The stock market or any market never reflects what its true value is. It reflects investors perception of the value or what people think it is worth.
Technical analysis is part of what we provide our customers. A technical analyst doesn't look at income statements, balance sheets, company policies, or anything fundamental about the company. The technician looks at the actual history of trading and price in a security or index. This is usually done in the form of a chart. The security can be a stock, future, index, or a sector. It is flexible enough to work on anything that is traded in the financial markets.
The technical analyst believes that the market price reflects all known information about the individual security. It includes all public and insider information. The market price reflects all the different investor opinions regarding that security.
So what's the big deal? Just as fundamental analysis looks at the past, technical analysis also incorporates the past into its analysis. True. However, the technical analyst believes that securities move in trends. And these trends continue until something happens to change the trend. With trends, patterns and levels are detectable. Sometimes the analysis is wrong. However, in the overwhelming majority of instances, it's extremely accurate. Many times I've successfully traded securities with only the knowledge of its chart behind me. I didn't know what the company did. But the underlying technicals indicated a direction to me. The technicals were right.
The tools of the technical analyst are indicators and systems which are used on price charts. Moving averages, support and resistance lines, envelopes, Bollinger bands, momentum... are all examples of indicators. These indicators all tell a story.
Many people believe that buy and hold is the right strategy for owning securities. I don't agree with that. ABC might be a company you want to own for the long term. That's great. However, there's nothing wrong with buying at 50; selling at 67; and buying it back at 55. There's also nothing wrong with buying at 50; selling at 67; shorting the stock at about 67; then closing your short at 55 and buying back the security. In the latter, you've made your money work a little more efficiently. In the case of the former, you've made money when the stock was going up, coming down, and then going back up again. Either way, your money has worked harder for you. Technical analysis can aid in predicting turning points and direction in securities prices.
Sentiment indicators measure the expectations of participants in the market. These participants can be broken down to include odd lotters, corporate insiders, NYSE members, advisory services, mutual funds, institutional traders, and floor traders.
These sentiment indicators are actually measuring the emotions of these investors. As is the case with most things in life, emotions change. They swing back and forth. And these sentiment indicators swing back and forth between extremely bearish to extremely bullish.
Some sentiment indicators are contrary indicators and some are correspond with their indication. The majority is usually most optimistic at a market top and the most pessimistic at a market bottom. The more optimistic or pessimistic the majority is, generally, the more significant the top or bottom is.
Market participants who are better informed (the minority of investors) seem to buy and sell in a contrary manner to the majority. When the minority seems to think things are the worst they've ever been and will probably get worse, a small minority is buying. Conversely, when things are great and will only get better is when this small minority is selling. At significant turning points, insiders are usually following a different course than the general investing public.
One very important thing to keep in mind with sentiment indicators is their results have been distorted over the past several years. This is due to the widespread use of options and futures on both individual securities and indexes. For example, short interest is not a reliable indicator anymore. In fact, it's probably irrelevant now. Stocks are shorted in conjunction with other strategies. Therefore, it is not a reliable signal.
Flow Of Funds Indicators
Flow of Funds indicators attempt to measure the ability or the financial position of different investor groups. It tries to measure their capacity to buy or sell stocks. It also attempts to measure where the money is going. If the money is going out of mutual funds, where is it going.
The flow of funds analysis looks for trends in bank trust accounts, customer's accounts, foreign investors, initial public offerings and secondary offerings, insurance companies, margin debt, mutual funds, and pension funds.
Flow of funds analysis has a couple of drawbacks. First, the data is lagged. It does not arrive at the technical analysts desk in a timely fashion. Second, the data is not always sufficiently detailed to be of much use in technical analysis. Third, it doesn't give the user a good idea as to where the money is going. It is much better at describing where the money is leaving. Some technicians believe that looking at liquidity in the banking system is a superior approach. As this measures pressure on the banking system and the entire economy.
Technical analysis is mainly concerned with market indicators. These technical indicators look at the trend of price indexes and individual securities. They evaluate the position of the security or index.
In technical analysis we look for divergence between indicators and continuity between indicators, all in an effort to determine the validity of a trend. It is important to understand that technical analysis measure the mass of investors or mass psychology. These indicators do not measure what a select few are doing.
The theory underlying these indicators is that once a trend is in motion it will continue in that direction. Technical analysis attempts to determine the strength of the trend and the direction of the trend. The technical analyst will attempt to identify the trend or the change in trend early. The technical analyst will also use his analysis to stay away from a market or a security unless there is a good amount of protection in place.
On a regular basis I'm asked to give an opinion on a particular security and my answer is, "I have no idea what it's going to do." On the other hand, a very dear friend of mine called me up one day and told me that his firm had just taken a position in one particular stock. He asked me what I thought. I told him that I would have waited until it bottomed at 51. He had bought it at an average price of 57-3/8. This was definitely not what another pro wanted to hear. About three weeks later it bottomed at 49-1/2 and traded between 49-1/2 and about 52 for another couple of weeks before it headed back up to where my friend bought it. He's dealing in tens of thousands of shares at a time. The difference between where he bought it at and where I would have recommended buying it is a significant amount of money.
Without sounding trite, he could have been right and I could have been wrong. In which case he may not have gotten into the trade. I obviously saw something his analysts didn't see or they may have seen it and discounted its importance. Nevertheless, this example underscores the importance of looking at technical indicators from many different perspectives.
When I read in a book or a magazine article or someone tells me that the preferred time period to look at a certain indicator is X, I become very skeptical. If they look at it in period X, I'm sure that I can find many more technical analysts who look at it in time period Y, or Z, or A, etc. The good technical analyst will look at different indicators in different time periods. However, we all become comfortable with certain time periods for certain indicators or securities. We've already experimented with other time periods and found the time period we feel the most comfortable with. What that particular analyst is really saying is that he feels the most comfortable with time period X. You may not.
Price, time, volume, and breadth are inputs into these indicators. Price reflects the level of change in investors attitudes. Time measures the cycle or period of change. For example, the longer it takes to move the market from a bearish to a bullish position, the stronger this reverse in direction will be. Volume measures the intensity of the change in investors attitudes. A security which moves up on very low volume is not as stable as a security which moves up on high volume. And remember that volume is relative. Volume should always be measured against the volume that individual security or index typically demonstrates. Breadth measures how many different securities in the same market are moving in the same direction. The more significant a trend is, the greater the number of securities involved in the move will be. For example, a trend which is limited to blue chip stocks or tech stocks, is not as significant as if a wide array of sectors and stocks are involved.