The Logic Behind Technical Analysis

Let me first say that I do not now engage in technical analysis; nor, have I ever engaged in technical analysis. I do not believe doing so would be a productive use of my time

Having said that, I do not claim technical analysis has no predictive value. In fact, I suspect it does have some predictive value. The Efficient Market Hypothesis is flawed. It is based upon the (unwritten) premise that data determines market prices. As Graham so clearly put it in “Security Analysis”:

“…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion

I’ve seen a lot of people cite this quote, without bothering to notice what’s really being said. Graham had a very broad mind, much broader than say someone like Buffett. That’s both a blessing and a curse. At several points in Security Analysis (and to a lesser extent in his other works), Graham can not help but explore an interesting topic more deeply than is strictly necessary for his primary purpose. In this case, Graham could have said what many have since interpreted him as saying: in the short run, stock prices often get out of whack; in the long run, they are governed by the intrinsic value of the underlying business. Of course, Graham didn’t say that. Instead he chose to describe the stock market in a way that should have been of great interest to economists as well as investors.

Data affects prices indirectly. The market is a lot like a fun house mirror. The resulting reflection is caused in part by the original data, but that does not mean the reflection is an accurate representation of the original data. To take this metaphor a step further, the Efficient Market Hypothesis is based on the idea that the original image acts on the mirror to create the reflection. It does not recognize the unpleasant truth that one can interpret the same process in a very different way. One could say it is the mirror that acts on the original image to create the reflection. In fact, that is often how we interpret the process. We say an object is reflected in a mirror. We rarely use the active “an object reflects in a mirror”.

For some reason, when we talk about the market we like to use inappropriate metaphors. We talk about wealth being destroyed when prices fall. Yet, no one talks of wealth being destroyed when the price of some product falls. When the market rises, we talk about buyers, as if there wasn’t a seller on the other side of the trade. Above all else, we talk about “the market” not as a mere aggregation of trades, but as some sort of object all its own.

The Efficient Market Hypothesis does not recognize the true importance of interpretation. Saying that data (publicly available information) acts on market prices omits the key step. After all, the same data is available to every blackjack player. Casinos just don’t like the way a card counter interprets that data.

The Efficient Market Hypothesis is not the only argument against technical analysis. There is also empirical evidence that questions the utility of technical analysis. However, empirical evidence alone is not sufficient to prove technical analysis has no predictive power. If most knuckleball pitchers had limited success, the knuckleball might be an inherently ineffective pitch, or there might be a better way to throw it. The same is true of technical analysis.

The adjective “random” is a very strange word. Although it is rarely the definition given, the most appropriate definition for random would have to be “having no discernible pattern”. The word discernible can not be omitted. If it is, we will take too high a view of science and statistics. There’s a great introduction to economics written by Carl Menger which begins:

“All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary. Human progress has no tendency to cast it in doubt, but rather the effect of confirming it and of always further widening knowledge of the scope of its validity.”

All things are subject to the law of cause and effect; therefore, nothing is truly random. A caused event must have a pattern – though that pattern needn’t be discernible. Even if one argued there is such a thing as an uncaused event, who would argue that stock price movements are uncaused? We know that they are caused by buying and selling. Stock prices are the effects of purposeful human actions. Several sciences study the causes of purposeful human action; so, it would be hard to argue any human action is uncaused. Furthermore, each of our own internal mental experiences suggests that our purposeful actions have very definite causes. We also know that the actions of some market participants are based in part on price movements. Many investors will admit as much. They may be lying. But, there is plenty of evidence to suggest they aren’t.

If the actions of investors cause price movements, and past price movements are a partial cause of the actions of investors, then past price movements must partially cause future price movements.

Technical analysis is logically valid. Not only is it possible that some form of technical analysis might have predictive power; I would argue it necessarily follows from the above assumptions that some form of technical analysis must have predictive power.

So, why don’t I use technical analysis? I believe fundamental analysis is a far more powerful too. In fact, I believe fundamental analysis is so much more powerful that one ought not to spend any time on technical analysis that could instead be spent on fundamental analysis. I also believe there is more than enough fundamental analysis to keep an investor occupied; so, he shouldn’t devote any time to technical analysis. Personally, I feel I am much better suited to fundamental analysis than I am to technical analysis. Of course, there is no reason why this argument should hold any weight with you. I also believe there is sufficient empirical evidence to support the idea that fundamental analysis is a far more powerful tool than technical analysis.

Even though I believe there must be some form of technical analysis that does have predictive power, the mental model of investing which I have constructed does not allow for such a form of technical analysis. In other words: logically, there must be an effective form of technical analysis, but practically, I pretend there isn’t.

Why? Because I believe that’s the most useful model. One should adopt the most useful model not the most honest model. I’m willing to pretend technical analysis does not work, even though I know some form of it must work.

Really, this isn’t all that strange. In science, I’m willing to pretend there are random events, even though I know there must not be random events. In math, I’m willing to pretend zero is a number, even though I know it must not be a number. A model with random events is useful. In most circumstances, a refusal to allow for random events would be harmful rather than helpful. The model with random events is simpler and more workable. The situation is much the same with zero. It isn’t a number. To include zero as a number, you would have to put aside the principles of arithmetic. So, we don’t do that. In school, you were taught that zero is a number, but that there are certain things you must never do with zero. You accepted that, because it was a simple, workable model.

I propose you do much the same in the case of technical analysis. You should recognize the logical validity of technical analysis, but create a mental model of investing in which technical analysis has no utility whatsoever

The ABCs Of Stock Options

As a performance incentive many companies are starting to offer employees the “option” to buy company stock as a part of their compensation packages. These “options” are referred to as stock options and they provide a unique opportunity for an employee to potentially increase his or her wealth along side company shareholders. The employee receiving company stock options should have a good understanding of the characteristics of the different types of stock options in order to maximize their potential benefits

A stock option is a right granted by a company to an employee to purchase one or more shares of the company’s stock at a set time and predetermined purchase price. The employee benefits when the value of the company stock appreciates over and above the predetermined purchase price following the granting of the stock options, enabling the holder to purchase the company stock at a discount. There are two types of stock options: non-qualified stock options and incentive stock options.

Non-qualified stock options (NQSO) are more frequently offered to employees than Incentive Stock Options because of their flexibility and minimal requirements. NQSOs afford the employee the right to purchase a set number of employer shares at a specific, predetermined price. If the employee wishes to acquire the employer stock then he or she will exercise the option and purchase the employer stock at the predetermined (exercise) price. If the stock’s value has appreciated over and above the predetermined price the employee has received the benefit of acquiring the stock at a discount. The difference between the exercise price and the market value (commonly referred to as the bargain element) will be taxable income to the employee as ordinary income, potentially as high as 35%.

The other type of stock option is the Incentive Stock Option (ISO). In direct contrast to a nonqualified stock option, there is no income tax consequence when an employee exercisers the option to buy the employer stock. The difference between the exercise price and the market value (bargain element) is only taxable upon the ultimate sale of the employer stock. In other words, a gain is only recognized when the employer stock is sold and not when the option is exercised. If the stock is held the appropriate time period before being sold, all the gains recognized may qualify for long-term capital gains treatment, a maximum rate of 15%.

Being able to take part in an ISO program allows an employee to receive a number of tax saving benefits. But with these tax benefits comes added complexity to keep track of and to understand. For example, to qualify for the favorable long-term capital gain taxation, the employee must hold the stock for at least two years from the date the ISO was granted and for at least one year from the date the option was exercised. This is commonly referred to as the “2 year / 1 year rule”. If the employee sells the stock before these requirements are met, gain on the stock is taxed as ordinary income in the year of the sale, essentially converting the ISO to a non-qualified stock option.

An additional complexity of an ISO that should be kept in mind by the employee is the potential for an alternative minimum tax (AMT) consequence upon exercise of an ISO. For this and other reasons, it remains important to work with your financial advisor and tax professional when evaluating the strategies to take full advantage of the opportunities and benefits of stock options

Understanding The Stock Market

Many people look to the stock market to enhance their hard-earned money more and more each year. Some people are not even aware of their investments, because they can come in the form of pensions with their place of employment. The company invests this money in efforts to increase your retirement funds. In order to fully understand what is happening with your money, you should understand how the investments work

The stock market is an avenue for investors who want to sell or buy stocks, shares or other things like government bonds. Within the United Kingdom, the major stock market in this area is LSE (London Stock Exchange. Every day a list is produced that includes indexes or companies and how they are performing on the market. An index will be compromised of a special list of certain companies, for example, within the UK; the FTSE 100 is the most popular index. The Financial Times Stock Exchange dictates the average overall performance of 100 of the largest companies with in the UK that are listed on the stock market.

A share is a small portion of a PIC (public limited company), owning one of these shares will give you many rights. For example, you will gain a portion of the profits and growth that the company experiences, additionally you will obtain occasional accounts and reports from the chosen company. Another exciting feature of owning a share of a company is the fact that you are given the right to vote in various aspects of what happens with the company

Once you purchase a share of a company you will receive something called a share certificate, this will be your proof of ownership. This certificate will contain the total value of the share, this will likely not be the price that is listed upon the exchange and is specifically for reasons of a legal matter. This will not affect the current value the share currently holds on the market.

Typically, as a shareholder, you will receive your profit in the form of a dividend; these are paid on a twice per year basis. The way this works is if the company makes a profit, you will as well and on the opposite end of this spectrum if they do not make a profit, neither will you. If a company does extremely well their value increases, which means the value of the share you own will as well. If you should decide to sell your share, you will only benefit from it, if the company has experienced growth

Basics of Stock Market

Financial markets provide their participants with the most favorable conditions for purchase/sale of financial instruments they have inside. Their major functions are: guaranteeing liquidity, forming assets prices within establishing proposition and demand and decreasing of operational expenses, incurred by the participants of the market

Financial market comprises variety of instruments, hence its functioning totally depends on instruments held. Usually it can be classified according to the type of financial instruments and according to the terms of instruments’ paying-off.

From the point of different types of instruments held the market can be divided into the one of promissory notes and the one of securities (stock market). The first one contains promissory instruments with the right for its owners to get some fixed amount of money in future and is called the market of promissory notes, while the latter binds the issuer to pay a certain amount of money according to the return received after paying-off all the promissory notes and is called stock market. There are also types of securities referring to both categories as, e.g., preference shares and converted bonds. They are also called the instruments with fixed return.

Another classification is due to paying-off terms of instruments. These are: market of assets with high liquidity (money market) and market of capital. The first one refers to the market of short-term promissory notes with assets age up to 12 months. The second one refers to the market of long-term promissory notes with instruments age surpasses 12 months. This classification can be referred to the bond market only as its instruments have fixed expiry date, while the stock market’s not.

Now we are turning to the stock market.

As it was mentioned before, ordinary shares’ purchasers typically invest their funds into the company-issuer and become its owners. Their weight in the process of making decisions in the company depends on the number of shares he/she possesses. Due to the financial experience of the company, its part in the market and future potential shares can be divided into several groups.

1. Blue Chips

Shares of large companies with a long record of profit growth, annual return over $4 billion, large capitalization and constancy in paying-off dividends are referred to as blue chips.

2. Growth Stocks

Shares of such company grow faster; its managers typically pursue the policy of reinvestment of revenue into further development and modernization of the company. These companies rarely pay dividends and in case they do the dividends are minimal as compared with other companies.

3. Income Stocks

Income stocks are the stocks of companies with high and stable earnings that pay high dividends to the shareholders. The shares of such companies usually use mutual funds in the plans for middle-aged and elderly people.

4. Defensive Stocks

These are the stocks whose prices stay stable when the market declines, do well during recessions and are able to minimize risks. They perform perfect when the market turns sour and are in requisition during economic boom.

These categories are widely spread in mutual funds, thus for better understanding investment process it is useful to keep in mind this division

Shares can be issued both within the country and abroad. In case a company wants to issue its shares abroad it can use American Depositary Receipts (ADRs). ADRs are usually issued by the American banks and point at shareholders’ right to possess the shares of a foreign company under the asset management of a bank. Each ADR signals of one or more shares possession.

When operating with shares, aside of purchase/sale ratio profits, you can also quarterly receive dividends. They depend on: type of share, financial state of the company, shares category etc.

Ordinary shares do not guarantee paying-off dividends. Dividends of a company depend on its profitability and spare cash. Dividends differ from each other as they are to be paid in a different period of time, with the possibility of being higher as well as lower. There are periods when companies do not pay dividends at all, mostly when a company is in a financial distress or in case executives decide to reinvest income into the development of the business. While calculating acceptable share price, dividends are the key factor

Price of ordinary share is determined by three main factors: annual dividends rate, dividends growth rate and discount rate. The latter is also called a required income rate. The company with the high risks level is expected to have high required income rate. The higher cash flow the higher share prices and versus. This interdependence determines assets value. Below we will touch upon the division of share prices estimating in three possible cases with regard to dividends.

While purchasing shares, aside of risks and dividends analysis, it is absolutely important to examine company carefully as for its profit/loss accounting, balance, cash flows, distribution of profits between its shareholders, managers’ and executives’ wages etc. Only when you are sure of all the ins and outs of a company, you can easily buy or sell shares. If you are not confident of the information, it is more advisable not to hold shares for a long time (especially before financial accounting published)