Sunday, May 18, 2014

Is technical analysis losing effectiveness?

Question: “From a distance it seems that so many people are now aware of a lot of technical indicators that they’re becoming obsolete, e.g. seasonal trends, advance decline line, AAII polls.  Do you agree?”

Answer: I view technical indicators the way I would ANY indicator in life -- to be taken with a grain of salt.  The trick of properly using technical analysis is knowing when the indicators are likely to be valid and when they're not.  This takes years of practical experience and is just as much an intuition than it is a hard-and-fast rule.  To me, the most important aspect of financial market analysis are the individual stock charts.  I try to scan through at least 150-200 charts per day of mostly NYSE stocks and ETFs.  Doing this can give you a good "feel" of what's really happening beneath the surface of the market and is more valuable than relying on technical indicators, IMO.

Are the indicators losing significance due to so many people using them?  Not necessarily, although this may be true at times.  The A-D line has been around forever and investors have always known about it.  Sometimes it works, sometimes it doesn't.  It gives the best signals when it aligns with other technical and sentiment indicators and charts.  In other words, a weight-of-evidence approach works best when it comes to indicators.  

I would also point out a favorite quote which I once read in a book on the Middle Ages by historian Jonathan Riley-Smith.  The quote was in reference to historical models but it can easily be applied to analytical models in the financial market as well:  "Models invariably break down when the criteria for them are applied too strictly."  This is why technicians are sometimes frustrated in their reliance on indicators; they're reading them too literally and not giving enough weight to stock price momentum, which is the single most important factor in most cases.