Anyone who has been to a fortune teller who reads tea leaves will tell you that if you stare at the patterns long enough, the remnants in your cup can magically begin to look like the vision of the future the fortune teller is foretelling. In the realm of investing, the same is true with technical chart analysis.

Now that it appears that markets have reached a turning point, practitioners of the ‘dark art’ of predicting and exploiting investment trends by analyzing charts have been getting some favorable reviews.

These Technical Analysts, like the ones heard weekly on the business TV shows, use a bewildering range of tools and concepts to prophesy prices — from simple support and resistance points to daily volumes, moving averages, trend lines, oscillators and volatility.

Their esoteric approach to forecasting contrasts with that of fundamental analysis, that focuses on factors like company earnings, management, strategy, industry backdrop and the general economic environment.

One recent article in The Times of London heaped praise on technical analysts, saying they had done a much better job than fundamental analysts in charting the course of markets through the financial crisis.

Specifically, what has excited observers in the media has been a break by the S&P 500 through a “neckline” of a reverse head and shoulders formation. This, according to the chartists, is a very bullish signal.

If such indicators as head and shoulders patterns really are so reliable, as The Times¹ says, why would anyone trade against them?

Secondly, not all technical analysts agree. For every chartist who points to a bullish break on a head and shoulders formation, for instance, there may be another pointing to a bearish ‘Elliott Wave’ pattern or something like it. This contradictory condition is constant and should indicate the inadequacy of technical analysis, not support for it.

Of course, there is no way of knowing which of these techniques has got it right until after the fact, which is too late for us regular folks who want to profit from our activities in the markets. But in the meantime, it can be very diverting to look at the pretty pictures they draw. This is more of what I call “investment pornography.”

Taking a less cynical view, there is an honourable intention in technical analysis in attempting to separate the fundamental noise in pricing from the underlying signal. Many of these analysts believe in “mean reversion” — the tendency for prices to revert to their long-term average levels.

Technical Analysts also rightly understand that market dynamics themselves — shifts in daily trading volumes for instance — can be important influences on prices.

But this still leaves open the question about whether such methods can reliably predict turning points. If they did (now think about this a minute) everyone would be using them.

And while changes in security prices reflect both permanent (or fundamental) and temporary (or technical) influences, it is impossible to discern, before the event, the degree to which these varying influences will affect prices. So, how can one consistently profit from this information? One cannot.

A third observation is that most technical analysis — apart from Elliott Wave theory – is concerned with relatively short-term movements in prices. To the extent that these signals are any good, they really are only relevant to day traders whose business it is to profit from noise.

Long-term investors, by contrast, will be concerned with very long-term trends in prices and will focus on consistently capturing those risks that the historical record shows carry a reliable reward. Capital Markets U.com Magazine is interested in helping these long-term investors, not speculators.

These long-term investors will also ensure that those who manage their money are cognisant of – and are able to exploit – temporary and technical factors in the market that can affect prices.

A prudent approach to investing is one that is not dependent on forecasting — either via charts or fundamentals — yet recognizes the short-term frictions in the market that can cost investors dearly.

And you don’t even have to be a tea drinker to benefit.

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¹ Anatole Kaletsky, ‘The Fortunes of the Markets are in the Charts’, The Times, July 27, 2009

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