FOOL ON THE HILL
Is Technical Analysis Voodoo?

Bill Mann takes a look at technical analysis, whose proponents have increased their volume in the past few months as many buy-and-hold investors have taken it on the chin. Does a nine-month period validate (or invalidate) an investing methodology, or does technical analysis stand the test of time? As in everything in investing, the closest one can come to "proof" is long-term success. So where are the ultra-successful technical analysts?

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By Bill Mann (TMF Otter)
January 5, 2001

I guess it should not be surprising that many people have short memories. A "What have you done for me lately?" patina colors almost every sector of public opinion: Athletes get hit with it, politicians get it, companies get it. If you're not producing now, you're nothing.

This year the Rule Breaker portfolio, among all of our real-money portfolios, has been shredded by negative sentiment from practitioners and media alike, stemming from its horrid 2000 performance of -50%. Suddenly the proponents of "buy quality at any price" are looking for someone or something to blame, and David Gardner -- with his bubbly, eminently positive view of the stock market -- makes for as good a target as any.

What I find interesting about the witch hunt is two things: First, David stated at the beginning of 2000 that he was comfortable with the prospect that his portfolio (the Rule Breaker is his money) could lose a significant  portion of its value over the year; and secondly, that we are seeing from many correspondents that one of the "lessons" learned from the carnage in 2000 is that investors "ignore the charts at their own peril," or something similar.

Technical analysis received a pretty big publicity boost in 2000, given the long, tortuous decline in several sectors popular with individual investors. I think that some of this attribution is faulty: Over the last nine months, those with some money on the sidelines inherently did better than most of those who were fully invested. Yep, long-term buy-and-hold sure took it on the chin.

The Rule Breaker has never been advertised as anything but a high-risk portfolio, nothing less than a venture capital portfolio. Ask any VC and he will tell you that, give or take a few percentage points, he EXPECTS more than 90% of his investments to lose money, and that he will actually earn the majority of his returns on 1% of those investments made. This is why "price doesn't matter" for Rule Breakers, because so few of them are expected to succeed, and those that do will do so brilliantly. It is an aggressive, high-risk way to invest, one to which I would only allocate a small percentage of my capital.

Using such methodology, of course price is less valid than a firm grasp of how the company expects to make money. I have seen no one yet who has devised a good model for valuing Amazon.com (Nasdaq: AMZN), except for those who can make a pretty good case that it is zero (and, of course, Paul Commins' YGBFKM methodology). David can speak for himself, but I would like to say that of all of the messages of Fooldom, this one may be the one that has been most poorly communicated and thus misrepresented.

Technical Analysis is a simple science: It states that stocks that are in motion tend to stay in motion, that a stock that rose today is more likely to rise tomorrow. It is a powerful tonic for those who are terrified by the notion that short-term stock market movements are without rationality. Technical Analysis allows investors to say "Ignore the reasons, they are meaningless. Focus on the patterns." The pure technician ignores such basic concepts as stock value, price, or other fundamentals on the belief that the institutional investors leave telltale signs when they are moving into or out of a stock, and that the "smart money" telegraphs its actions by virtue of its sheer size.

This is a powerfully attractive theory, and I do not doubt that there are those who can practice it with some success. But these people are not the "average" technical analysts. They are, in fact, few and far between.

Where are the role models?
One of the chief criticisms of technical analysis is that it has many practitioners, but no true success stories. The Warren Buffett, Ben Graham, or Philip Fisher of technical analysis does not exist. Howard Ruff made blunder after blunder. Joseph Granville was extremely influential in the late 1970s, when he had successive years of uncanny calls. In 1982, Granville famously pooh-poohed some of his earlier errors by stating that he had failed to read the charts correctly, and that his system was so foolproof that he would never "make a serious mistake on the stock market in [his] life."

Soon after, Granville's charts told him that the stock market was going to crash in 1982, and that not only should they sell, they should short. He made the call as the Dow hit 800, but within a year it had risen to more than 1200. This was the beginning of the longest rally in history, and millions of dollars disappeared with Granville's disastrous call. In his wake have come others, such as Elaine Garzarelli -- she of the famous 1987 "The market's gonna crash" call (good one) and that it would keep falling (less good).

The fact is that there are no truly successful long-term practitioners of technical analysis. Just as every "proof" that exists in investing relies heavily on data-mining and thus will never conclusively be proven one way or the other, there is no way that I could claim that technical analysis does not work. But where are the stars? Where's the massively successful guru whose methods for utilizing technical analysis have worked for decades? Perhaps Warren Buffett is a "six-sigma" individual whose performance is unlikely to ever be duplicated, but his methods are teachable to a point: "Buy quality at an attractive price. If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."

Why technicals may not be teachable
Contrast the above with "The stock seems positioned to break through resistance at $65, but a stop loss should be placed at $54." When I see such comments, I see a perfect hedge: "Well, the stock will go up or down if it doesn't stay in the same place."

I know this is not a fair criticism, and I freely acknowledge my bias. Quite simply, I have never seen any evidence that shows that any replicable technical scheme works for an extended period of time. When I say "works," I do not mean that every technical analyst loses money, but simply that technical analysis does not provide returns long-term above the S&P 500 at a level to justify the tax, commission, and time outlays that its adherents must shell out to play the game that way.

The more people who practice technical analysis, moreover, the less likely it is to work. If hundreds of thousands of people are looking for a "pennant formation" on Cisco (Nasdaq: CSCO), for example, the chance of everyone getting in fast enough to enjoy the rise that it is supposed to predict is nil. Some would, and should Cisco in fact rise, they would then be rewarded for being superior technical analysts.

But what happens the next time, when those who did not get to enjoy the rise look for the patterns that have been shown to predict the pennant which then predicts the rise? Well, then knowing about the pennant is worthless. It's just this: If there were a surefire way of knowing that a stock would double in the next week, then the stock would double immediately in anticipation of the event. Were pennants sure signs, then they would be immediately followed, inevitably, by a spike. This would initially be self-fulfilling, and then ultimately it would collapse upon itself.

In his seminal book The Money Masters, John Train speaks of a standing wager he has with any technical analyst. It goes something like this: He will take a chart from several years ago and remove any identification from it as to company name or time. He then cuts the chart in half, giving the earlier portion to the chartist while keeping the later portion to himself. Since chart-reading is supposed to be prophetic, this should be no hardship to the technical analyst. In order to win the wager of $100 the analyst must be able to tell whether a stock was higher or lower at any point in the second period than the first. And since technical analysis is predictive and requires that the practitioner pay friction costs, Train asks for modest odds to compensate.

How have the takers of this bet fared? Hard to say, since no one ever has taken the bet.

As prudence would demand, I expect that proof will be demanded of me in my assertion that technical analysis is an inferior methodology for investing. People will of course roar about one-year performance, and compare it to the Fool portfolios. I ask you this: Who invests only for one year? The reality is that there is no such thing as an investing strategy that outperforms each and every year. Any investor who thinks otherwise, regardless of the strategy she employs, had best prepare for grave disappointment.

I am perfectly willing to look at the other side of the coin here. In fact, this is a dialogue that is long overdue. The Motley Fool has long held that technical analysis is an inferior way to invest, instead asserting that the study and superior detection of "value," defined in various ways, is much more important than any market-timing scheme. I'd invite anyone to take the Train wager. I'm ready to believe you. Also, please feel free to put your thoughts or investing strategy down for public discussion on the Fool on the Hill discussion board.

Fool on!

Bill Mann, TMFOtter on the Fool Message Boards