Looking for Market Direction?

For most investors, when it comes to technical analysis and markets, they fall into two very distinct camps:

Either they love it or they hate it.

But for those who swear by it, the lines on those charts are more than points on a graph. They are windows into a world where the price action of the past gives clues into the price action of the future.

Needless to say, that is a "crystal ball" type of approach to the markets that leaves the non-believers simply shaking their heads. It's nothing more than "black magic," they insist.

One of them is actually a hero of mine, named Warren Buffett. You may have heard of him. He's known around the world as the "Oracle of Omaha", yet he has no use whatsoever for charts and their deeper meanings.

In fact, Buffet's disdain of this tea-leaf reading is well known. "I realized technical analysis didn't work," Buffett has said, "when I turned the charts upside down and didn't get a different answer."

But Buffett is hardly alone on that score. Others like investing legend Peter Lynch have joined him observing once that, "Charts are great for predicting the past."

Even still, technical analysis does have its proponents, even in the face of those two non-believing heavy weights. For a swath of investors they simply wouldn't think about heading into the markets without their charts. I am one of them.

Fundamental Analysis: The Devil is in the Details

However, I have a foot planted firmly in both camps. On the one hand, the need for fundamental analysis is obvious to me. After all, how can you really determine a company's intrinsic value without looking at its balance sheet, cash flow statement and income statement?

The short answer is that you can't. In this case, the devil really is the details and the only place to find them is to sort through the financials.

Buffett, of course, is a master of this - having learned it from Benjamin Graham. His book, The Intelligent Investor is often described as the value stock player's bible. Buffett even calls it "by far the best book on investing ever written."

Of course, it was Graham who famously said, "In the short term the market is a voting machine, but in the long run it is a weighing machine."

And within that quote, is the idea that really tends to separate those that believe in fundamental analysis from the technical crowd.

The difference is typically in the time frame, which is why Warren can look at a chart and see nothing, but a trader sees all sorts of things.

So What is Technical Analysis?

In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. The difference between the two is monumental, which is why technicians have little use for fundamentalists either.

Instead, technicians focus almost solely on price and volume and use their charts to predict the future movements they derive from them. That's why they are often referred to as chartists. Using charts, they study the supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future.

In other words, a technical analyst largely attempts to understand the underlying emotions in the market by studying the market itself. And using any number of chart patterns, oscillators and indicators, chartists use historical data to identify and profit from existing market trends.

As a result, technical analysis basically rests on two market assumptions. They are:

1. Stock Prices Tend to Move in Trends

For a technical analyst, the trend is always his friend. That's why most technical trading strategies are trend following. That includes the broader market trends as well as those of individual stocks.

Because once a trend has been established, technicians know that the future price movement will likely continue in the same direction. Of course, any break in this trend is often where technicians decide to sell. That's why fundamentals are of little use to technicians. To them a stock is either moving up, down, or sideways.

2. Markets, Like People, Repeat Themselves.

Above all, technicians believe that since markets are made up of people, they follow predictable patterns. As such, they attribute the repetitive price movements in stocks to market psychology. The belief is that once a consistent pattern of behavior has been established it can be used in the future to provide good entry and exit points.

Now which one of these schools of thought is the best remains a matter of contention. After all, they are radically different in their approach. A technical analyst believes the markets are 80% psychological and 20% logical, while the fundamental analyst believes in the reverse.

However, the truth is that a larger argument can be made for using both of them since both styles have been successful in the past.

The problem is that while most retail investors can reel off P/E's and book values with the best of them they couldn't begin to find a head and shoulders top if their lives depended on it. So technical analysis is largely useless to them.

That's why in future columns I'll be breaking down the basics of technical analysis in much greater detail explaining its ins and outs.

Because whether you believe in technical analysis or not these days, failing to at least understand them is giant mistake.

Your bargain-hunting analyst,

Steve Christ, Investment Director

The Wealth Advisory