The Limitations of Technical Analysis

By Kenneth Robson on May 21, 2017 • ( 0 )

I agree that Technical Analysis is the best, probably the only discipline needed for successful trading. The incessant flow of corporate and economic news, data of a fundamental nature, and the often conflicting opinions of analysts and other financial gurus, are merely “noise” to be disregarded when it comes to planning strategies.

It matters not what market, or security is chosen. Traders must focus only on optimizing their entry and exit points by studying charts of price and volume action. To this must be added careful money management for success.

However, is this formula adequate for those of us who are Savers, not Traders, and invest in portfolios of equities for the longer, rather than the shorter term? I would argue no. Indeed Australian fund managers mostly rely on fundamental analysis in their research for stock selection.

I do not wish to belittle the value of Technical Analysis. Rather I wish to stress the importance of retail investors paying more attention to noting and acting on technical signals for adjusting their portfolios.

This post uses a monthly, and a daily candlestick chart of Australian mineral sands miner Iluka Resources, to make a few points as to the advantages and limitations of Technical Analysis for the timing of stock entries and exits

Monthly chart of ILU

ILU Mnthly May 17

In the second half of 2011 buyer enthusiasm for the stock drove the share-price to $19, the RSI well into over-bought territory, and a crescendo of trading volume. Attention to the formation of a “Double Top” pattern might have saved many shareholders from possibly loosing more than half their capital, as the share-price collapsed well below the support-resistance level at $8 to a low of about $5.

The share-price stabilized during 2015 and 2016 and in doing so appeared to have formed an inverted head and shoulder pattern, warning of the possibility of a change in trend. In fact, an uptrend has emerged, and $8 resistance has been penetrated.

This may be bullish for Iluka’s prospects, but TA simply cannot predict how its continuing corporate story will unfurl. Charts provide a graphic display of the fluctuating balance between buyers and sellers, but can reveal nothing of the undeclared intentions of market participants.

Daily Candlestick Chart of ILU.

ILU Dy May 17

For most of the past year Iluka’s share-price was confined to a range between $6.50 and $7.70. However between 19/04/17 and 26/04/17 the share-price rose dramatically from a low of $7.25 to not quite touch $9. At this level it was over-bought on the RSI, and not surprisingly the price then fell away and formed a lower high. An important technical consideration to monitor is whether or not support at $7.70 will hold.

Such sudden trading price spikes are likely to reverse as precipitously as they appeared. Those shareholders wishing to avail themselves of the increased profit the spike affords sellers, must be ultra-quick off the mark to avoid slippage. On the other hand buyers who are enticed by the rising price to capture what they can of the rise are likely to be too late and end-up sitting on an immediate loss.

TA devotees would have noted the bearish engulfing pattern of 26/04/17 which warned of the end of the impulsive move higher, and been aware that a correctional move lower would follow. This would have been a good time for Iluka shareholders to take profit on some or all of their shares.

With the “long” moving averages (120 and 240 period averages in the chart above) created by investors rather than traders, at $7.10 and $7.40, potential buyers should look elsewhere or wait patiently for considered investors to enter and push the market higher if they are going to.

The limitations of Technical Analysis

Despite the obvious edge to investors who use technical analysis, it does have limitations of which they should be aware.

Charts may display trends but they do not explain the reasons the price has moved in the way it has. Does this matter? I believe it does. The reason may be a clue to future movement. Is a fall in a share-price due to a decline in company profitability, to economic head-winds, excessive capital raising, or market opportunism?

An important corollary consideration to remember is that while TA demonstrates the value of trending, of support and resistance, and may show whether a stock is over-bought, or over-sold, and likely to revert towards the mean, it says nothing about economic and market conditions, the quality of the management, the likelihood of gains or reverses in profitability, and the chances that new enterprises will succeed as hoped. Investors also need to take into account their risk tolerance, and charts do not rate risk.

For example it may have just been the activity of short-sellers who considered the price at $19 to be quite unrealistically high, and led to its fall from grace to $5. How can one know whether short-sellers will re-appear to take the share-price still lower? Do remember that in a falling market, rebounds should be considered an opportunity to sell, not an indication to buy.

Technical evaluation of charts, plus the Fundamental Analysis of corporate data, are twin disciplines for investing success.