How “Financial Voodoo” Can Protect Your Portfolio
Technical analysis has long been one of two major disciplines used to guide investment decisions, yet many within the financial community heavily criticize the approach. At the extreme, financial analysts dismiss the discipline entirely, portraying its techniques as little more than “financial voodoo.” Like any discipline, technical analysis has its limitations. We find, however, that technical indicators play a critical role in a disciplined approach to protecting investment portfolios.
Conceptual Basis for Technical Market Analysis
To gauge broad market trends, fundamental analysts focus on the economy and the factors that affect its growth. In brief, they attempt to determine the direction and the pace of economic and earnings growth.
Technical analysts evaluate how investors are responding to those fundamental drivers by evaluating patterns of market movement. Steady and rising investor enthusiasm creates patterns that differ from those created by growing caution or outright fear. That helps reveal whether market trends will continue or if a change of direction is more likely.
There are reasons to believe market reactions reflect a wisdom that is not available through other sources. Psychologists have shown that group decisions often outperform even the best individual within a group. Under the right conditions, markets also reflect the wisdom of groups. Millions of investors base decisions to buy and sell on what they see in the economy, allowing markets to reflect information that may not otherwise be apparent. That gives technical indicators a very broad base to forecast market trends.
Analyzed data going back to 1980 confirmed that technical information has predicted market movements.
- When technical conditions deteriorated significantly bear market declines of 20% or greater occurred within the next twelve months 32% of the time and declines of 10 to 20% occurred another 27% of the time.
- When technical trends remained strong, however, bear market declines occurred less than 2% of the time, with less than a 7% chance of a 10 to 20% selloff.
Ardent technical advocates contend that technical warnings provide actionable signals earlier than fundamental indicators can. For the most part, though, the economic and technical indicators we tested provided tactical alerts at about the same point in the major market declines that occurred. One exception was in 1987, where technical measures were clearly superior. Market breadth weakened significantly as the Fed started tightening monetary policy ahead of the 33% market decline that occurred over three months, but there was no meaningful economic slowing before that market collapse. Because the Fed eased back on their tightening when the market fell, they may have prevented economic decline that otherwise would have occurred. Whatever the reason, the technical information predicted a market decline that the economic measures missed.
While technical reactions may reflect wisdom unavailable from other sources, they are not infallible. The history of financial markets is filled with examples of asset bubbles and crashes that investors could have avoided by resisting the prevailing trends.
Technical signals can also be “overly predictive.” While our research showed that technical information accurately forecast the major bear markets that occurred, the indicators gave over twice as many false signals as accurate ones. Investors have several options for dealing with false tactical allocation calls. First, investors can simply consider them an unavoidable cost of doing business. Incorrect calls would almost certainly erode the value of correct calls, but that cost should not exceed the value created by correctly anticipating bear markets.
Alternatively, errors in individual measures can sometimes be eliminated by comparing alternative measures of the same conceptual factor. The overlap in a set of measures should reflect the common underlying factor being measured, while variation restricted to individual measures is more likely to reflect error that should be ignored. If economic and market deterioration both reflect the erosion of conditions that lead to major market declines, comparing the two types of measures should clarify the risk of selloffs.
On their own, economic and technical indicators each had about the same number of false signals. Aligning the two, however, eliminated 80% of the false signals in both types of information. The accuracy and timeliness of the signals were not affected, but the error was significantly reduced.
Getting Tactical with Technical Information
Clearly, it is a mistake to dismiss the usefulness of technical analysis. If anything, technical measures seem a little more sensitive to the risk of market declines than economic measures. Moreover, it appears that investors can make far better tactical allocation decisions if they consider both fundamental and technical information.
At this point, favorable technical and economic readings indicate only a modest chance of a major downturn. As long as those indicators remain constructive, our work suggests that the current equity bull market should still have room to run.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.