The widely misunderstood value in disciplined technical analysis

Financial commentary is so rife with rubbish most of the time that it is hard for real facts to get a thought in edge wise. Most frequently commentators talk their book, or cherry pick facts to support their supposed skill set. In truth the vast majority simply strap capital to market cycles for better and for worse, taking credit for any upside moves while denouncing the inevitable down cycles as unfortunate and “unforeseeable”. Droves of others speak confidently in theory, with no real time experience managing money successfully through live market cycles.

Those who have no meaningful risk management rules, often try to dismiss those who do. The most dangerous and reckless players are usually given to the most aggressive rants about how much “the market is up” or what others “missed out on” during a period of positive price trends. In reality what a “market does” within a particular time frame usually bears little resemblance to the cumulative gain or loss experience of an individual’s capital over a full market cycle.

Buy and hold or constant equity allocations as an investment strategy is a disaster in real life, and particularly during secular bears when stock valuations move from shockingly over-priced speculative bets, to systemically under-loved and finally valuable investments over the course of a volatile 15 to 20 year period. Nevertheless, perpetually allocating to stocks is the most common recommendation. The fact is that full cycles take some years to complete, and it is human nature to make short-shrift, emotional assessments at half-time.

Over the years, I have read many studies or comments on the merits of Technical Analysis (TA) as a risk management tool. Most begin inherently biased against the idea of risk exposure timing and so are quick to dismiss TA as voodoo. Others focus on day trading systems and conclude that the friction costs outweigh any capital benefit when compared with buy and hold.

Both of these conclusions miss the potential value of TA completely in my view. On a longer-term trend, over a full market cycle, TA used with objective discipline can be hugely beneficial in growing capital. But not in the way most expect. Not in “beating” the stock market in a given year or years of a bull cycle, but in protecting capital when it matters most–shielding it from losses during bear markets.

A new study looks at disciplined TA properly over full market cycles and confirms it valuable. See: Head and shoulders above the rest? The performance of institutional portfolio managers who use Technical Analysis.

By replacing the usual obsession with catching all the upside of market moves, with a focus on avoiding the highest risk periods and the capital losses that eventually follow them, effective risk management using TA can produce higher cumulative gains with a fraction of the volatility and capital risk over a full market cycle. I have been writing and speaking about all of this for years, and cover it in my book Juggling Dynamite. But this article on Dow Theory (another TA system) also does an excellent job of explaining the value of TA. Yes it can be done! Capital can survive and thrive through a secular bear market.

“Investors get blinded by performance. However, in real life, the investor is killed by draw downs. A 15% average performance is worth nothing if, somewhere along the road, there is going to be a draw down of -50%. Buy and hold is nice in theory, and it may work provided the investor has deep pockets (staying power) and psychological fortitude. However, in real life, very few investors possess both attributes at the same time. Thus, the publicized return figures of many investing strategies are not attainable in real life because the investor cannot endure the draw downs..”

You can read the whole article here.

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6 Responses to The widely misunderstood value in disciplined technical analysis

  1. dazzo says:

    It seems to me that using TA would not have been of much use analyzing the Nikkei which has gone nowhere in over two decades. Would you have bought in anywhere during that time?

  2. dave says:

    Basic TA kept me out of apple at the top and potash and other commodities in 2007. IF viewed on long term charts I believe it can easily spot overvalued and undervalued conditions. The shorter the time frame the less useful it becomes in my opinion.

  3. David Nelson says:

    Wouldn’t it have been useful in keeping you out of the market?

  4. Tony Hladun says:

    From my reading of this paper my conclusion is that in a secular bull market buy and hold works. The declines are short and small so trading actually introduces larger losses. Like we do here in Alberta at rodeos, you get on the bull and hang on for dear life. In a secular bear market going in and out (technical analysis) works because it’s the declines that kill you. The declines are also long enough and big enough to execute a trading strategy. That is, in a bear market you try not to get eaten.

  5. Manuel Blay says:

    Your conclusions are right. It is almost impossible to outperform secular bull markets with technical analysis. However, the issue the investor is confronted with, is how to spot in real time, whether one is just witnessing a temporary correction within a secular bear market or the decline is the first big one within a new secular bear market. In hindsight is very easy to say, “1966-1981 was a secular bear market” but in real time, it is not an easy feat.

    So, riding a bull in its entirety maybe a losing proposition if the investor gets it wrong and the bull was not a secular one but a cyclical (short lived) one.

    Thus, if the investor wants to play it safe, he should assume that nobody knows in real time the future and hence apply technical analysis under all market environments. In good times, the investor will slightly underperform but in bad times he will outperform when most needed.

    Here you have some figures concerning technical analysis (Dow Theory) versus buy and hold during the 1966-1981 secular bear market:

  6. dave says:

    Of course some like Vanguard founder John Bogle says any trading is an absolute waste of time and buy and hold is the only way

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