Investors, like all humans, prefer order. Most find it
hard to accept the concept of randomness, no matter what the
laws of chance might explain. As such, investors tend to
look for patterns in data to help better understand what has
transpired—and what may yet occur, especially in the stock
market. Therefore, is it any wonder, amid the recently
rising market volatility, that the latest group of
experts—the chartists—are being ushered onto the market’s
main stage proclaiming to investors the existence of order
amidst all the chaos?
Investment technicians—or, chartists—contend that the price
action of stocks and bonds, both individually as securities
and collectively as the general markets, tends to move in
discernible trends and patterns. True technicians care
little about what business or industry a company is in or
whether it’s an industry leader or laggard. The trend lines,
however, are key to a technician’s analysis. It is
chartists’ job to filter through all available price action
and determine which price changes provide useful information
and which are meaningless.
To successfully understand current price action and forecast
potential future action, a technician must rest his or her
analysis on the basis that the past is prologue. Chart
analysis is, indeed, a firm acknowledgement that history
does repeat itself. Technicians also assume that all known
information is contained in the price of the stock and
therefore only new and previously unknown information can
affect the current price.
The fundamental tenet of charting is that once a trend
starts it is does not easily change its course. Therefore,
technical analysis is more about anticipating changes than
it is about identifying current trends. Trend changes can
provide for a potentially profitable entry into or exit from
the investment. The technician buys when the patterns look
favorable and sells when they are not.
Yet, for many investors, the unresolved question remains:
how can technicians steadfastly contend that any and all of
the information needed to successfully participate in the
market is contained in the price patterns on the charts,
especially when academic literature has masterfully
demonstrated that future price changes cannot be predicted
from past changes?
A couple of reasons come to mind. First, it is conceivable
that the herd mentality does lend some validity to the basis
for the existence and continuation of a trend. When
investors see the price of an investment moving higher and
higher, they don’t want to be left behind. In turn, their
desire creates a self-fulfilling prophecy—the continued
price increase causes more investors to expect the trend to
continue. In other words, the trend is your friend.
Second, technicians contend that the flow of information to
investors is not uniform and, thus, the existence of new
information can only be ascertained by observing the price
action of the security. Technicians suggest they can
identify this “smart money” by the price action it creates
as it enters or leaves the security. Simply put, somebody
knows something.
Whether the technician improves his or her long-term
investment acumen from the information identified in the
charts is debatable. As I see it, the technician buys into
the market only after identifying an established price trend
and sells only when it is broken. The anticipation of sharp
reversals—a potentially lucrative forecast—rarely occurs.
Additionally, there are only a finite number of patterns
available to the technician. Therefore, as more investors
come to recognize each patterns meaning, the intrinsic value
of a correct interpretation depreciates. The fact of the
matter is that due to the nature of their analysis,
technicians are traders rather than long-term investors. In
other words, the trend is their friend, until it is not.
If long-term investors, knowing that markets fluctuate and
that the future is rarely dependent upon the past, accept
the contention from chartists that the information needed to
provide order to the chaos is contained in the price
patterns on the charts, then my advice to them is, caveat
emptor.
Please note: The next edition of Insight Line will be
published September 10.
This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its
accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information
in this report does not pertain to any Van Kampen product and is not a solicitation for any product.
|
View pdf
