ARTICLES

Technical Analysis

A few weeks ago, I wrote an article about the relationship between fundamental and technical analysis. (Click here to see the article)

In this article, I would like to take that discussion forward by considering the theoretical foundations of technical analysis and its merits as a method of predicting future share price movements.

Technical analysis (i.e. the analysis of price graphs) begins with the assumption that there are patterns in share price charts which can be used to improve the investor’s probability of making accurate predictions. If we accept that share price charts do, in fact, contain patterns, then we need to ask the question, “Where do those patterns come from?”

The answer to that question is that the patterns originate in group investor behaviour. Investors as a group exhibit certain consistent behavioural patterns which can be directly linked to specific charting formations. Perhaps the easiest way to explain this is by way of an example.

The moving average (MA) is arguably the most basic and widely used technical analysis tool. Studies done in the United States have shown that a simple 200-day moving average, applied to the Dow Jones Industrial index over the past 100 years is approximately 10 times as profitable as a buy and hold strategy. In other words, an investor who acted on every buy signal and sell signal given by such an MA over the last 100 years and paid the standard dealing costs on every transaction would have made ten times more profit than another investor who simply bought the Dow Jones 100 years ago and held it over that period.

This seems to indicate that using the MA definitely improves investor performance – and that means it must be exploiting something consistent within psychology of the investors as a group whose purchases and sales give rise to the charts.

The pattern which makes MA's effective has its origins in the psychological difficulty which people have in adjusting their perceptions of asset values, quickly.

In your life, you have always thought of big-ticket assets as having more-or-less constant values. For example, the one of the most traumatic experiences you can have is to write off a motor vehicle – because what was worth R250 000 a few minutes ago is suddenly worth nothing. Your mind has great difficulty in adjusting to the new reality.

If I told you that your house was worth nothing you would have extreme difficulty in accepting that – even if I was right.

From a young age, we are socialized to accept that asset values change only very slowly over a long period of time – if they change at all.

Let us suppose that you have a share which is changing hands in the market today for R20. Would you sell it for R1 tomorrow morning? Obviously not – nor would anyone be foolish enough to offer you R1. But if the share was over-priced at R20, then it is quite conceivable that you might accept R19 for it tomorrow morning. And, if you were still holding it the day after that, you might accept R18 – and, in time, it might eventually reach R1. But, it would never do so in one day – but over a period of weeks and months – which means that mathematically the share price must cut down through its moving average giving a clear sell signal.

This unwillingness to accept rapid and radical changes in the value of assets is the generalized human characteristic which allows the MA to work. It results in share prices moving in broad sweeping trends either up or down – broken by occasional periods of sideways movement.  To the extent that share prices move in trends, the moving average will work and the buy and sell signals that it gives will be effective. To the extent that share prices move sideways, the moving average will not work.

With this idea in mind, two important understandings become clear:

• That technical analysis is really the study of group investor behaviour – as it manifests in share price and volume patterns. It follows that when you are considering a technical indicator (like the moving average) you should try to establish which human behavioural characteristic it is exploiting because that will give you a closer appreciation of its efficacy.
• That technical analysis is really a social science in the same way as economics or psychology. Economics and psychology have naturally ended up in the realm of statistics and probability, because they are striving to identify patterns within particular areas of human behaviour. Hence , economics tends towards econometrics and psychology tends towards psychometrics.

In psychology and economics, the “size of the sample” is critical. No psychologist would come to conclusions based on the study of a single individual – because that single individual might be an outlier in some way (a person with an extremely high IQ or a psychopath, etc.). In fact, the broader his study and the larger the size his sample the more compelling his results become.

So, what is the size of the sample in technical analysis? It is the volume traded. The more heavily traded a financial indicator is the more reliable it becomes technically. Thus, a thinly traded share is technically unreliable because a single investor getting in to or out of the market for reasons which are completely unrelated to the market (e.g. he sells because he needs the money to put down a deposit on a house) can move the chart significantly. But, with a heavily traded share, the activities of the individual are lost in the overall direction of the trend.

Thus, a heavily traded share is more technically reliable than a thinly traded one. An index is more technically reliable than a share – and so on.

DISCLAIMER

All information and data contained within the PDSnet Articles is for informational purposes only. PDSnet makes no representations as to the accuracy, completeness, suitability, or validity, of any information, and shall not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. Information in the PDSnet Articles are based on the author’s opinion and experience and should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. Thoughts and opinions will also change from time to time as more information is accumulated. PDSnet reserves the right to delete any comment or opinion for any reason.

PDSNET ARTICLES

Exponential Growth

The  S&P 500 index is important because all the stock markets around the world tend to follow it. If the S&P is in a bull trend then London, Tokyo and the JSE will also be in a bull trend – and vice versa.

The S&P500 index began 68 years ago on 4 th March 1957 with an initial value of 43,73. It took nearly

The US Jobs Market

International investors who trade on Wall Street are generally negative about any good news from the economy because it tends to make the monetary policy committee (MPC) more hawkish and less likely to reduce interest rates. The opposite is also true. But there comes a point where bad news is so bad that investors begin to fear that the US economy is heading

Jackson Hole

Once a year in late August central bankers and academics congregate in Jackson Hole to discuss the state of the economy and consider the way forward. Traditionally, the Chair of the Federal Reserve Bank (“the Fed”) addresses the meeting and gives direction to its thinking on monetary policy in the US. This year, the comments of Jerome Powell resulted in the

Choppies

Choppies is a supermarket chain which operates in Botswana, Namibia and Zambia. It is listed both on the Johannesburg Stock Exchange (JSE) and on the Botswana Stock Exchange (BSE). Notably, the company has resisted the temptation to re-enter the highly competitive and cut-throat retail market in South Africa, having exited that market in 2020 due to sustained losses. Despite

Gold Resistance

All investments throughout the world can be ranked on a scale from high risk to low risk. As a general rule, in the world of investment, risk and return rise together. In other words, as the risks in an investment increase, so does the return necessary to attract investors.

At the one end of the scale there are very low risk investments

Sibanye takes off

We have been writing about Neal Froneman and Sibanye for years now. Beginning in 2013, Froneman assembled the Sibanye group over a period of 7 years, buying up mining operations both in South Africa and America at bargain prices. Initially he bought precious metals producers, but more recently he has been diversifying into base metals like zinc and lithium which

The 16 Year Bull Trend

Since the Second World War, the stock markets of the world, including the JSE, have always tended to follow the New York Stock Exchange (NYSE) - and the NYSE is best measured by the S&P500 index (S&P) of its 500 largest companies.

For this reason, we believe it is important for private investors to constantly

CA Sales Revisited

Retailing in Africa is difficult with many of our leading retailers having attempted to open stores in countries to the North of us without notable success. These countries are often unstable and volatile politically. Getting adequate stock to branches has proved problematic and expensive.

It is not surprising therefore that a company has been

Bluetel

Bluetel (BLU) is a company involved in pinless top-ups, prepaid electricity, ticketing and universal vouchers. As such it is a company with substantial repeat business from existing customers. This type of business model is attractive to investors because it implies minimal working capital and strong cash flows.

Bluetel’s purchase

The Debtors' Book

A BIT OF HISTORY

Many years ago, in 1982 when I started this business (which became “PDSnet”), I ran advertisements in both the Rand Daily Mail (RDM) and in the Star – which were the two most widely read newspapers in Johannesburg at the time. At that time, we were a very small business and had no credit rating at all. Despite this the RDM immediately