When approaching the stock market, an individual usually finds out almost immediately that there are two opposing approaches when it comes to evaluating companies, assets and investments in general: fundamental analysis, and technical analysis. Well, to be completely fair, there is also sentiment analysis, but nobody preaches that it is a good way to evaluate investments for the medium to long-term.
Technical analysis is a belief that future price movements can be predicted by current and previous price movements. Technical analysis has as a foundation the belief that prices are not random and that they reflect all the available information: in other words, technical analysis is based on the belief that financial markets are efficient. This belief alone is one of the main reasons why this kind of analysis is very popular. The only problem is that the efficient market hypothesis does not imply that financial markets are efficient, and empirical evidence confirms this conclusion. Another reason is simply the fact that is simple, as it doesn’t involve any background in finance, financial knowledge or computations. Considering that most people that find out technical analysis do so through the internet, and more specifically through “get rich quick” ads of any sort, it’s not surprising that a lazy and simple solution is that appealing. The third reason why technical analysis is so appealing is that it involves pattern recognition, which is part of our evolutionary biology.
However, prices alone are not sufficient to determine the direction nor the quality of an investment. Fundamentally, that’s because of several reasons.
First and foremost, in the short- to medium-term, prices are random, which means that nobody can predict them. The only trend that is not random is the long-term trend, which is not tradable and, therefore, it does not appeal to day traders and people who seek fast ways to make money. The only way to make money on the long-term trend is to “buy and hold”, that although profitable is extremely boring as a strategy.
Furthermore, those who believe in technical analysis focus entirely or primarily on price, because they think that previous prices can predict current and future prices. They have it entirely backwards, because they don’t understand how price works or what even is a price. Ironic to have a strategy based on price, without understanding what’s the price. At any given point in time, the price of an asset, of any kind of asset, is a subjective valuation based off the expectations of that asset’s future cash flow. We outlined this concept applied to stocks in our article “What drives value in the Stock Market?“, so be sure to check it out. Since the current price is an estimation based on future cash flows, future cash flows cannot be predicted based off previous prices: the two are completely uncorrelated.
As if it wasn’t enough already, we have to consider the pattern recognition problem within technical analysis. Indeed, the main issue there resides in the fact that you can give the same identical price chart to two different people, and they will see different patterns in these charts. These patterns will then yield radically different conclusions as to the direction of that price. Human beings will read into charts whichever pattern they want to see, and that’s how they will make their decisions.
Aside from this incredible subjectivity, let everyone, for the sake of explanation, jump to the same conclusions reading a chart. If that was the case, everyone would be reading the same pattern from that chart, and theoretically everyone should be making money. But that’s not the case. If everyone thinks the same, it means that profit in the space will gradually dry up, as some people will act before others, thus crowding them out.
There are also a bunch of empirical studies that demonstrate how technical analysis and trading signals do not yield any profitable strategy in the long run. It’s interesting to see that technical analysis is not predictive of price movements, but it’s predictive of volume: this should suggest to us that technical analysis works by the same mechanisms as self-fulfilling prophecies. You can find one of these studies, titled “Noise Trading and Illusory Correlations in the US Equity Markets”, here.
In conclusion, we didn’t find any difference between charting and guessing, and we would suggest beginners to learn about corporate finance and valuation, rather than listening to internet’s financial gurus. We wrote a tutorial about how to value a company using the discounted cash flow model right here, be sure to check it out!
