Does Technical Analysis Work?

A number of legendary investors spend their days looking at complicated technical charts - but is it a strategy for investment success? 

Chris Menon 26 November, 2019 | 2:20PM

Algorithm

Chartism, more commonly called technical analysis, involves the close study of past patterns in stock prices to help determine current investment decisions. It is derided by many investment purists as pseudo-scientific mumbo-jumbo.

However, the strategy is widely used by both professional and amateur investors. Its most famous adherent was the legendary fund manager Anthony Bolton who ran the Fidelity Special Situations fund (now Silver-Rated and run by Alex Wright) from 1979 to 2007, during which time he delivered an annualised 19.5% return for investors.

Bolton used chart patterns and other technical indicators to confirm the fundamentals and time his buys and sells on stocks, particularly for bigger, more complex companies.
Leigh Himsworth, portfolio manager on the Fidelity UK Opportunities fund, is also an avid user. He finds charts to be very useful in two areas: firstly, in the very short-term to time his entry into or exit out of a stock, and also to try to identify very long-term trends.

Short-Term Opportunities

In the first instance, Himsworth believes short-term investor enthusiasm (or otherwise) for a company can be can be represented in charts through technical indicators. “I often use relative strength indicators, which really give an idea as to how over-excited the market is," he explains.

On one particular day, for example, if a company’s numbers are really good then you can see the weight of money trying to buy the stock, pushing the price up. If that continues for a period of time, the "relative strength indicator" will suggest the company is technically over-bought. This can also happen in reverse, in which case you get a stock being technically oversold.

Typically if the relative strength gets over a mark of circa 70 (on a scale of 0 to 100), it looks very stretched on technical terms. "At this point, I look to either trim or top slice any holdings," says Himsworth, "If it drops below 30, then I will look to enter or add to my position.”

In addition, if he thinks a market has gone too far in any direction he also uses so-called "Fibonacci levels" (horizontal lines on a chart) to gauge support and resistance levels. “I use that for things such as market levels or currencies or commodities, things that are not directly related but do have an impact on the market,” he says.

Himsworth also uses charts to compare current market levels to very long-term trends for economic indicators such as inflation, bond yields and annuity levels. One such example is comparing the price-to-earnings (PE) ratio of the FTSE All-Share with the yield of the FTSE All-Share and the growth outlook. He says: "I look at that and ask: ‘does it look appropriate where we are versus bond yields over history?’ The annuity rates at the moment are in the realms of just above 4%. If I can get circa 6% growth on the market plus a median yield of about 4% that looks quite attractive.”

But even an avid chart-user such as Himsworth believes you shouldn't let charts dictate your investment decisions. He says: “The fundamentals come first and you use the charts to confirm the work you’ve done and then the trigger points; don’t use the charts blindly.”

Getting Technical

Dr Paul Jourdan, chief executive at Amati Investors, also uses charts - or, as he prefers to call it “behavioural technical analysis”, since “what you are seeing in charts is really investor psychology". 

He is clear about the benefits and limitations of the technique though. While using charts to understand investor psychology is a useful exercise, he thinks using them for definitive signals is far more difficult. 

He adds: “Just remember that charts never prove anything, they just give you some insights into the probabilities of various outcomes. There are no necessary (in the philosophical sense) conclusions that you can derive from them but you can get some good indicators and insights that you can then combine with your knowledge of the fundamentals. If you use the two together it is effective.”

Jourdan thinks using charts is an essential part of understanding what drives trends and what they look like when they finish. “It is impossible to make money out of investment without a price trend in the right direction, so understanding what drives trends and what they look like when they finish is important,” he says.

He also tends to agree with Bolton about charts being particularly useful when investing in large-cap stocks. This is because the more liquid a stock is, typically the more generic its behaviour is likely to be - that's because you have more players involved in buying and selling, which tends to lead to smoother patterns. Smaller companies, in contrast, can be quikier, have fewer players driving their trends and thus can sometimes be more prone to misleading signals.

Still, he warns against using technicals in isolation: “I am not a believer in using charts and nothing else. It is a useful adjunct, but to understand them well you have to understand as much as anyone else does about the fundamentals. It is then much easier then to come up with good theories as to why behaviour looks as it does.

In summary, far from being mumbo-jumbo, professional investors attest that technical analysis can be a useful tool for investors - but it should not be the only tool in your investor toolkit. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Chris Menon  is a financial journalist writing for Morningstar.co.uk.

Audience Confirmation


By clicking 'accept' I acknowledge that this website uses cookies and other technologies to tailor my experience and understand how I and other visitors use our site. See 'Cookie Consent' for more detail.

  • Other Morningstar Websites