Category: Trend

Why Technical Analysis is Needed

Why Technical Analysis is Needed

For more than thirty years, I have had the pleasure of working with some of the best portfolio managers in the world. Many of them have been on the cover of Barron’s, The Wall Street Journal or have been interviewed on CNBC. My conclusion is that, with a few exceptions, the best money managers use both fundamentals and technicals together. An investor who has confidence in identifying which stocks to buy and the patience to wait for the technicals to agree with their fundamental conclusions has a distinct advantage over the competition.
I have had many investors, both individual and institutional, tell me that they do not believe in technical analysis. While I am not going to say that using technical analysis is for everyone, I do believe that it will help in most cases. I have watched long term professional investors follow their fundamental models and evaluations without the help of technical analysis and it has hurt their timing and their performance in most cases.

Understanding where a stock is positioned in relation to its long-term trend will help to identify whether a decline in the stock is a buying opportunity or not. The chart above shows the long-term trend (blue). The red bars are examples of a stock declining on this chart where the first would be considered good weakness – a buying chance – while the second is bad weakness – likely something that has more downside risk in the coming weeks or months. Keep in mind, for a shorter-term trader, the long term trend is derived from a daily chart or an hourly chart as opposed to a monthly or weekly. The process of analysis is the same but the time frames change.
After working with some of the best fundamental investors in existence over the past three decades, I have found that their fundamental models can often be early since the stock will pass the screen as price is moving down to their fundamental buy level. The problem is that this drop sometimes coincides with a break of key support and when that occurs the decline can continue to weaken over the next three to six months.
Warren Buffett, one of the great investors of our time, has been successful without the use of technical analysis. However, the average investor must keep in mind that he has deep pockets. He will add to his losers until they turn around. Kraft Heinz Company (KHC) is shown below. This is one of his investments which he has owned for a long time. I am not trying to find flaws in Buffett’s approach. In fact, his long-term performance speaks for itself. Nonetheless, it is important to realize that most investors cannot stomach a 50-75% drop in a stock and have the faith to see it through or keep buying. Most will give up at some point when the severity of the drop gets to be too much to stomach.

Incorporating technical analysis into your approach will help to eliminate this scenario. In fact, this method, when applied correctly should be reflected in small losses when compared to the size of your average gain. The most important factor is that it allows you to define the risk before you buy the stock. Being very diligent about the loss side of the equation and keeping them manageable is probably the most significant factor in your success over the long term.

The Key to Trend Analysis

The Key to Trend Analysis

As I mentioned in my last article, the difference between the 18 moving average and the 20 moving average is very small.  I believe the techniques described on this website and in my videos can be employed by any intermediate term moving average line 18 to 22 periods in length.  If you prefer to use a 20 MA instead of 18 MA, that is fine.  However, stick with it.  Please do not switch back and forth.  Your mind will learn to assimilate to whichever MA lines you choose.  But, if you continue to switch the lines, your subconscious mind will never be of service.  I know from my own experience after using the same MA lines in viewing millions of charts over the years that there are times where I know what is coming (an intuitive feeling) but I have a difficult time explaining it to my clients in the form of hard facts.  This is the subconscious mind taking over and it can be a powerful tool in chart reading.  It will only work after your mind has processed thousands and thousands of charts which have the same look to them. 

Whichever length you choose, this intermediate term moving average is the most important component in this strategy.  While I use the 18 MA and the 40 MA as a buddy system, it is the 18 MA which really drives this approach.  The position of the 18 MA on the monthly chart will play a large role in defining your longer-term investment strategy for a given instrument.  It has the same effect as the wind blowing at your back when riding a bike.  If you have ever tried to ride a bike on open road with the wind in your face, this will give you the sensation of what it is like to make a long-term investment when the 18-month MA is working against you, i.e. bad weakness. There are very few exceptions to this rule.  The monthly chart of Amazon (AMZN) below shows what can take place when the 18-month MA line is working for you.  This line has been rising since 2009 except for a pause in 2014 where it flattened but never turned down.  As long as this MA has good upward slope, the long-term trend is bullish with good momentum.  The slope of this line is important to monitor.  I have bolded the line on the next few charts to show that the 18 MA on each timeframe is the driver for this approach and quite often will be the same as the trendline if it were drawn in.  Also, it tends to

provide support on pullbacks when it is rising and offers resistance on rallies when it is declining.  It is a moving line so it is an area of support/resistance as opposed to an exact level. The monthly chart of Walmart (WMT) is a good example of how the slope of the 18 MA helps to provide a bias for the long-term trend.  Since we are using an 18-month MA, it is considered the long-term trend.  An 18-week MA would be considered the intermediate-term trend.  The first shading on the WMT chart shows a flat period for this MA line and that puts the bigger picture trend in the neutral camp until the breakout in early 2012.  Then, in late 2014, a sharp selloff turned the 18-month MA lower.  There was no

confirming price evidence of a change in trend (explained in the 1-2-3 Change in Trend article). The decline reversed back to the upside after spending significant time shifting the slope of the 18-month MA line back up in early 2017 (second shaded area).  The act of turning this monthly line is time consuming and often provides plenty of time to monitor while this process takes place.  In this example, it took nearly a year to turn from the point that rallied up to it for the first time in 2016. Note that when this line turned higher, it became nice support on two deep pullbacks during 2018.

Simple Ways to Define the Trend

Simple Ways to Define the Trend

The goal of investing is to find low-risk, high reward entries.  Granted, managing and exiting positions are extremely important skills as well.  However, a good entry makes the process much easier.  The first step in this process is to identify the trend of the stock or market you are thinking of buying.  I have touched on the use of moving averages as a way of defining trend.  However, there are many methods to achieve similar feedback. 

I have been influenced by several great traders and teachers, including W.D. Gann, Victor Sperandeo, Linda Raschke, Dave Landry, Kevin Haggerty and Stan Weinstein.  Each of these market professionals agrees that PRICE is the ultimate factor that determines if stock is in an uptrend, downtrend, or transition.

Google Inc (GOOG) Daily

The chart of Google shows price only. It is clear based on this chart that GOOG is currently in an uptrend. The stock is moving from the lower left side of the page to the upper right and it is making higher price peaks and higher price valleys. It is best to keep technical analysis simple.  I have been telling clients for years that PRICE and VOLUME studies are the foundation to good technical analysis.  Before one starts to study indicators, I recommend first becoming an expert on price and volume.

In today’s computerized world, many of the software programs can be programmed to identify price trends assuming one knows how to do it. As described earlier, moving averages work very well for this purpose. I have drawn trendlines on tens of thousands of charts over the years and I still do. However, the proper use of moving averages can save a lot of time in this regard and reduce much of the ambiguity.

Another way of seeing and defining the trend is with the use of swings or waves.  W.D. Gann referred to these reversals as swings.  In the 1970’s, Art Merrill wrote a book about this concept and referred to the changes in direction as filtered waves. Many software programs call this indicator a Zigzag.

Above, the chart of Apple Inc. shows a 4% filtered wave overlaid onto the price chart.  A filtered wave means that all movement which is less than the filter is ignored.  In this case, any pullback of less than 4% does not create a wave.  Notice during 2009 this stock made higher bottoms based on a 4% filter. Using this filtered wave theory (Art Merrill, Filtered Waves- Basic Theory), one can quickly ascertain the direction as well as the longevity of the trend of a given market.

Here is the same time period as the previous chart.  However, this chart of Apple Inc. (AAPL) has our 2 simple moving averages, the 18-day moving average and the 40-day moving average. Notice that in February the 18-day MA crossed over the 40-day MA and remained above for the entire year. This reflects the same positive feedback that we just discussed with a 4% filtered wave. These are two very different approaches to defining a trend, but both are very simple and the resulting signals are virtually identical in this case. 

Why an 18 and a 40 MA? Why not a 20 and a 50 MA? Or exponential moving average?  What about the 200-day MA? (one of the most widely used MA lines). These are valid questions. Using a 20 and 50 instead of 18 and 40 would work fine. Frankly the difference between an 18 MA and a 20 MA is quite negligible. Put both on a chart at the same time and you will see what I mean. I favor the 18 MA simply because the slope shift is a little quicker than the popular 20 MA. In addition, for this method of using 2 moving averages together like a buddy system, I have found the simple MA lines to be more useful then the Exponential version.  Again, it is a personal thing and the use of EMA’s (lines which give more weight to the most recent closes in a sequence rather than weighting them all equally like the simple average) can be employed with success but you will probably need to adjust the length to make the signals a little more comparable. 

In my opinion, moving averages should not be used as an exact science. In fact, technical analysis in general, while having various quantitative benefits, is probably best when not used as an exact science either. The question of the 200-day MA is easy to answer. If we display a weekly chart with 18 and 40 MA’s, the 200-day MA is shown in the form of the 40-week MA. I prefer to use multiple time frames in my analysis because it has proven to be very helpful in refining my stock selection and timing process.  Having the ability to look at each individual time frame and its own structure, price action and momentum is useful information when trying to find key inflection points.  This will become clearer as I give more examples throughout the text.  Also, I will show why I use the 40 MA together with the 18 MA in future articles.

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