Most people start off accepting the
basic premise of what is called "fundamental analysis", that a
financial security (share, option, warrant, futures contract) has what
is called an "intrinsic value". However, a little experience in the
markets soon shows that this intrinsic value is difficult to determine
and that expert analysts are often in disagreement about it. The
reason is that such valuation is very subjective. Anyone with any
experience with takeovers will know about "independent expert"
valuations that vary wildly.
A more important problem is that the
market often prices financial securities at prices at variance with
commonly agreed value. While it can be shown that there is a long term
correlation between value and market price, in the short term (months
or years), market prices differ substantially from value. So, while
one can profit by buying securities that the market is undervaluing
and holding them until the market adjusts, our capital could be better
employed elsewhere in the interim. In other words, there is a timing
problem.
Instead of trying to determine the
underlying value of a security, technical analysis seeks to identify
when the market actually begins to identify mispricing in the market.
Once this happens, price tends to rectify the situation. However, this
does not happen over night and instead takes place gradually, forming
a trend on a graph of market price. What the technical trader tries to
do is enter once the adjustment process is under way and exit once it
has finished.
There are two common misconceptions
about technical analysis. The first is that they try to forecast the
future. Indeed, some analysts do try to do that. However, they are no
more successful than economists in general and those employed by
governments in particular. However, those who trade successfully using
technical analysis do not try to forecast prices. Instead, they
restrict their endeavours to identifying trends. This is much easier
to do and is a much more profitable approach to the markets.
The second common misconception is that
it is necessary to identify the top and bottom prices in the trend.
Again, there are some technical analysts who try to do this, with
conspicuous lack of consistent success. Those technical traders who
are consistently successful in the markets enter the trend once it has
clearly started and exit once it has clearly ended.
How does the technical analyst do this?
It is done by studying the market for the financial security itself.
This primarily means studying price, but includes the volume of
trading. In some derivatives markets (principally futures and options),
the open interest, or number of contracts open at any time, is also
used.
This is because the technical analyst
understands that there is a difference between the value of a company
if you purchased all of it in a takeover and the value of its shares.
The value of the shares is driven not only by the underlying value of
the company, but also by the needs and expectations of shareholders
and potential shareholders. Two simple examples are the person who
must raise cash in a hurry, who will accept a lower price because of
time constraints and the fund manager caught short of a stock that
starts to move, who will pay a higher price because he cannot afford
to let his competitors do better in the fund performance ratings.
By Colin Nicholson
Colin Nicholson BEc, SF Fin is a life member and past president
of the ATAA. He is author of The Aggressive Investor and
www.bwts.com.au
web site, writes a weekly column in BRW and monthly articles in AFR
Smart Investor on technical analysis and psychology of investing. He
is currently the President of the ATAA NSW State Council.
