October 2, 2011
If you knew that the stock market recently combined a “head and shoulders” pattern along with an “island reversal,” you would have seen the recent dip in the stock market coming and might have sold off some of your stocks.
Chances are, your financial advisor didn’t say anything about it and, in fact, didn’t know that it even happened.
Most advisors, stock brokers and money managers follow the traditional “buy and hold” approach to investing, which relies solely on the fundamental analysis of individual stocks and other securities. They don’t pay attention to market trends. They believe in holding good securities long-term and riding out the market’s ups and downs, because eventually the market will find the merits of a company’s stock and price it correctly.
Terms like “head and shoulders” and “island reversal” are used by investment managers who use technical analysis. Their numbers are small, but increasing, given the market’s performance during the current millennium.
Money managers who use technical analysis adjust their clients’ portfolios based on market trends. They saw the bear market of 2008 coming and moved clients out of the stock market. Traditional “buy and hold” money managers advised their clients to ride out the bear market, which cut the value of their stocks in half.
Again, money managers who use technical analysis saw the recent market drop coming and moved clients out of the market, while traditional managers advised clients to buy and hold.
The “buy and hold” crowd continues to buy in and hold on to the idea that the only thing that counts is fundamental analysis. That approach has not worked well, of course, during the current century, but most of the world continues to buy and hold – and to think of technical analysis as the financial equivalent of reading palms.
A Brief History
While technical analysis is not yet widely accepted, it may be the oldest method of analysis for beating the market. Its history can be traced to seminal articles published by Charles H. Dow in The Wall Street Journal between 1900 and 1902.
Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, analysts could identify not only business conditions, but market trends and the likely direction of individual stocks.
Dow used his Dow theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index, which were compiled by Dow for The Wall Street Journal. It can be applied not only to stock markets, but to markets for other securities as well, including foreign exchange markets.
Support Growing For Technical Analysis
While technical analysis is not yet widely accepted, in spite of its history, it is becoming more popular, given its recent track record, compared with that of fundamental analysis.
As one example, Sam Stovall of Standard & Poor’s acknowledged that technical analysts were more accurate than fundamental analysts in their forecast of the 2008 bear market.
“People were so taken by surprise in 2008,” he told Minyanville in 2010. “The technicians saw it. The fundamentalists didn’t. We ended up with a bear market of 57%.”
Likewise, The Wall Street Journal recently published a market analysis from financial historian Richard Sylla, who accurately predicted the decade-long market malaise that began the new millennium. Sylla is optimistic long-term, based on his study of market patterns.
While Sylla did not address the short-term direction of the market, he concluded that if the S&P 500 stock index follows its historical average, it should nearly double in value by the end of 2020. He also said the Dow Jones Industrial Average should increase 84% from its recent levels.
Sylla’s research shows that markets have risen and fallen in consistent waves for more than 200 years, with the pattern becoming even steadier since World War II. When 10-year average annual returns dip below 5%, he found, markets begin to bottom out and recover.
The Journalalso noted in July that the market was following a classic “head and shoulders” pattern, indicated by “a high, a low, a higher high, a low, a lower high,” and that there were also signs of an “island reversal,” in which “indexes fall rapidly between sessions, forming a ‘gap’ in the days' trading ranges, and then quickly ‘gap’ back higher.”
The Journal concluded that, “Before these patterns could be completed, the S&P would have to fall under its 200-day moving average.” It did and the market moved downward.
Technical analysts regard the 200-day moving average price of an index, such as the S&P 500, or of an individual stock as the dividing line. An index or stock trading above the 200-day average is being bought and is in an upward trend. An index or stock trading below the 200-day average is being sold and is in a downward trend.
The moving average smoothes out short-term price fluctuations and provides a high-level look that makes sense of the market. For money managers attuned to managing risk, a close below the 200-day moving average marks a change in trend, from a bull market to a bear market.
So would you keep your money in the market if you knew it had crossed below the 200-day moving average?
Some are beginning to recognize that it’s not a matter of fundamental analysis vs. technical analysis. The world is not one dimensional; there’s no reason that fundamental and technical analysis can’s be used together.
Fundamental analysis is necessary for identifying and choosing specific investments. Technical analysis is necessary to track market trends and guide overall decision making. It’s as simple as that.
Brenda P. Wenning is president of Wenning Investments, LLC of Newton, Mass. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.
By Brenda P. Wenning