Investor Discussions - Technical Analysis
Wealth & Pension Services Group
Matt B. Bailey, CFA - Portfolio Manager
At Wealth & Pension Services Group, we follow an in-depth investment process which entails many forms of research. This includes the use of both fundamental and technical analysis to help form our view of the markets. In this piece, we plan to explore the field of technical analysis, compare it to fundamental analysis, and demonstrate how we use it when making investment decisions.
The history of technical analysis goes back to the early days of Wall Street in the late 1800’s. Until the last few decades, most technicians used hand-drawn charts to find trends and price patterns. Since then, technology has helped the field evolve by speeding up the charting process and making data more accessible. Even so, technical analysis remains centered around the use of historical data to predict future price movement.
The other form of investment research is fundamental analysis. This type of security analysis involves analyzing a company’s financial statements (balance sheet, income statement, etc). Although good at forecasting longer-term returns (5-8 years), it struggles when providing near-term predictions. This is where technical analysis can assist by providing shorter-term signals.
Charts and Trend Models
Technical analysis has many forms and can be used in different ways. The most common method is the plotting of past price data on charts. These charts help to identify useful pieces of information such as: price trends (both positive and negative), patterns of behavior (buys or sells), inflection points, and entry/exits points. Although not perfect, technical analysis provides additional market insight and can help reduce risk. For example, analysts may use a trend line as a guide for when to buy or sell a security. If the price of an investment falls below a trend line, the analyst may see that as a reason to sell (chart 1).
Another form of technical analysis is the use of trend models. Trend models aggregate quantitative data such as: price history, economic figures, and investor sentiment. The output of the data is used to assess the market’s internal health and provide signals of impending changes. Trend models tend to move slower than the market but can still provide timely information. They can also help manage risk by delivering early warning signs of trend changes. These warnings can assist with the decision making process of when to reduce risk.
How We Use Technical Analysis
Our firm uses two trend models managed by 3rd party research firms. One model utilizes over 130 different inputs including: stock and bond valuations (fundamental analysis), economic data, investor sentiment, and supply/demand statistics. Over time, this model has provided timely signals for increasing or decreasing portfolio risk. It’s important to reiterate, these signals are not designed to time the market. Instead, they are designed to help manage risk and avoid large drawdowns. This particular model uses three ratings for current market conditions: positive, neutral, and negative. Our firm uses the ratings as a gage to help make asset allocation decisions to varying asset classes. For instance, when the model moves from positive to neutral, we may decide to reduce our stock exposure.
In addition to trend models, we use traditional chart analysis when making investment decisions. Simple techniques such as selling once a trend line has been broken can help to reduce downside risk. We also use supply/demand statistics to see where investors are allocating money. This data helps to locate new trends as they begin to develop. Relative strength analysis is another area that provides good market insight. It’s a simple process of dividing one investment by another to see which is outperforming.Chart 2illustrates the positive trend the S&P 500 ETF has exhibited over the last 3 years. It also shows its strong relative strength versus international developed stocks (MSCI EAFE ETF).
Conclusion: Bringing it All Together
Technical analysis is a form of investment research that has been utilized for over a century. Advancements in technology have helped the field evolve from hand drawn charts to complex computer models. It provides a view into the emotions of investors and can be used to manage risk. Additionally, it can also be used in conjunction with longer term fundamental analysis by delivering timelier trading signals. When analyzing the global markets, it’s important to keep an open mind. We think fundamental and technical research complement each other and provide a more complete view of the global markets. Within our investment research process, we combine them in hopes of improving our investment decisions and management of risk.
As always, please feel free to contact us with any questions you may have.
Matt B. Bailey, CFA, CMT
Source: JP Morgan