Some Poor Indicators
Laszlo Birinyi Jr. 07.24.06
I am no fan of technical analysis, to say the least. This school of market-watching purports to forecast the direction of the overall market and of individual stocks by finding patterns among statistics like price trends. Sometimes it can be useful for predicting the paths of individual stocks, sometimes not. But when it comes to the market as a whole, the chartists (as the faith's practitioners are known) have a very bad record.
I'm revisiting this subject because at times like this--an early-2006 rally giving way to a sharp correction and a lot of fear in the air--chartists' certitudes get a lot of undeserved notice. Over the dozen years I've written this column, I've several times taken technical analysts to task for their failings. From my two-page broadside against them ( Dec. 1, 1997) to my most recent critique ( Sept. 15, 2003) they have responded with great vitriol but have never gotten around to refuting my conclusions. A recent update of my 1996 study ("The Continued Failure of Technical Analysis") found that chartists' efforts are bearing even less fruit lately.
Their bum steers abound. In the February 2003 issue of Stocks and Commodities, one report entitled "Houston, We Have a Technical Problem" warned of a prolonged bear market. Two months later, in the New York Times, another article was headlined "This Can't Be a Bull Market, There Are Two Many Bulls." The market that year was up 25%.
As I read the situation, most technicians today are unenthusiastic to downright bearish on the market. Unfortunately, their underlying rationale is extremely skimpy. In the Feb. 6 issue of Fortune one technician spied a large decline ahead because something could go wrong. Well, of course it could. This pending market collapse was not forecast because the charts said short-term rates were going to 6% or that the financial stocks all had negative patterns or something remotely tangible, even in chartist terms. It was just an off-the-top-of-the-head opinion, garbed in vague scientific terms.
Two indicators the chartists favor have limited value, in my experience: the Moving Average Convergence Divergence (MACD), which purports to identify when to trade based on comparisons of price movements, typically between 12- and 26-day spans; and Stochastics, an index that uses a five-day moving average to determine whether a stock is "overbought" or "oversold." Trouble is, the Bloomberg machine has a back-test function where you can review the results of those and six other technical indicators. We found that they don't work.
Buying the 30 Dow Jones names in mid-June 2005 and holding them until mid-June of this year would have netted you a 5.8% gain. But if you used MACD, buying and selling when it told you to, the result would be a 3% loss--before commissions. Buying and selling according to signals from Stochastics was only slightly less damaging. In some individual Dow stocks you would have fared even worse. American Express (nyse: AXP - news - people ), for example, rose 12% over that period, while buying and selling it according to MACD would have lost you 9%. Along the way you would have made 22 trades, which makes for a lot of fees.
Another indicator, the Advance-Decline (A-D) Line, has utility, of a very limited sort. The concept is pretty basic: When more stocks rise than fall on a trading day, then the market's tilt is bullish, and bearish if the opposite. The typical approach has you subtracting decliners from advancers and adding the result to a running total. It works better for individual stocks, where the running total simply counts the number of days (over the past 50 days or whatever) on which the stock was up, versus the number on which it was down.
In 1999 the market's A-D Line went down all year even as the market went up 20%. As the A-D Line treats all stocks equally, regardless of their capitalizations, it failed to capture an upward movement that was concentrated on the 33 largest S&P 500 names. And every bear market has ended with the A-D Line at its absolute low, foretelling nothing whatsoever about the next day.
I do use the A-D Line for individual stocks to see where they are trending. If an A-D Line is up and the stock has fundamental merit, I buy. I examine long- and short-term moving averages (50- and 200-day) and opt for stocks where both are continually rising for at least three months. Three that qualify now: heavy equipment maker DEERE & CO. (79, DE), offshore oil driller TRANSOCEAN (74, RIG) and conglomerate UNITED TECHNOLOGIES (62, UTX).
Chartists may venture a guess as to when the favorable trend in these stocks might end. I won't, but historically these are persistent, long-term patterns. So you don't have to watch them every day, but make it a habit to review their status regularly.
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