Author: Eric Uhlfelder

3 June ‏2002‏, The New York Times

A stock’s price movement can tell you much about its near-term prospects, but not everything.

The one thing this interminable bear market has taught investors is that buying into a seemingly sound company and sitting tight can be a very costly strategy.

“Among the hardest lessons for investors to understand,” observes Kevin Marder, chief market strategist of the NY brokerage Ladenburg Thalmann, “is that one’s perception of a company and how the market values its stock are often two very different things.”

Technical analysis helps investors sort through the confusion, especially when news and stock behavior are out of joint, by replacing sentiment with fact. Its premise: the market ultimately knows best. Therefore, the study of price and volume patterns are the most prescient indicators of where a stock is going.

While this approach appears to ignore the fundamentals that the Peter Lynchs of the world tell us drive stocks, such as consistent revenue and earnings growth, reasonable valuations, manageable debt, and strong, long-term corporate leadership, it actually seeks to be a step ahead of the curve by acknowledging that key events are happening before they are fit to print. Put another way, prices are a succinct amalgamation of all key factors, whether or not they are generally known.

“Seeing a stock break out of a trading pattern on higher than average trading volumes,” observes Frank Gretz, chief technical analyst of Shields and Company in New York, “often portends changing institutional investor sentiment, the force that drives a stock.”

Consequently, individual investors are often chasing stocks after material developments have been priced into shares, making them relatively expensive. And this generally holds true whether the news is positive or negative. In this way, technical analysis helps mitigate risk by getting investors to shift their focus to the larger picture: the preservation and enhancement of capital.

Take, for instance, the big Dutch-based life insurer AEGON, a company that many equity analysts had regarded as among the top plays in a defensive industry. Between 1998 and 2001, revenues grew from E17.2 billion to E31.9 billion, and earnings soared by an annualized rate of 24 percent.

But if an investor had bought the ADR at the start of 1999 at $63.13, more than a year before the market broke down, he would never have been in the black. The protracted bear market eventually took its toll on the company’s underlying fundamentals. Today, its shares trade under $10.

It’s not that technical analysis would’ve foretold the ultimate collapse of AEGON’s stock; just that it would not have supported a decision to buy.

A key indicator was existence of a classic negative trading pattern: a jaggedly descending price chart where the stock continues to break down past a previous low, and when it tries to rebound, it fails to climb above its previous high because demand simply isn’t there.

Some investors may see a buying opportunity if a sound company’s stock falls far enough. However, technical analysts wouldn’t consider such an investment until they see a decisive bottoming and upturn in share price.

Technical analysts rely on all sorts of signals to buy and sell, such as the relationship between moving averages and identification of distinct trading patterns that take the form of rectangles, triangles, rounded tops and bottoms, and head and shoulders.

The most compelling patterns, according to Michael Kahn, author of Technical Analysis: Plain and Simple, are those that incorporate many indicators, such as the cup with a handle. This pattern is created when a stock falls then rebounds toward a previous high–a key resistance level–forming the cup. A bit of profit-taking then occurs, followed by renewed buying, sending the price to new highs…in an ideal world.

“A pickup in trading volumes should be evident as the price rises,” adds Mr. Marder, “while the temporary selloff should be coming on reduced volumes, suggesting that the bulk of investors are sticking with the stock.”

A current example of a cup with handle is the $20 billion Australian bank Westpac, which trades on the New York Stock Exchange under the ticker WBK. After having hit a peak of $48 on July 20, 2002, the stock subsequently slid to a low of $36.09 on October 10 in the aftermath of the Bali bombing which killed scores of Australians. This formed the left side of the cup.

Since then, the stock has been steadily climbing, forming the right side of the cup. Shares hit resistance when they closed at $47.01 on April 1, 2003. They wavered there for several weeks [the handle] and then shot past this high-water mark and closed the month of May near their record high of $53.45.

One could argue that since company financials and analyst support remained positive over the past year, waiting for the stock to eclipse its previous high before investing—as a pure technical analyst might advise–might be overly cautious. But there’s the rub.

In using this strategy, selecting too short of time frame may not give the market sufficient time to wring out all risk; selecting too long a period to ensure the story is legitimate may leave too little money on the table.

Investing in equities that track historically proven patterns doesn’t guarantee success. And if an investment does turn south, technical analysts won’t wait long before selling. They set very quick triggers that generally gets them out of a position before the loss exceeds 10 percent. This reflects their focus on preserving capital rather than affirmation that they had picked a good stock.

Most technical analysts are equally disciplined on the upside. As their stocks rise, some maintain moving sell orders that kick in once a stock breaks down by 10 to 15 percent from a previous high.

Because technical analysis is the study of investor behavior, it can also be applied to all sorts of indicies, from industries, sectors, and entire equity markets, to energy, agricultural commodities and currencies.

The rebound of the euro may have surprised some. But a closer look at its trading pattern against the US dollar between the second quarter of 2000 and second quarter of 2002 reveals the making of a pretty firm bottom. And until the euro’s run shows signs of stalling, shorting the dollar may still be profitable.

But acknowledging the limitation of any one strategic approach, Phil Roth, chief technical market analyst at Miller Tabak in New York, quips that “the biggest mistake a fundamental analyst makes is thinking that a stock and a company are the same thing. And the biggest mistake a technician makes is thinking that a stock and a company are different.”


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