ever. But these indicators misfire plenty-they hit the mark sometimes, keeping diehards' faith alive, but their foibles are many. The Hindenberg Omen flashed 30 times between 1986 and June 2013. Only four of those occurred near bull market peaks. 20 occurred during bull markets. The Russell 2000 has hit the Death Cross four times in this bull market, most recently last September. It hit a new high March 2-no small cap bear market began. The S&P 500 has crossed below its 200-day moving average seven times since this bull began. Selling at any of these times would have caused you to miss big returns. Stocks are forward-looking. They move on expectations of the future, something past performance-and technical indicators-will never reveal.

Yet they remain popular, because volatility is uncomfortable, and having numbers to help us explain and navigate it can make folks feel better. It brings a veneer of rationality to the market's madness.[ii] That seems to be what happened this week-a phenomenon we like to call searching for meaning in bouncy times. Instead of seeking guidance in charts, which could lead to costly myopic decisions, we'd suggest simply accepting that volatility happens, often with no apparent rhyme or reason, and looking longer-term-at something other than plots of past movement, like the many fundamental indicators suggesting this bull market has room to run.

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[i] We mean no disrespect to Japanese game shows, which are great fun. They have a lot going on, but that is part of the fun. The Ichimoku cloud is not fun. It just has a lot going on.

[ii] An irrational pretend-rational veneer.