PostHeaderIcon Why using technical analysis in stock market investing does not work – Part 2

Last time in “Why using technical analysis in stock market investing does not work – Part 1.” I gave you the first reason on why technical analysis does not work. I extensively discussed what is the nature of technical analysis and reasoned out that because of its nature, technical analysis is not  a very effective tool to be used in stock market investing. Better invest in a Turkish property instead of using pure technical analysis in the stock market. Today we continue with Reason number 2 and 3.

Reason #2 – Using technical analysis in stock market investing does not work because its tools are flawed.

Predicting market sentiment is measured by looking at the “charts.” When technicians look at the charts they seem to see all kinds of weird objects and shapes. They see cups and saucers, heads and shoulders and triangles. The problem is each technician looking at the same chart does not see the same thing. The conflicting opinions on what is the probable track that a stock is suppose to take. This practice is no different from reading the palm of somebody’s hand to determine his or her future or using the “stars” to predict what tomorrow may bring. Using charts to determine where stocks might be headed is plain and simple voodoo. It does not work. There is so much bias in chart reading that you do not get a concrete conclusive result. You might buy a dart board and hire a monkey to throw darts at a list of stocks and prices to determine which to buy and when to sell it. You will probably get the same results.

Technical analysis tools are so flawed that even the expert technical analyst are at conflict with each other on which system actually works. There are more than 500 technical analysis trading systems and tools that have been developed all throughout the years.

Technical analysts might right now be scrambling and buying darts to throw at me. They might accuse me of being wrong as there is no study to back my claims. Well let me go to my third point.

Reason #3 – Using technical analysis in stock market investing does not work because a lot of credible long term studies reveal that it does not work.

A recent study on the effectiveness of technical analysis conducted by Birinyi Associates Inc. released on July of 2010, proves my third point.  This was posted in the Bloomberg website. A part of the news report read as follows:

“. . . Analysts who use patterns in price and volume charts to forecast gains or losses in the stock market fail to make investors money, according to a study of technical analysis by Birinyi Associates Inc.The advance-decline line, which represents the number of daily gains minus declines, is an example of technical analysis that fails to forecast market moves, according to a report yesterday by the Westport, Connecticut-based firm.“Most indicators are descriptive, not indicative,” a group of researchers led by Laszlo Birinyi, the firm’s founder, wrote in the report e-mailed to clients yesterday. “They tell us what is going on, but seldom predict future moves.” They added that “‘experts’ tell us historical trends, antecedents and other characteristics which too often are the convention, the theoretical, the last instance or the logical.”

The cumulative difference between advancing and declining stocks hasn’t shown consistent trends, reaching a peak at the end of some multiyear bull markets and in others during the middle or earlier, Birinyi data from 1966 to 2002 show. That means investors aren’t able to determine how much longer rallies will continue based on the net number of rising shares among New York Stock Exchange-listed companies.

The measure peaked in November 1998 during the bull market that began two months before. It was 17 months before the Standard & Poor’s 500 Index topped out and the bull market ended, according to Bloomberg data. Investors who bet that a peak in the advance-decline line meant the bull market would end missed out on a 34 percent rally.

Despite inconsistencies in predictive value, technical analysis should instead be a tool that’s part of a broader strategy for managing holdings, said Birinyi, a research and money-management firm that oversees about $300 million.“Technical approaches can and should be a useful adjunct to every investor’s — amateur and professional — arsenal, if and only if used properly and with understanding,” Birinyi wrote. “Technicals detail and hopefully illuminate, but do not predict.”

A study released in October 2009 by finance professors at Massey University in New Zealand showed a similar conclusion. They examined more than 5,000 technical trading rules to see if they added value. The authors found “. . . no evidence that the profits to the technical trading rules we consider are greater than those that might be expected due to random data variation . . .”

Stay tuned for the last part of this series “Why using technical analysis in stock market investing does not work” – Part 3.” Only here on D’ Intelligent Investor.

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D’ Intelligent investor is one of the first few updated value investing blogs in Asia and probably the only updated value investing blog in the Philippines where you can learn stock market investing through intelligent investing that makes business sense. The stock market investing strategies are very different from what most stock market players advocate. The strategies featured here are mainly value investing principles more specifically inclined with what are perceived to be Warren Buffett’s style of investing. Other value investing strategies by great value investors such as Benjamin Graham, Peter Lynch, John Boggle among others are also featured.