In the last two postings, as an introduction to my experience at the Michael Price investing seminar earlier this month, I’ve talked about the two opposing types of investors, fundamentalists and technicians. The last posting was devoted to a discussion of fundamentalism, a school of finance that uses the strategy of "buy and hold" to analyse a company’s "fundamentals," then buy quality companies and hold on to them for long periods of time. Buy-and-hold assures reliable annual returns over a long period though there will certainly be many dips, sometimes significant dips, over short periods. And it’s not even necessary to understand fundamentalism to effectively use buy-and-hold. Just choose the quality companies that have already been selected by the Dow index. What could be simpler?
Today I will discuss the flip side of the coin - the technicians.
I’ve talked extensively about the American Association of Individual Investors (AAII), an organization I belong to and whose monthly seminars I’ve been attending for ten years. The AAII scoffs at buy-and-hold. They are exclusively technicians who go strictly by the numbers. The could care less about the company’s products, management, market share, balance sheet, profits or anything else. In most cases, the only thing they know about the companies they buy are their names. This is something that would horrify a fundamentalist. But technicians don’t consider fundamentals to hold any relevance to their decisions. All they care about is the movement in the price of the stock. They spend their lives on their computers monitoring the day by day and, in some cases hour by hour, movement in the price of the stock. There are then literally hundreds of statistical factors and thousands, if not millions, of mathematical algorithms, which are programmed into their computers and which tell them in which direction the price is most likely to move. They then put in "buy" and "sell" orders accordingly.
This is the world of technical analysis, certainly not one for the timid or uneducated. These people are all techies and they live to do trades. They may start any given day with their computer delivering thousands of different companies or mutual funds into their portfolios. Then they choose some amalgam of the encylcopedic volume of statistical formulas and algorithms that are available from their mathematical warehouse and spend their days working the numbers until they narrow the field to some half dozen or so candidates that their computations tell them will be moving in some significant way in the near term, be that days, weeks, or months. Then they put in their orders, always putting in both the "buy" and the "sell" at the same time. You heard that right. If they’ve done their homework properly, they can determine not only that there will be a movement but just how big that movement will be.
Most technicians follow 50 to 100 funds or stocks at a time and may actually be invested in 30 to 50 of them. They watch them day by day, always having new candidates ready to go whenever a previously placed "sell" order kicks in. Sometimes it takes weeks or even months for a particular security to peak out and sell. But for a technician, 5 to 8 months seems to be the maximum they’ll hold on to a particular company or fund, though in some cases this can go as long as 18 months. But far more frequently, it’s a matter of weeks and there are even many a day when they buy and sell several times during that day.
In the more extreme cases, they track their holdings and do trades hour by hour and, sometimes, even minute by minute. The most extreme case in history has been in the news lately. There is a small investment company in Manhattan run by a group of math prodigies who have invented extraordinarily advanced mathematical algorithms that will literally track price movements to the nanosecond. (That’s one-millionth of a second!) They have made many millions of dollars by literally profiting a fraction of a penny here and a fraction of a penny there on millions and millions of shares in a given nanosecond. They buy at one nanosecond, then literally sell for a hundredth or even a thousandth of a penny profit just a few nanoseconds later. These math geniuses have programmed a supercomputer that makes this possible. Hundreds of thousands of trades per second all day long.
This is the most extreme application of technical analysis that has ever been used, and the company that does it was profiled on "60 Minutes" a few weeks ago. It’s a brave new world that Wall Street and securities law have not yet caught up with. There are obvious dangers. Last spring, for instance, there was some sort of a logic glitch in one of the processing chips and it caused the computers to do massive hysterical trading, selling billions of shares all at once. Computers at other brokerage firms received this data and were programmed to react so they too started hysterically selling. It caused what has since been referred to as the infamous "flash crash," a 700 point drop in the Dow in just 40 minutes. (It was all recovered.) It may have taken the Dow down to zero except that the New York Stock Exchange saw that something was very wrong and halted all trading for a few hours until they could determine what went wrong. When the investigation revealed a computer malfunction, the SEC got involved and decided a new rule was in order. Now the computers that handle the trades on the exchanges are all programmed to automatically shut down trading on any stock or fund that rises or falls 20% in five minutes.
The AAII believes passionately in technical analysis and cannot understand why anyone would trade any other way. The first thing they teach you in university finance classes is that it’s not possible to time the market, that is determine when the market is going to go up and when it is going to come down. Furthermore they teach you that those who try will likely lose everything because you’ll almost certainly be wrong most of the time. And finance professionals are required by law to strongly warn their clients against engaging in this practice. Obviously it’s not against the law to trade this way, but it is against the law not to explicitly warn clients about the folly of trying. If the client decides to go ahead and try market timing anyway, then at least his broker is off the hook. (But the truth is most market timers don’t use brokers.)
AAII passionately believes that the admonitions against market timing are a myth perpetuated by an industry that wants to keep this secret to themselves. The secret the AAII wishes to expose is that the intelligent and diligent use of technical analysis can be used to successfully time the market. They don’t mean just making timing possible, but actually reliable and consistent. They preach that any person of average intelligence can master these strategies if they only commit themselves to doing so. They preach that making trades based on a diligent analysis of the "technicals" will very reasonably produce 50 to 80 percent annual returns. Most importantly, they preach that technical analysis will allow any committed investor to avoid the downturns. And if you can do even that much, you will beat the market handily.
So they scoff at buy-and-hold because they think it’s silly to settle for 10% market returns when you can have 50 just by doing a little work. They think buy-and-hold is lazy, and because buy-and-hold assumes you’ll be riding through the troughs as well as the peaks, they also think it’s wreckless.
Of course, as I’ve said, it is my opinion that they do not really understand buy-and-hold, so strong is their devotion to the technicals that they have never done more than a superficial study of fundamentalism. If they would let me (but they will not), I could easily demonstrate quantitatively that far from being a lazy strategy, it is one that is easily as sophisticated as technical analysis if you want it to be. And far from being wreckless, it is one of the safest, most conservative, most reliable and most profitable ways to invest. I could chart them the last 150 years of the stock market and show conclusively that there hasn’t been a 15 year period, let alone a 20 year period, when the annual average wasn’t around 10%. I can show them a long list of all the high-risk aggressive mutual funds that use market timing and show them consistently that they never beat the market for long. I can show them the history of Top 10 performing mutual funds each year that use market timing and that each year the list is different, that the winner in one year will not even be on the list the next. This means that timing the market is like flipping a coin. The funds that do it successfully are not being smart, just lucky, as is proven by the fact that they cannot do it consistently. Perhaps the individual investors in the AAII will not show their results but the professionals on Wall Street by law must. If the professionals can’t do it, why should we believe that individuals can?
Those, in brief, are arguments against the use of technical analysis to time the market. There are, of course, some very good arguments in favor of it. If Warren Buffett is the king of fundamentalism, then William O’Neill, the publisher of the daily financial newspaper Investors Business Daily (IBD), is the king of technical analysis and market timing. In fact, when I first joined the AAII, I was told that their strategies were all based on the teachings of William O’Neill. Much to my surprise, except for that first meeting, I’ve never heard his name mentioned once, nor the name of the publication that has revolutionized investing for so many. He’s written a number of best-selling books detailing his methods, all of which I’ve found very intelligently written, but IBD is also the second most widely read financial media in the country, second only to the Wall Street Journal. Even more surprising, when I read him I found that he promotes technical analysis only as one of many tools available to the investor. In fact, he strongly advocates that any intelligent investor needs to use both fundamentals and technicals to make good trades. Quite the surprise that the AAII claims to base its philosophy on his.
For my next posting, I’ll talk about William O’Neill, Investors Business Daily, and the arguments in favor of technical analysis and market timing. All of this will be very important when I introduce the Michael Price strategies and FastTrack.
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