Looking for patterns that repeat themselves can often be derided as "drawing lines on charts". But technical analysis should be part of an investors toolkit, writes Chris Johns
The current chatter amongst the "technical community" is that the US equity market is looking tired and is vulnerable to a setback, perhaps one of significant proportions. And where the US equity market goes, the rest of the world's stock exchanges are bound to follow.
With the exception of Japan, most of the world's major exchanges are highly correlated with Wall St.
Technical analysis is often derided by fundamental types as merely "drawing lines on charts"; others accuse chartists (another name for technicians) of being fooled by randomness. The charge is that people who look at past price movements for patterns that repeat themselves over time are kidding themselves.
Earlier practitioners used to look at things such as Kondratieff waves and other long-run supposed regularities in the data. Technical analysis amounted to little more than simple trend following - and there is some, albeit disputed, statistical evidence that some asset prices do, for a time, follow a definite trend.
The trick is to try and spot one early and to jump on board. Traditional methods involved noticing something called consolidation and then identifying signs of a "break-out". For anyone used to making bull or bear bets on markets, the most impressive aspect of this approach is its supreme indifference to an asset price's direction.
If the break-out is to the downside you sell; to the upside and you buy, whatever the fundamental analysts might be saying. After that, the trick is to ride the wave and get out at the right time.
These days, people still run rulers over charts and graphs but the techniques have moved to encompass some of the latest developments in mathematical theory. Some hedge fund managers I know have taken time out of their careers to study some of the most recent innovations in mathematics at one of the world's leading universities.
The techniques they subsequently apply to the forecasting of financial asset prices are a far cry from trying to discern a "double bottom" (an unfortunate charting term) on a graph, but the principles are similar.
The idea is that there are patterns in the performance of equities, bonds and exchange rates that, if you can find them, are exploitable.
Vast amounts of money are now devoted to buying and selling of all sorts of assets, purely on the basis of technical models of varying degrees of sophistication.
Finance theorists usually acknowledge that there may be something to all of this, but only because so much money is being managed in this way. The prophecies of the technicians are sometimes right because so many people bet their money in the same way the forecasts become self-fulfilling.
Most academics still cling to some notion of market efficiency, a key part of which is the view that there is nothing predictable about asset price movements since all available information, including any insight to be gained from past regularities, is currently in the price.
The existence of active fund management (as opposed to purely passive index trackers) is, for the academics, a complete nonsense; trying to beat the market is doomed.
Technical analysts respond pragmatically. They argue that if their techniques work then that is good enough. Anything that makes money consistently should not be knocked, merely invested in, no matter how many efficient market theories are violated.
I have worked alongside some technicians who have reminded me of the alchemists of old; their attempts to turn base metal into gold met with as much success. But not all technicians are quacks; I have been mystified but impressed by the work of one or two people, particularly those applying high-level maths.
Perhaps academic finance theories will one day discover why these techniques work; modern ideas about "behavioural" finance could be one route that sees the technicians reconciled with the academics.
One thing is for sure: charting is for traders, not investors. If your concern is for your pension fund then you don't need to worry too much about the signals being sent by the technical models. All of this stuff is for people trying to make money by astute moves in and out of markets over the relatively short term, something that is notoriously hard to do, even for the professionals.
But if you are worried about performance over the next few months, then some technicians are saying there is lots of trouble ahead. Interestingly, they seem to believe that all of the main asset classes are going to take a hit.
In particular, US equities and treasury bonds, as well as gold, are due for a tumble. In the currency markets I am hearing that the yen is the currency most in favour and that some people see the recent modest fall in the euro as the start of a classic break-out that heralds something of a trend for the next few months.
For us old-fashioned fundamentalists, some of this strikes a chord, while other parts of the analysis still looks decidedly flaky. We can make the case that equities have come a long way over the past year to the point where valuations are stretched - as they undoubtedly are in the US - and global security concerns are hardly a supportive backdrop: it is relatively easy to be cautious about the short term. But it is a stretch to maintain that US fundamentals argue for a major stock market correction, particularly now that the much awaited jobs recovery is in place.
Nevertheless, technical analysis should form part of any investor's toolkit. Even if you are a sceptical fundamentalist, chartism can be useful for helping to time entry and exit; when to buy and when to sell.
For those investors lucky enough to be sitting on cash, now might be a good time to do nothing. Holders of equities and bonds concerned with the short term might consider a move of part of their portfolio into cash.
