Why Investors Should Use Technical Analysis

Yesterday, a heated discussion of technical analysis broke out on the Realmoney.com chat board with some participants declaring they don’t “believe” in technical analysis.  It’s the same discussion that breaks out about once a month on Realmoney.com and it’s often repeated on other fundamentally oriented sites like Fool.com. 

But saying you don’t “believe” in technical analysis in investing is like saying you don’t “believe” in hammers in carpentry.   It’s a completely nonsensical statement that is borne out of hubris and complacency.   Technical analysis is simply an investing tool and using it competently can only increase your investing success.

Just like learning to use any tool, the quality of the end result will depend on the skill and aptitude of the user (the first time I used a hammer, I broke my dad’s finger as he was pointing out where not to hit.)  Does using any tool preclude making mistakes?  Of course not.    Does it preclude two competent technicians from reaching completely different conclusions?  Certainly not.  Just like two fundamental analysts can come to different conclusions about the value of a stock based on the exact same financial data, two technicians can come to different conclusions about the direction of the market.  Of course, no one ever questions whether "fundamental analysis" as a practice is valid or not…they just question the competency of the analyst. 

Numerous practitioners of technical analysis make it seem needlessly complex and arcane (myself included).  However, understanding simple concepts such as the Trader Vic 1-2-3 reversal and how to draw a trend channel is not complicated.  Simple technical tools can save you hours of time searching for new investment ideas and thousands of investing dollars in timing entries and exits.  Despite what academics and fundamental analysts will have you believe, prices move in trends and understanding those trends with technical analysis will help your investing results.

I use technical analysis in several ways.  First, I use it to find stocks to buy.  I screen for oversold stocks based on their weekly charts.  I like buying oversold stocks because I want to buy high quality companies whose stocks have already gone down.  Arne Aslin from Realmoney.com had a great quote that I have taped to my monitor — "There are only two types of companies – ones that have problems and ones that are going to have problems."  I’m looking for companies that have problems where the bad news is already known and discounted in the market.  If a stock is nearing oversold levels, valuation is at the low end of its historical range and the company is already starting to make improvements, I have a good idea that the bad news has been discounted.  Then all I need to find is a good catalyst such as new management or a new product that can re-ignite the stock. 

The other technical screen I use is to find stocks coming out of long-term bases.  I want stocks that have been going sideways for several quarters or even years through good and bad earnings.  This ensures that the stock is in "strong hands" – investors that understand the story and won’t flip the stock as soon as it moves up or down a $1.  Once a stock is in "strong hands" it can start moving up rapidly once the positive fundamentals start appealing to the greater investing public.  The best example of stocks coming out of long term bases happened in 1994.  Numerous large cap stocks just launched higher out of two and three year sideways ranges as the chart of KO shows.

Second, I use technical analysis to time the purchase and sale of stocks.  Once I find a stock to buy, I want to buy it down, ideally as it hits trendline support and/or potential reversal points such as a weekly DeMark Sequential (TM) buy signal.  When selling, I want to sell as the stock is rising into resistance or hitting the top of a trend channel.  Selling into strength and buying into weakness is the only way I know beating the market and generating incremental positive alpha. 

Finally, I use technical analysis to provide an "early signal" of a problem stock.  If a stock is supposed to be going up because it has beaten earnings and is in a strong group but is instead lingering or going down, there’s usually something wrong with the fundamental story.  Technical analysis is a great way to "double check" your investment thesis and make sure that somebody, somewhere doesn’t know something you don’t.  This doesn’t mean I sell a stock every time it squiggles under a trendline, but I do sit up and take notice and make sure the reasons I bought the stock are still valid. 

I think these are simple technical concepts that can be added to any investors tool box.  They don’t require you to become a chart reading master and they don’t require huge leaps of faith that moon cycles and ocean tides affect investor behavior.  All the techniques require is an open mind and the "belief" that some tools are worth learning how to use.