How much does technical analysis matter on the buy side?

By September 7, 2016Investment Process
stock market

Ben Graham once said that in the short-run, the market is a voting machine; in the long-run, the market is a weighing machine.

Technical analysis helps you think about how the market votes in the short-run. In practice, technical analysis is used by momentum and growth funds that look at short-term trends, while value investors are focused on the long-term valuation of the business and don’t use technical analysis.

One inherent assumption in technical analysis is that market herd behavior drives stock performance more so than the intrinsic valuation. Price charts can give investors insight into market behavior and predict how stocks move going forward. Technical analysis and behavioral finance are intertwined, and in the short-term, the market does move with a herd mentality.

You see this particularly in high growth sectors like internet and biotech, where positive or negative momentum can persistent for some time. For example, prior to LinkedIn’s sale to Microsoft, the stock’s performance is difficult to explain in terms of cash flow yield or P/E, but was rather driven by the sentiment of its user growth and ability to monetize the user base.

Value investors on the other hand, tend to have longer-term investment horizons of 3 – 5 years. The market becomes a weighing machine over the long-run. The intrinsic value of a stock drives its performance in the long-term, which more than offset behavioral influence. Therefore, fundamental valuation is key to value investing rather than technical analysis.

John Murphy is a well-known figure in technical analysis. For those interested, I recommend his book Technical Analysis of the Financial Markets:

https://www.amazon.com/Technical-Analysis-Financial-Markets-Comprehensive/dp/0735200661

Author Buyside Focus

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