This is the second in a series with the first few paragraphs the same as the first one. I am not sure why there are so many vague and totally subjective analysis techniques that have become part of technical analysis. Probably because the main stream Wall Street and their marketing department, academic finance, does not follow technical analysis like they do the accepted rubbish from the ivory towers. Early in this WHY series I tried to be convincing that technical analysis’ basic premise is the analysis of price; price that is determined in the auction marketplace. See the first WHY Are So Many Esoteric Things Attached to Technical Analysis here.
Support and resistance are mainstays in technical analysis; sadly, misused and abused by many. The purpose of this article is to hopefully explain why they work when used properly. I have to admit that when I first got interested in technical analysis and charting, I drew trendlines all over the place. Once I began to fully understand the basic premise of technical analysis; that it is based upon price; price that is determined in the auction market by buyers and sellers. I have discussed my thoughts on trendlines in an earlier article but after 45 years only now consider horizontal trendlines since they are based upon price. I see others drawing trendlines all over charts connecting visually appealing points at bottoms and tops, often not with much accuracy. That is the only good thing they are doing; most non-horizontal trendlines should be drawn with a large brush or marker. Just switching from arithmetic to semi-log charts can change them.
This is an attempt to help validate new high and new low data and, to be honest, is still a “work in progress.” If you consider the facts relating to new highs and new lows, you will see the necessity for this. A new high means that the closing price reached a high that it had not seen in the last year (52 weeks). Similarly, a new low is at a low not seen for at least a year. Note: This makes them very different than Advances, Declines, Up Volume, and Down Volume, which are based upon the difference over the previous day. These indicators try to identify when the new high or new low is determined to be good or bad using the following line of thinking.
Once a bear market gets underway (nautical term), few will make adjustments to their portfolio. Usually it is well into the decline before most even begin to get concerned, and then they are convincing themselves that it is too late and they might sell right at the bottom. That is certainly the siren song of most. Market tops are extremely difficult to identify except in that wonderful world many live in called hindsight. Especially after an extended bull market well into its 7th year.
When I started in this business, most of my analysis was done with graph paper, colored pencils, and a very expensive red LED calculator (mid-1970s). I subscribed to Barron’s and on Sunday afternoon would sit at my desk (which looked a lot like a kitchen table) and calculated various moving averages for the NYSE Index, the advance decline line (required a calculation of its own), and about 50 active stocks that I followed. I would diligently plot them on graph paper as if they were to be preserved as future works of art.
I am on record for saying that academic finance is the marketing department for retail (sell side) Wall Street. Note: Sell side is the secondary market where you buy and sell stocks; versus the primary market where capital is raised. Over the years (notice I use that phrase often?) I kept a mental record of the things that clients have asked about in regard to the stock market. Most of the time they were asking about things they were told by their advisor or brokerage salesman. The best way to combat this misbelieving is to offer a counter to them.
Back in the days of printed newspapers, magazines, and newsletters the acquisition of news and information was easier, or so it seemed. The reason it seemed easier is that there was much less of it. Today, with the internet, 24-hour financial media, blogs, and every conceivable method of acquisition, information is overwhelming. Once I realized that some information was actionable and most of the rest was categorized as observable, then things became greatly simplified. Hopefully this article will shed some light on how to separate actionable information from the much larger observable information. As you can see from the Webster definitions below they initially do not seem that different.
The story about Abraham Wald’s work as a member of the Statistical Research Group during World War II can shed some light into money management (widely disseminated as Abraham Wald’s Memo). Wald was tasked with damage assessments to aircraft that returned from service over Germany, and determine which areas of the aircraft structure should be better protected. He found that the fuselage and fuel systems of returned planes were more likely to be damaged than the engines. He made a totally unconventional assessment: Do not focus on the areas that sustained the most damage on these planes that returned, but focus on the essential sections that came back relatively undamaged, such as the engines. By virtue of the fact the planes returned, the heavily damaged areas did not contribute to the loss of the aircraft, but losing the engine would, and therefore would not return. Hence focus on more armor around the engines. For an airplane in battle, protecting the essential parts; and it will fly again. Investing is not unlike an airplane in battle, protect the assets from destruction, such as large losses (drawdown), and the investor will live to invest again. Most of modern finance is focused on the non-essential parts. You can do an Internet search on Abraham Wald and find many examples with much more detail. I first read about it years ago in a statistics book and have seen it repeated often.
Most blog authors on StockCharts.com are writing about the current markets and do an exceptional job. I do not write about the current markets as I wanted to share my experiences after 40+ years as a technical analyst. Not only experiences with trading and investing, but model building and money management. I also share the details of all the Master’s degrees I have – those expensive learning experiences that hopefully I learned something from. Since I rarely go back into the archives of other’s blogs that I read, I wondered if that is common or not. Hence, after talking with Chip, a summary of my past articles might encourage new readers to take a look as most of the material is timeless. That’s timeless, not worthless! This is the fifth of the summary series and starts in April, 2016 and ends in July, 2016. I’ll try to do future summaries whenever I have a dozen or so articles to include. You can click on the article name for a link directly to the article.
This is the third article dealing with cognitive biases that totally screw up your decision making. The first article, Know Thyself, covered anchoring, confirmation bias, herding, hindsight bias, overconfidence, and recency. The second article, Know Thyself II, covered availability, calendar effects, cognitive dissonance, disposition effect, and loss aversion/risk aversion. Most of my education on behavioral investing came from books by James Montier, Hersh Shefrin, and Thomas Gilovich. Two great websites for this stuff are from Tim Richards and Martin Sewell.