Technical analysis is research into the supply and demand of investments based on historic trade information, in terms of both price and volume. Technical analysts, often called chartists, believe that it is possible to detect the onset of a movement in stock or market value from one equilibrium condition to another. To do this, they use charts and computer programs of past stock, commodity, and market movements to identify trends that they believe will predict pricing movements. Chartists are not concerned about why conditions are changing, they only want to identify the beginning of the change to take advantage of short- and intermediate-term gains. While most of these analysts predict short and intermediate pricing trends, some also forecast long-term market cycles based on their data.

Like many professionals in the security industry, chartists believe that the value of the market is determined by supply and demand for stocks. Furthermore, like others, chartists think that the supply and demand is influenced by many factors, not always rational, which are weighed continuously and subjectively by the market. Technical analysis differs from other schools of security forecasting, however, in the timing of stock price changes. Chartists believe that stocks move in trends lasting over long periods and that astute investors can profit from these trends if they act when the trends first begin. This supposition is based on two beliefs. First, chartists contend that information about stocks leaks into the market over extended periods. Stock prices change gradually as information moves from industry insiders to analysts and finally to investors. Second, chartists believe that a further time lag occurs because investors do not unanimously agree about the validity of the information or its impact upon the security in question. The gradual nature of price changes gives investors time to act to take advantage of a trend.

Thus, it is the job of the technical analyst to develop a system that can detect the beginning of a movement from one equilibrium price to a new higher or lower price. It must be underscored that chartists are overwhelmingly concerned with detecting the onset of a change in the supply and demand of a stock (or other investment) so that they can benefit from the price changes associated with finding a new equilibrium.

HISTORY AND BACKGROUND

Technical analysis is, perhaps, the oldest form of security analysis. It is believed that the first technical analysis occurred in 17th century Japan, where analysts used charts to plot price changes in rice. Indeed, many present-day Japanese analysts still rely on technical analysis to forecast prices in their stock exchange, which is the second largest in the world. In the United States, technical analysis has been used for more than 100 years. This form of analysis was especially helpful at the turn of the century when financial statements were not commonly available to investors.

In recent years, the ever-increasing use of personal computers has led to substantial growth in technical analysis, and numerous software packages have been developed to meet these increased needs. Thus, technical analysis can be applied not only to stocks and their markets but also to bonds, commodities, fixed-income markets, industries within markets, and currencies. Moreover, one of the most popular current applications of technical analysis is for futures derivatives.

TRADING RULES

Technical analysts rely on many rules, often using several at once when deciding whether to buy, sell, or do nothing with an investment. Some of the best-known rules are contrary opinion rules, rules that follow sophisticated investors, and rules that follow the market prices and volume. As with other types of forecasting, however, these rules can be interpreted in a variety of ways, leading to a variety of forecasts using the same information.

The first type, contrary opinion rules, maintains that the majority of investors are incorrect about stock decisions most of the time, but especially at market highs and lows. Thus, when the majority of investors are very bearish, a chartist using this rule would say that it is a good time to buy; conversely, when the majority of investors are bullish, the contrary opinion rule would dictate that selling is the best course of action. A specific example of a contrary rule is the odd-lot theory. In this theory, analysts watch transactions involving amounts less than a round lot (usually 100 shares) called an odd lot. Because this theory contends that small investors are usually wrong in forecasting pricing peaks and troughs, analysts recommend doing the opposite of those actions taken by people purchasing odd lots.

In addition to contrary rules, some chartists follow the activities of investors that they consider smart and savvy. An indicator of such activities is Barron's confidence index, which is a bond index comparing Barron's average yield on ten high-grade corporate bonds to the average yield of 40 average bonds on the Dow Jones. This comparison results in a ratio that should never exceed 100 because the 10 high-grade bonds on the numerator should always a have lower average yield than the average bonds on the denominator. In bullish markets, investors tend to take increased risks and buy lower-quality bonds to reap the higher yields; doing this eventually decreases the low-quality yields and, thus, the ratio increases. Conversely, when investors are bearish, they buy safer, high-quality bonds forcing their yield still lower, and the ratio decreases. While this indicator has merit, it can give analysts false information because it is solely based on the demand for bonds and in no way accounts for fluctuations in their supply. If the bond supply suddenly changes, their subsequent yields will also change with little regard to investor preference.

In addition to using some of the above rules, chartists often take into account stock prices and trading volume when making their purchasing decisions. The Dow theory asserts that stock prices move in three different fashions: (1) major, longer-term trends; (2) intermediate trends; and (3) short-run movements. When analyzing stock prices, chartists try to discern which way the long-term pricing trends are heading, realizing that there will be short-lived trends in the opposite direction. In addition to having an interest in stock price changes, chartists are also interested in stocks' trading volumes relative to their normal trading volumes. While a change in stock price indicates the net effect of trading activity, it gives no information on how widespread the public interest is about the stock. Thus, if a stock price increases in an environment of heavy trading and then has a setback in lighter trading, chartists would probably still view it as a bullish stock, thinking that only a few investors were selling to make a profit.

Technical analysts also use the breadth of market measure to influence their decisions. This is a measure that compares the number of stocks that have increased in price, the number that have decreased, and the number that have remained stable. Similarly, the advance-decline series is an aggregated examination of the net stocks gaining and declining each day.

ADVANTAGES AND DISADVANTAGES

As stated earlier, technical analysts make decisions by examining market and security trends with little regard to the cause of those trends. Conversely, fundamental analysts make their decisions by relying on accurate information about companies and markets before it becomes available to the general public. Because technical analysts do not believe that it is possible to receive and process this information quickly enough, many of the advantages relating to technical analysis correspond directly with the disadvantages of fundamental analysis.

For example, to project risks and future returns, fundamental analysts depend heavily on financial statements for information on a company's or industry's past performance. Technical analysts believe that there are inherent shortcomings in relying on these statements. First, the incredible variety of accounting methods makes it difficult to compare firms within the same industry and almost impossible to compare those in different industries. Second, financial statements do not contain all of the information that investors need to make sound decisions, such as information on sales of specific products or on the firm's customers. Finally, financial statements do not include any psychological aspects, such as goodwill, that influence stock prices. By observing patterns and information derived by the stock market itself, technical analysts avoid the trappings that often snare fundamental analysts.

In an efficient market, prices quickly and fully reflect all available information. Therefore, technical analysis can work only if security markets are in some way inefficient. Numerous studies testing the efficacy of simple technical trading rules have failed to provide compelling evidence of superiority over a simple buy-and-hold strategy. More recent studies suggest, however, that small benefits can be gleaned from more complex technical trading rules. Yet, past pricing patterns are not always repeated in the future. A forecasting technique can work for a time but later miss a major market turn. Another disadvantage of technical analysis is that pricing forecasts can be self-fulfilling prophesies. Thus, if a stock price is predicted to increase when it passes a given price, it sometimes will do so purely because people will buy the stock at the threshold price, expecting it to continue to increase. In this situation, the stock price typically returns to its real equilibrium value at a later time. A final problem is that there is a great deal of subjective judgment involved in making predictions. Two analysts can look at the same pricing history and arrive at very different pricing projections.

Technical analysis is a method of forecasting security prices by examining past price movements and other observable indicators of market activity. This technique rejects the more conventional mode of fundamental valuation based on financial statements. Technical analysis also requires a lack of efficiency in the pricing process although many studies indicate that major security markets are highly, if not perfectly, efficient.

[ Kathryn Snavely.

updated by Paul Bolster ]

FURTHER READING:

Argenti, Paul A. The Portable MBA Desk Reference. New York: Wiley, 1994.

DeMark, Thomas R. The New Science of Technical Analysis. New York: Wiley, 1994.

Downes, John, and Jordan Elliot Goodman. Barron's Finance and Investment Handbook. 2nd ed. New York: Barron's, 1987.

Fabozzi, Frank J. Investment Management. 2nd ed. Upper Saddle River, NJ: Prentice-Hall, 1999.

Reilly, Frank K. and Keith Brown. Investment Analysis and Portfolio Management. 5th ed. Fort Worth, TX: Dryden Press, 1997.