Technical Analysis Is Stupidhttp://www.fool.com/investing/value/2010/04/30/technical-analysis-is-stupid.aspx Anand Chokkavelu, CFA
April 30, 2010
"Stupid is as stupid does."
Financially speaking, I define stupid as anything that loses me money. On that basis, I find technical analysis quite stupid indeed.
In case you're unfamiliar, investors generally break down into two main camps: fundamental analysts and technical analysts. Fundamental analysts invest based on factors such as the quality of a company's management, growth prospects, return on equity, price-to-earnings ratio, and macroeconomic factors. In contrast, technical analysts invest based on a company's stock price movement and volume.
Based on the evidence, I'm convinced that buying stocks using technical analysis will lose you money.
How they try to beat the market
Fundamental analysts explain that shares of a company's stock represent a piece of a business. Ultimately, investors are buying a piece of that company's future cash flow generation. Whether they're growth investors or value investors, their research and analysis aims to give them a feel for these future cash flows. When a company's stock price underestimates a company's earnings potential, they buy.
Technical analysts argue that fundamental analysis is redundant, because all relevant information is already represented in a stock's price. In its strongest form, this theory agrees with the efficient-markets hypothesis, which holds that there's no legal way to beat the market -- with one key exception. Technical analysts believe that price patterns repeat themselves, because we humans react similarly to similar market events.
Why technical analysis will lose you money
To illustrate, I've put together a table that shows how six companies break down on some key metrics that fundamental analysts would look at. The first three companies compete against each other in the megaretailer space. The second three companies all manufacture large equipment:
Source: Capital IQ (a division of Standard & Poor's) and Yahoo! Finance.
The first thing you should notice is how different the numbers are within a sector. For example, Target and Deere generate around three times the operating margins of Costco and Boeing, respectively. Of course, you have to factor in Target's greater leverage versus Costco, and the fact that Deere manufactures vastly different products than Boeing.
The disparity gets even more outlandish across sectors. Compare Costco's minimal leverage (debt-to-equity of 22%) to the massive leverage of all three manufacturers. And that's before taking into account the huge differences in price multiples and growth rates.
Just looking at these four basic metrics and the factors that drive them, you can start to see how complex valuing a company can be. You can also start to see how two intelligent, rational investors could have markedly different opinions on each company we've discussed. Considering these points and the wild price swings of Mr. Market, I find it very hard to believe that there isn't any opportunity for smart investors to use fundamental analysis to earn excess returns.
Meanwhile, technical analysts ignore everything we just talked about. They hold that the only thing that matters is patterns. You can ignore profitability, sales growth, debt position, industry, management, regulatory environment, country of operations, etc. If two companies, no matter how wildly different, happen to have similar historical charts, a technical analyst will predict similar outcomes for each.
That simply doesn't make sense.
But again, the proof is in the profits. Technical analysis is only stupid if it loses us money. Speaking of which….
The damning evidence
The more you dig, the weighter the evidence against technical analysis gets.