Humans are hard-wired to find patterns in our world and assign meaning to them, often believing they give clarity about the future—in other words, we’re drawn to fortune telling. We’ve seen this over the centuries, from tea leaves and tarot cards to Paul the octopus, who predicts the outcomes of Germany’s national soccer matches. So it’s no surprise investing has developed its own form of fortune telling in technical analysis—or charting. And while this practice has legions of adherents in the investing world, we don’t believe technical analysis’s short-term predictions are reliable enough for your long-term investing strategy.
What Is Technical Analysis?
Technical analysis involves poring over historical market data and stock return charts to spot patterns. The technical analyst’s goal is to trade profitably based upon those patterns—buy when the signal says to buy and sell when the signal says to sell. Technical analysis focuses on what happened to a stock’s price, but ignores the factors that drive those price moves.
Technical indicators tend to carry either visually descriptive names like “head and shoulders” and “cup and handle,” or ominous monikers of doom like “the Hindenburg Omen.” As with most marketing, having a good name probably helps increase attention and market acceptance. Unfortunately though, clever names are not enough to overcome technical analysis’s biggest hurdles.
The Problem With Technical Analysis
Technical analysis focuses exclusively on the past. It looks at what happened to a stock’s price and uses that history to predict future movements. The problem? Stocks don’t work that way. A statistician would explain that stock prices are not serially correlated—meaning yesterday’s stock movement has no bearing on today’s or tomorrow’s. Relying solely on technical analysis is like trying to drive a car by only looking in the rearview mirror. No matter how hard you stare at what just happened, you’ll get no clues about what’s to come.
Even if someone discovered a consistently predictive technical indicator, market forces would quickly price in the measure and destroy its profitability. The indicator would essentially become useless as soon as the market determined it was reliably useful.
Your Brain Really Wants to Believe in Technical Analysis
But the human brain is a pattern-spotting machine—it’s almost too good at it. Processing logic, remembering facts and making calculations are all relatively weak brain functions—you have to force your brain to perform these tasks because they’re all relatively new chores for humans. But pattern recognition is a core capability, something the brain does essentially automatically because it’s been looking for patterns since day one.
How much easier is pattern recognition? If you’re like most people, it probably takes some conscious effort to add three-digit numbers in your head. You probably also struggle to remember your computer passwords occasionally.
But with no thinking on your part, that coffee stain on your desk looks exactly like a face and the cloud on the horizon looks like a roaring lion—a phenomenon known as pareidolia.
Finding patterns (even ones that aren’t there) is how your brain begins to make sense of the world. Pattern recognition aids learning, but your brain can’t turn it off. In his 1991 book How We Know What Isn’t So, Cornell psychologist Thomas Gilovich explains:
We are predisposed to see order, pattern, and meaning in the world, and we find randomness, chaos, and meaninglessness unsatisfying. Human nature abhors a lack of predictability and the absence of meaning. As a consequence, we tend to “see” order where there is none, and we spot meaningful patterns where only the vagaries of chance are operating.
This is why technical analysis seems to make sense. The random line of a stock’s price over time looks like it’s more than randomness. And occasionally, the pattern does coincide with its predicted outcome, which reinforces your brain’s belief that there’s a connection. But remember, even a broken clock is right twice a day.
An Example: The Death Cross
Consider the “death cross,” a technical indicator that supposedly indicates dark times ahead for the stock market—as its ominous name would imply. A death cross occurs when the plot of a stock’s or index’s 50-day moving average crosses below the line of its 200-day moving average. Proponents say the death cross shows a downturn gaining steam.
To be a profitable investing strategy, the appearance of a death cross would need to reliably signal a stock market downturn, allowing the investor to either sell and avoid losses or take a short position to profit from the fall. While it’s true that an index’s 50-day moving average would sink below its 200-day moving average during the initial stages of a bear market, this death cross could happen many other times, too, as Exhibit 1 shows.
From 1928 to 2018, S&P 500 data show 51 death crosses, but less than a third occurred as a bear market was forming. This suggests the death cross is a poor tool. Most of the time, the death-cross-following investor would have watched stocks rise not long after selling.
Exhibit 1: Death Crosses Mostly Lead Astray
If Not Technical Analysis, Then What?
Since stock prices aren’t serially correlated, investors should avoid the past-focused pitfalls of technical analysis and look forward, not backward. We believe long-term investing success means considering the fundamental backdrop to develop an appropriate investment strategy: Examine the economic and political factors that will drive business results and profitability over the long-term. This is what markets do every day—every trading day, at least.
Then you can compare what you learn with what the market has priced into stock results. The difference between reality and expectation is what drives markets, not past performance or the shape of lines on a graph.
Save the Tea Leaves for Drinking
Volatility is painful, but technical analysis isn’t a reliable tool to help you navigate it. There is no magical crystal ball—or miraculous stock-picking octopus. By staying focused on the long-term and using forward-looking fundamentals to define your investment strategy, we believe you’ll be much more likely to reach your investment goals.
Keep the tea leaves, but use them to enjoy a cup while you do your research.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
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