Recent stock market movements have the Dow flirting with 10,000 and a number of technical indicators flashing red.
Trying to see pattern where none may exist is psychological, not predictive, and a common cognitive error befalling investors.
Charts can only show us what has happened, but not why.
Instead of focusing on where an index or stock price is or isn't, investors should focus on fundamentals and what they bode for economic and business growth ahead.
Recent stock market movements have the Dow flirting with 10,000 and a number of technical indicators flashing red. As we've noted often, the Dow is a flawed index, and numerical thresholds are meaningless, but what about the technical indicators? With all those charts and numbers and arrows pointing this way and that, technical analysis sure seems smart—but relying on it to guide investing decisions is actually anything but.
Indicators like the Hindenburg Omen and head-and-shoulders patterns are making headlines today, but aside from catchy names, what do they offer investors? Humans dislike uncertainty—of which the stock market has an abundance—and technical analysis allows us to create neat little patterns to explain price movements. But trying to see pattern where none may exist is psychological, not predictive, and a common cognitive error befalling investors.
Let's look at it this way: Technical analysis studies patterns in past price changes to forecast future market action, but if historical performance really dictated future performance, wouldn't we all be millionaires by now? Billions would be spent on high-powered super computers to uncover profitable chart patterns and ensure investing success. Unfortunately, stock price movements aren't serially correlated. In other words, what a stock or index has done in the past doesn't tell you anything about what it will do in the future—a stock may rise or fall one day, week, or month, and do just the opposite the next.
It's not surprising then that indicators like the Hindenburg Omen and the head-and-shoulders pattern hardly have pristine track records. For example, in July 2009, a head-and-shoulders pattern emerged in the S&P 500 but stocks continued their huge rally. And the joke goes the Hindenburg Omen has called 14 of the last 3 bear markets.
Further, technical analysis contradicts the basic investing tenet of not following the herd—after all, these indicators are readily available to any interested investor. Additionally, though technical analysis is thought to be fairly black-and-white, choosing specific start dates, end dates, and scale could skew conclusions and lead to inconsistencies. The Hindenburg Omen, for example, was thought to be triggered on August 12th based on new highs and lows on NYSE-traded stocks, but the calculation included fixed income products and not just stocks—blurring the black-and-white into a gray area. (For good arguments against the recent Hindenburg Omen in markets, see here and here.)
Charts can only show us what has happened, but not why. There are simply too many factors and variables that drive market movements to be captured by one or even several charts. Instead of focusing on where an index or stock price is or isn't, investors should focus on fundamentals and what they bode for economic and business growth ahead. There are risks to the economy and stock market, but none should be mistaken with early twentieth century dirigibles or dandruff shampoos.