I have a secret. Come closer and I'll tell you. I studied technical analysis—and I liked it. Despite my secret passion, I realize technical indicators on their own offer little to no value for long-term investors. In fact, the basic tenets of technical analysis ensure changing markets will eventually render a method ineffective. I call this technical paralysis.
As a refresher, primary market analysis is either fundamental or technical. Fundamental analysis studies the economic, political, and sentimental drivers—or the "why" behind supply and demand factors. Conversely, technical analysis studies historical patterns and past market action—or the "what" to determine supply and demand factors. Price trends, moving averages, and relative strength are forms of technical analysis.
Early in my studies, I was fortunate to chat with a well-known author/analyst about my desire to incorporate technical analysis in portfolio management. During our conversation, he said, "Learn to play the piano with both hands, or your performance will be awful." I was puzzled—weren't we just talking about technical analysis? Besides, I'm a bass player. He clarified, "Never forsake the fundamentals when making investment decisions, as they reveal the why behind the what." Good advice.
A benefit of technical analysis is that it's black and white—no opinions, just facts. A triple bottom is a triple bottom—it's not up for debate. However, this "benefit" is detrimental to long-term investors. Why? Everyone views the same analysis, that's why. To be a successful long-term investor, you must know what others don't. Technical analysis provides a lot of cool, nerdy information, but ultimately shows what most folks already know. To know what others don't involves much more than following an indicator.
Finance theory dictates no one market index perpetually outperforms all other indexes. In other words, the NASDAQ can do exceptionally well for a few years, but over long periods it should provide annualized returns in line with other indexes. There are similar traits with respect to technical indicators.
For example, the Dow Theory worked well initially, but after 1938 it became relatively ineffective. (Listen closely—you can hear Dow loyalists grinding their teeth.) This was only a few years after the Theory really began to take hold on Wall Street. Several variations of the Theory popped up in the 1950s and, similar to the pure 1930s forms, the culmination of its popularity marked almost the exact moment it no longer provided value. As the popularity of a method increases, the reliability begins to diminish. At some point, the primary benefit factor is already accounted for by the masses, and the method is basically useless.
It's common for technical indicators to conflict with fundamental analysis—especially during market corrections. The market drops 10% and technical indicators are blasted into a tailspin. The indicators don't care why this is happening—they just know it is happening. Ignoring why a market moves is a big mistake—especially when it's moving on emotion. Reference any past market correction for examples.
The anecdotal evidence for technical analysis is powerful during volatile markets. This year provides an amplified platform for technical pundits. They've been telling us for the last FIVE years the bear market never ended. Now they finally have proof—in a neat little package of Dow Theory sell signals with a side of credit crunch cookies. Those of us who wouldn't listen and remained invested are finally going to suffer! (Insert maniacal laugh here.) Reminder—those of us "who wouldn't listen" over the last five years participated in a 130% advance for the global markets. Pretty nice for a bear market that never ended.
Technical analysis can be historically adapted to seem plausible. During a volatile year like 2007, the lure for investors can be too much. They mistake a bull market correction as a sign the technical indicators are right and abandon fundamentals. This leads to methods more appropriate for short-timing day traders than individuals with long-term objectives. And let's not forget—most of us are investing to achieve long-term goals. Losing sight of this is where investors lose sight of a prudent investment discipline.
To date, there is no pure technical method proven to deliver practical long-term value as a primary driver in portfolio management. When market analysis is viewed as a science rather than a craft, it becomes easier to see there is no universal formula that always works. To know what others don't, you must account for the many variables otherwise ignored by the charts. Doing so means the difference between believing something will tank the economy and knowing it likely won't.
17th century Dutch philosopher Spinoza offers potent words: "All things excellent are as difficult as they are rare." Any approach to market analysis which is easily described and widely followed will, by definition, have limited success. Investors should realize changing markets necessitate constant innovation in analysis methods in order to provide long-term value. As history shows, the market always reverts to the fundamentals in the intermediate to long-term. Realizing this will help you avoid technical paralysis.