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THE ART OF TECHNICAL ANALYSIS 
Technical analysis is an important element of the private investor’s technique. It is particularly useful in establishing or sharpening the timing of a transaction once a share has been selected. The very simplest form of technical analysis occurs where you observe, for example, that a certain share regularly moves between 3000c and 3500c. Once you have become aware of this pattern you would be inclined to wait until the share returns to 3000c before buying. That is the most basic form of technical analysis – where you observe and exploit a pattern.
Awareness of patterns in share price movements is most easily stimulated by studying share price charts and looking for formations, trends, support and resistance levels and other indications. Your software keeps a record of every share’s price and volume going back decades and can, of course, immediately show you the chart of any listed company’s shares going back as far as 20 or 30 years – but it is up to you to recognise the patterns.
In general, the computer cannot identify the pattern for you, because this requires a degree of interpretation. Private investors who become keen on technical analysis usually prefer it because it does not involve as much hard work as poring over the company’s financial results. It is easy to believe that a computer system can also make an interpretation – but it cannot. Computers are just fast idiots. They can crunch the numbers quickly and draw graphs, but they have no judgement and are generally very bad at pattern recognition. It is your judgment and pattern recognition that makes technical analysis useful and profitable – but always remember that interpreting charts is more of an art than a science.
The objective of these notes on technical analysis is to enable you to interpret the graphs that you see to make the best profits. Technical analysis is a vast field of study, and we do not attempt to cover every aspect of this discipline in these notes. Rather the idea is to pass on an approach to analysis that will assist you to develop effective investment habits.
 
TECHNICAL VS FUNDAMENTAL ANALYSIS
 
Technical analysis is the study of historical price and volume patterns with a view to predicting future price and volume trends.
This contrasts with fundamental analysis which attempts to evaluate the future profitability of a company by analysing past and present factors such as financial strength, market share, competition, management expertise, gearing, labour relations – and, in fact, anything which might affect the company’s future profitability.
Fundamental analysis attempts to determine the real value of a share.
Technical analysis is a study of investors’ perceptions of that real value – as it appears in the share’s price and volume patterns.
Technical analysis assumes that all the fundamental factors that affect a company or that happen in the marketplace will be or are discounted into the price that investors are prepared to pay for that share and the number of shares they are prepared to trade at that price. The pure technician says, therefore, that the price and volume pattern are the best indicators of where a stock is going next – and there is no need to examine the fundamentals because the other investors have already done that, and so those factors are already in the share price. In our opinion, both fundamental and technical analysis are necessary to make good share selections and timing decisions in the market.
 
THE IMPORTANCE OF TIMING
 
The mass-psychology which determines market actions means that market sentiment is usually the most powerful force acting on the prices of shares. Studies in the United States indicate that as much as 80% of a share’s price move is caused by the movement of the market as a whole (systematic factors) and only 20% relates to the specific share (unsystematic factors).
The famous crash of October 1987, when the market fell 23% in a single day, is a good example of the power of market sentiment. Despite good company results and a buoyant economy, share prices plummeted. It is inconceivable that from one day to the next the entire share market was actually worth 23% less. Either it was over-valued before the crash or under-valued afterwards – or, more likely a bit of both. The only reasonable explanation for this massive fall is that investor perceptions had shifted. The fundamentals of the companies concerned had hardly changed at all.
Even for investors adopting a medium- to long-term view, timing is of considerable importance. The JSE Industrial index fell from around 490 to 200 between 1969 and 1971, and then took a full ten years (up until 1979) to get back to 1969 levels in nominal terms. An investor whose timing had been very wrong (i.e., who bought at or near the peak) would have to have waited ten years to recover just the nominal value of his capital – without considering inflation or the opportunity cost of his money!
More recently, the sub-prime crisis of 2008 saw a massive wipe-out of wealth on world stock markets. Central banks have tried to compensate for this with an unprecedented monetary policy stimulation culminating in a massive quantitative easing programme which was still continuing in late 2020 (in Europe) and which was then extended to compensate for COVID-19. Massive macroeconomic events can offer alert investors a significant opportunity, but they also present considerable risk. The idea of technical analysis is that there will always be investors who are much better informed about economic and other developments than we are – but their trades will leave a tell-tale signature in the charts – which we can follow and exploit. This is especially true of the illegal but common practice of insider trading.
Our primary objective in using technical analysis is to identify the troughs and peaks of the market cycle. If we can do this, we are able to buy low and sell high. Buying at low prices and selling at high prices is the oldest, most tried and tested method in the world for getting rich – but then, as the old Wall Street saying goes, “Nobody rings a bell at the top of the market!” It is up to us to determine when we are at or close to the tops and bottoms of the market.
 
DOW THEORY
 
The Dow Theory, which derives from the writings of Charles Dow around the turn of the nineteenth century, attempts to identify changes in the primary trend of the market. It is the oldest and by far the most extensively publicised technical analysis method. It is still very widely followed in America and major Dow signals tend to move the New York Stock Exchange. On the day before the crash of 1987, the Dow Theory gave a clear sell signal. The next day there were $8 billion worth of sell orders overhanging the market.
$44 dollars invested in 1897 in the DJIA on a buy-and-hold strategy would have risen to $2500 by 1981. The same $44 dollars applied using the Dow buy and sell signals would have grown to roughly $51,268 over the same period. That pattern of successful Dow signals continues until today.
There are three market movements according to Dow Theory:
The primary trend, which can last from about one year to four or five years, and sometimes longer. For example, the current bull trend on Wall Street has been going up for more than 12 years if you discount the impact of COVID-19 – which we see as an aberration from a technical perspective. Consider the chart of the S&P500 index:
 
<figure class="figure"><a class="lightbox" href="/onlinecourse/images/images/SP_(11).png" data-plugin-options="{'type':'image'}"> <img class="figure-img img-fluid" src="/onlinecourse/images/SP_(11).png" /> </a>
<figcaption class="figure-caption">S&P500 Index: May 2008-June 2021. Chart by ShareFriend Pro.</figcaption>
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Secondary trends in Dow Theory are important (but not primary) changes in trend. These are called “rallies” if they occur in a bear market, and “corrections” if they occur in a bull market and can last from a few months up to about six months.
So-called “daily fluctuations”, which can last anything from a few hours to a few weeks.
Some basic pointers from Dow Theory are:
“Corrections” and “rallies” will usually fall between 33% and 66% of the primary move. This is sometimes referred to as the 50% rule.
A sideways movement (a “line”) represent a period of accumulation or distribution, depending on which way the line breaks.
Volume should expand on rallies and contract on corrections. Low volume on a price advance may indicate an impending change of trend.
Primary bull trends are identified by “higher highs and higher lows”. Primary bear markets are identified by “lower highs and lower lows”.
The 1/3 rule: the secondary reaction must have retraced at least 1/3 of the primary trend to indicate a change in the primary trend.
Today, a bull trend is generally reckoned to remain intact until there is at least a 20% correction. Anything above a 20% downward move is considered to be a new bear trend. COVID-19 caused the S&P500 index to fall by 34% - but because it was not caused by economic factors, we see it as an aberration and ignore it for the purposes of technical analysis.
 In Dow Theory, the averages must confirm each other. This means that the industrial and transport indexes on the New York Stock Exchange must also both change direction before the new trend is established. It is useful to realise that at the time that the Dow Theory was proposed, the railway network of America was in full swing – so transport shares were a lot more important than they are today.
So, Charles Dow gave us the concepts of a “bull” and “bear” trend as well as the idea that these primary trends contain rallies and corrections. At the same time helping us to see that the short-term fluctuations of the market should basically be ignored. These fluctuations are the “noise” in the market, and you will learn various techniques for eliminating them or smoothing them out – so that the more important trends in the market can be easily seen.
<figure class="figure"><a class="lightbox" href="/onlinecourse/images/images/SP2.png" data-plugin-options="{'type':'image'}"> <img class="figure-img img-fluid" src="/onlinecourse/images/SP2.png" /> </a>
<figcaption class="figure-caption">S&P500 Index: July 1988-June 2021. Chart by ShareFriend Pro.</figcaption>
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In the above image, you can see a semi-log chart of the S&P500 Index from the 1988 to 2021. The bull (green) and bear (red) trends have been clearly marked, and you can see the corrections marked by the blue circles.
 
THE RANDOM WALK THEORY
 
Assessment of shares has been the subject of considerable discussion and dissension since Charles Dow made his historic observations around the turn of the 19th century. If it were not for the vast sums of money that depend on this subject, humanity would surely have relegated such an ambivalent subject to after-dinner conversation, along with religion and politics.
But what Charles Dow was suggesting is that the movements of the market are not, in fact, random and that there are observable patterns which can be used to improve investment performance. This is a serious idea which massively impacts our approach to share selection and transaction timing.
Most disciplines, even in the social sciences, do not suffer from the extraordinary controversy that surrounds share assessment.
There are three main schools of thought whose protagonists often totally reject the arguments of the other two schools. These three are: fundamental analysis, technical analysis, and modern portfolio theory (MPT).
The first issue which has to be decided is the question of whether the markets are, in fact, predictable in any real sense. Both fundamentalists and technicians believe that the market is predictable to a sufficient extent to make analysis worthwhile.
The MPT school maintains that predictions are essentially impossible because, they argue, the market moves at random (and hence the fundamentalists and technicians waste their time trying to predict what will happen). They are adherents of the “Random Walk” theory. Of course, if the market is in fact random, then all forms of analysis are a waste of time – because, by definition, nobody can predict a random series. This would imply that the millions of investment analysts employed all over the world to choose shares and time transactions are wasting their time and are redundant.
 
The random walk theory depends on the assumption that the share market is totally efficient. This, in turn, implies two things:
 
<ol style="text-align: justify;">
<li>that at any point in time there are many willing buyers and many willing sellers for all shares – which can probably be accepted for the more heavily traded shares but not for the rest.</li>
<li>that information is disseminated immediately to all investors – and that they all act on it in the most knowledgeable manner. This is far harder to swallow. We are all aware that the first people to know pertinent information are usually the officers of the company itself or people closely connected to them. These may be followed by one or two stockbrokers, and then, perhaps, by a journalist on the Business Day or Finance Week. Eventually the information might even reach the ordinary daily news outlets, if it is sufficiently newsworthy. But even then, it is probably in the hands of only a few thousand people. The fact is that information spreads slowly through the market, causing share prices to discount gradually over a period of time. In other words, the share market is not totally efficient – and markets are not random.</li>
</ol>
The inefficiencies of the market create opportunities for private investors to profit.
Leaving aside the requirements for an efficient market, it must surely be obvious to any observer of shares that their prices do not move at random. A random series can easily move from 100c to 10 000c and back to 100c within a single day. No share has ever done anything like that. Even the infamous 1987 crash only moved shares 23% on average in one day – and that was the largest one-day move in recorded history.
The fact is that, for any share, the price of today is strongly influenced by the price of yesterday. Academics call this influence “dependence”, and mostly they dispute its existence. Simple observation will, however, show that the probability of a move of greater than 5% in a good quality share’s price from one day to the next is extremely low.
Think of it this way: If Anglos (AGL) closes at 48000c today what is the chance that they will double or halve tomorrow? Virtually zero. If you agree with this, then clearly, they are not moving at random – which begs the question, “Where does this dependence come from?” There are a number of possible causes of dependence, one of which is (as mentioned above) the gradual manner in which new information permeates the investment world. Far more important, however, is the general unwillingness of humanity to accept radical changes in the values of assets generally.
From a young age we are all imbued with the idea that assets (such as motor cars and houses) last for a long time and therefore retain the preponderance of their value. We find any rapid devaluation of a major asset traumatic, but a slow depreciation is quite normal and acceptable. If I told you that your house was worth half of what you currently think it is, you would have a great deal of difficulty in accepting that – even if I was right. The most traumatic experience is to write off a motor car in an accident – because what was worth R250 000 a few minutes ago is now a useless worthless pile of scrap metal. Our mental processes and conditioning do not allow us to easily accept huge changes in value quickly.
Suppose that you were holding a share which was trading in the market for 2000c today. Would you accept 100c for it tomorrow? Certainly not! Nor would anyone be stupid enough to offer you 100c. But if the share was over-valued at 2000c, you might quite easily accept 1900c for it tomorrow; and if you were still holding it on the next day you might accept 1800c. And it might, in fact, reach 100c – but it would never do so in one day!
So, the generalised inability of people to quickly adjust their perceptions of an asset’s value creates a degree of dependence and implies that shares cannot and do not move at random. It causes shares and markets to move in broad sweeping trends – and to the extent that they do that they may be predictable.
 
TECHNICAL ANALYSIS AS A SOCIAL SCIENCE
 
It stands to reason then that if share prices do not move at random, then their movement must contain patterns. It merely then remains to find an algorithm that will identify and isolate those patterns so that they can be used to predict future movements. That is the subject of technical analysis. The source of those patterns is the behavioural characteristics of people who participate in the market – such as their unwillingness to quickly adjust their perceptions of the  value of a share.
So, technical analysis is the study of group investor behaviour. For this reason, technical analysis is best seen as a social science.
Two points are worth making in this regard:
 
<ul style="text-align: justify;">
<li>Firstly, all social sciences tend to move towards statistics and probability. For example, no psychologist would state conclusions based on an experiment involving a single individual (because he might be a psychotic or a schizophrenic). In fact, the larger the size of his sample in the experiment, generally, the more reliable his results.</li>
</ul>
 
In technical analysis, the size of the sample is the volume traded. The more heavily traded a share or index is, the more reliable the technical indicators become. With a thinly traded share, one individual, buying or selling for reasons which are entirely unrelated to the market, can throw your technical analysis out of kilter. Where there is substantial volume, the activities of individuals are lost in the overall direction of investor sentiment. So, a heavily traded share is more technically reliable than a thinly traded share; an index is generally more technically reliable than a share – and so on.
 
<ul style="text-align: justify;">
<li>The second point is that, if technical analysis is a social science, then it makes sense to look for the underlying group behavioural characteristic in each technical indicator before placing reliance on it. </li>
</ul>
This is sometimes very difficult to do – especially with the more esoteric technical methods, but the general difficulty which humanity has in adjusting its perception of value quickly leads to those broad sweeping trends in share prices – which are exploited by a number of indicators (such as the moving average).
 
CATEGORIES OF TECHNICAL ANALYSIS
 
It is useful to divide technical analysis into three broad areas: –
 
FORMATION ANALYSIS
 
Formations (which we cover in module 22) are too numerous to warrant individual attention, but there can be no doubt, for example, that the concepts of support and resistance are easily linked back to human behaviour and are one of the most reliable concepts in formation analysis. A support level occurs when a share (or other indicator) is falling and reaches a point at which major players have left buy orders. On reaching this level it immediately begins to rally as these orders kick in. On the other extreme it may encounter pre-set sell orders which prevent it from rising. Once support or resistance is broken, it tends to result in a strong continuing move in the direction of the break.
 
WAVE AND CYCLE THEORIES
 
Wave and cycle theories are usually very difficult to link directly back to human behaviour. The principal idea is that investors are influenced by some sort of cosmic “biorhythm” which causes them to behave in specific ways at specific times. This seems very difficult to sustain, but there can be no doubt that the market is cyclical, and you ignore cycles at your peril. Some of the longer “wave” theories such as the Kondratiev wave are easily related to the average economic lifespan of a person.  
The logic being that no one who actually experienced the 1929 crash would ever again participate in an over-priced market. In other words, that each generation has to learn for itself the hard way that what goes up must come down.
Others, like the Elliott Wave or Gann Theory are very difficult to connect to behavioural patterns.
 
LINE CHARTS
 
Line charts are based largely on the idea of dependence and the fact that people seem to oscillate from optimism to pessimism concerning the future prospects of a share and the market in general. Certainly, there is no doubt that shares shift from being over-priced to being under-priced as the weight of opinion fluctuates. The advent of computers has caused this area of analysis to become very highly developed in recent years so that thousands of oscillator algorithms have been experimented with. Some work and some do not. Many are available in your charting software for you to look at and experiment with.
The secret is to try and see the underlying logic of the indicator and its relationship to group investor behaviour.
Later on, in this course we will address all three areas of technical analysis. Formations are best seen and analysed through candlestick charts but can be applied to many different chart styles.
At this point you should read the following <a href="/index.php/market%20action">article on Market Action</a> from June 2021.
 
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