Numbers vs charts: The right way to boost your returns

Is technical analysis a load of old cobblers? Some investors certainly think so. Peter Lynch, the famous manager of the Magellan fund, described it as “the science of wiggles”. Warren Buffett says he came to doubt price charts’ predictive power “when I turned the chart upside down and didn't get a different answer". 

To an outsider, technical analysis – the practice of discerning patterns in market data to forecast future price moves – seems to possess some pseudo-scientific hallmarks.

For one, charting is too slippery a concept to test. As such, it would fail the philosopher of science Karl Popper’s definition of a theory. “A theory that does not present a set of conditions under which it could be considered wrong would be termed charlatanism – it would be impossible to reject otherwise,” writes Popper fan and former trader Nassim Nicholas Taleb in Fooled by Randomness.

Factor-based investing, by contrast, has been rigorously analysed. For half a century, across thousands of academic papers, the links between stock fundamentals (like price to book value, size, or returns on capital) and stock returns have been documented to death.

That’s not the same thing as saying factors can predict returns. Historically, some have exhibited statistically significant predictive powers, even if recent years have brought signs that some classic quantitative edges have thinned. But fundamentals-led investing is a broadly coherent framework, compared to the often vague and generalised rules of thumb that technical analysts champion.

Take, as an example, a favourite reference point of trend-followers: a stock’s 200-day simple moving average (SMA). If its price exceeds this average, a share is said to be in an uptrend. By clinging to this bullish indicator, it is claimed, investors can ride prices higher. As of 22 May, 79 members of the FTSE 100 were above their 200-day SMA, suggesting many fresh trades to pursue (although were this reversed, as was the case in October, investors could always follow the downtrend by going short).

But as seasoned traders will tell you, most of the time, these signals will stutter, peter out, or reverse. Despite its friendly reputation, the trend isn’t always your friend. Noisy and often chaotic markets, especially when viewed over short time horizons, turn many indicators into mirages.

Unsurprisingly, this means many investors struggle to profit from a technical approach.

One 2014 study found that individual investors using technical analysis showed a higher tendency toward short-termism, over-trading, overly concentrated portfolios and lower returns. Disclosures made by platforms offering retail investors the ability to trade in futures, options and derivatives – and which often promote the use of technical analysis tools – appear to reflect this. Some 71 per cent of retail accounts on IG Group (IGG) lose money trading spread bets and contracts for difference (CFDs), for example.

To which, the technical crowd might simply argue: they’re doing it wrong. Perhaps the fault isn’t with the method, but most traders’ application of it. After all, how many people with an IG or eToro account have a clear strategy to first find good trades, manage risk and correctly size positions, and the self-awareness and discipline to know how to cut losses and ride out winners?

They may have a point. Lots of economic activity involves cash-rich amateurs paying over the odds for professional-level products and tools that they’ll never master. To some, the notion of steering through complex markets day in, day out is appealing. It’s certainly more exciting than buy and hold. Nevertheless, at the very least, the evidence suggests technical investing is either hard to do well, or riven with survivorship bias and selective, anecdotal-based measures of its efficacy.

However, we shouldn’t be blind to the flaws in fundamental investing, either.

The discipline may have its own rules of thumb for quality or cheapness, as guides to future returns. But often, this is highly subjective. Based on its growth prospects and surging cash flow, Nvidia (US:NVDA) might be cheap, or staggeringly expensive. Confused by hindsight bias and the noise of competing narratives, it’s easy to overlook fundamentals’ inability to reliably predict short-term price movements ahead of time, even if they are the chief driver of returns in the long run.

Fund managers issue plenty of opinions about fundamentals. They contribute a lot of ‘noise’, often in the service of marketing. But over time, very few professional stockpickers manage to beat the market, and even fewer once fees are factored in. As a result, the non-technical crowd suffers from survivorship bias – via a focus on the Lynches and Buffetts – to an even greater degree.

Then there is the risk of losses. By typically focusing on the far horizon, fundamental investing must accept the prospect for ugly short-term performance. Technical analysis’ rearguard against steep market drawdowns – to cut losses as soon as they appear – is one of its great attractions.

Nor are fundamental investing’s academic credentials ironclad. Quantitative investing – which is meant to distil fundamental principles into measurable ones – has in recent years suffered from a replication crisis (although the resilient performance of the Investors’ Chronicle’s stock screens suggests this isn’t a universal phenomenon).

It isn’t only the chartists who struggle to turn yesterday’s evidence into tomorrow’s returns.

A middle ground

It should be clear to readers that Investors' Chronicle leans heavily towards fundamentals. Not only are its precepts easier to understand, communicate and scale within a portfolio, but they are more easily married to the goal of long-term wealth-building and compounding. 

But rather than take an adversarial position – or trot out all the philosophical differences between technicians and value investors – it’s worth asking how (or whether) the former might complement the latter.

Investors' Chronicle’s resident stockpicker, Simon Thompson, believes it’s possible. Although his Bargain Shares portfolios take their cues from the godfather of fundamental investing, Benjamin Graham, Simon regularly looks at technical indicators and trends to “help skew the odds of a positive outcome more heavily in my favour”.

“Ultimately, investing without assessing technical analysis is like having one arm tied behind your back,” he says. Given the option, it “should always form some part of an investor's armoury”, Simon adds, citing the huge price gains made on recent Alpha Report small-cap shares Hvivo (HVO) and Gulf Marine Services (GMS) as evidence that a stock’s price and volume can support an investment case.

For some investors, such anecdotal success stories might not cut the mustard. After all, if pattern recognition reliably points the way less than half of the time, then what real use can it have?

Charts, as a form of price information, aren’t immaterial or meaningless. If you are about to sell a house, for example, you might conclude that the market price is whatever you can get. But if you read that house prices just dropped 20 per cent in three months, it is likely to affect your decision to sell today. You’re more likely to rationalise recent falls as the product of forced selling into a credit-starved illiquid market, rather than a reflection of ‘true’ value. The psychology of the market is, in other words, part of the valuation exercise.

“Irrespective of whether you believe in technical analysis, the fact is that many investors do, so the behaviour of these market participants will have an impact on price action,” Simon adds.

Another traditional value investor who saw things similarly was Anthony Bolton, who delivered a market-beating 20 per cent annual return during his leadership of Fidelity’s Special Situations Fund (GB00B88V3X40) between 1979 and 2007. In his memoir, Investing Against the Tide, he describes himself as a fundamentalist “at heart”, while adding that were he restricted to one input for his investment decisions, it would be an “up-to-date chart book”.

Under less constrained conditions, Bolton used technical analysis as “a framework or overlay into which I put my fundamental bets on individual stocks”, particularly if they were larger and more liquid. If positive trends confirmed his view, he might have added to a position. Conversely, a contradiction might lead him to review his thesis, although Bolton also ignored charts if his convictions were strong enough. Whatever the weather, he relied on charts of fundamentals – the historic shifts in a stock’s ratios or factors – for context.

Seemingly, Bolton’s openness to technical analysis isn’t shared by the current managers of the Special Situations fund. “It’s not something Alex [Wright] and Jonathan [Winton] focus on too much,” reports a Fidelity spokesperson.

Even if they did use technical analysis, this shouldn’t be a surprise. To stay in business today – let alone attract investor cash – retail-focused equity fund managers need to deliver acceptable returns and communicate their multi-year investment process. It is far easier to both explain and invest in business trends than it is to constantly respond to short-term price trends, signals and indicators.

That’s one kind of fund management, at least. But not every large manager of capital downplays the instructiveness of price data and signals. In fact, it may be one of the most lucrative sources of alpha.

Technically, the best

On 10 May, the mathematician Jim Simons died. Though never a household name, he was also a strong contender for the title of history’s greatest money manager. As the founder of the New York-based quantitative investment firm Renaissance Technologies, he ran the firm’s flagship Medallion Fund, which generated a headline average annual return of 64 per cent in the 22 years between its launch and his retirement from day-to-day management at the start of 2010.

Such returns appear impossible. Doubly so, when you consider they were made at a lower volatility than the financial markets in which it invested. The fact that Medallion closed its doors to outside investors in 1993 and has restricted its growth by distributing profits to a now almost exclusively employee-led ownership structure, only explains so much.

Simons, who worked as a university professor and then a codebreaker for the US government before moving into finance, came to investing without pre-conceptions. Although he was deeply driven by competition and money, he saw markets as complex problems to be solved, regardless of whether the solution made sense.

Equally adept at finding like-minded geniuses from the worlds of science and maths, Simons built a team around a series of algorithms that sought statistically significant pricing patterns in seemingly chaotic markets, and repeatable short-term arbitrage opportunities to exploit them. In The Man Who Solved the Market, the reporter Gregory Zuckerman documents how Simons and his colleagues spent years profiting from the “snap-back” in shares that had suddenly experienced big price rises or drops, after discovering that retracements followed around 60 per cent of sharp market moves.

Sometimes, the fund found predictive edges in human responses to swings – regardless of how ‘rational’ these responses appeared. Simons once said, simply, that his fund made “money from the reactions people have to price moves”. In other instances, algorithms found pricing patterns that, while non-random and statistically robust, couldn’t be easily understood. According to Zuckerman, as early as 1997, more than half of the price signals they worked with were non-intuitive.

Similarly, extreme levels of investment success can be found at the trading firm Jane Street or the hedge fund Citadel, both of which have positioned themselves as market makers and intermediaries to better capture (and exploit) small statistical edges multiplied across colossal trading volume.

But where, you might well ask, is the applicability in this? After all, the fact that a few boffins can draw on machine learning and massive capital resources to secretively hunt down tiny price edges is of little use to the average retail investor.

It would be a good question. With replication essentially off the table, you’ve a better chance of singlehandedly waging an activist campaign against BP (BP.).

Rather, for fundamental investors, it is the insight that why markets behave cannot always be divined or understood, but that prices nevertheless need to be treated with deference. For every iffy claim made by the technical analysis field, there is a humility among many of its greatest practitioners that some opinionated fundamental investors can learn a lot from.

Indeed, whatever your persuasion, it is challenging to articulate exactly why a portfolio of tradeable securities performs in a certain way over a given time frame. Although we might ascribe equities’ long-term success to big-picture concepts such as “innovation”, “business competition” or “supply and demand”, the underlying complexities facing even a single business are hard to fathom. The claim that you should only invest in what you know forgets the fact that even a chief executive of the average listed company has an at-best knowledge of everything required to turn a profit.

“I think the market is incredibly efficient, but efficient at different things, depending on what you’re looking at,” says David Lundgren, a US-based fund manager who is a dual charter holder in both technical and financial analysis. “Short term, for example, fundamentals mean nothing. The market’s job in the short term is to find the price that lets in as much money as possible and at the same time as it can let out.”

If we were feeling pernickety, we might point out that understanding trends still relies on a ‘why’. Dow Theory, named after the godfather of technical analysis, Charles Dow, distinguishes primary from secondary and minor trends, each made up of their own phases. The job of technical analysis is therefore still interpretive, and therefore concerned with cause and effect. Insofar as it seeks a better answer to the investors’ question of ‘when’ to buy, it still must supply some reasoning.

Cross purposes

If these two schools of investing seem at odds, it may be because they are looking in different directions, rather than facing off.

For example, one of the technical crowd’s chief arguments against buy-and-hold fundamentalists is that the latter tacitly accept drawdowns that they might otherwise have avoided. But this often reflects an approach to risk that overlooks the difficulty of moving in and out of volatile markets, and the propensity for rebounds to follow sharp falls. Similarly, some traders decry passive equity investors for accepting the wheat and the chaff, conveniently forgetting the fact that indices’ edge lies in their exploitation of market cap-weighted relative strength, a form of momentum investing.

On the other hand, neither is it entirely fair to compare the trading of leveraged, fee-heavy and frequently volatile short-term investment products to a traditional stock portfolio. For one, although the latter can theoretically go to zero over long time periods, the former can lead to margin calls and large negative positions in short order. More importantly, they tend to aim at different targets.

Many successful traders, including those disposed towards technical analysis, are often very risk averse. Many of their assets or personal wealth is tucked away in less volatile assets, such as physical property, cash, gold, or bonds held to maturity. Others, such as futures trader and market technician Alex Spiroglou, seek to benefit from shares’ long-term upward drift by keeping a core equity holding alongside satellite-like positions no bigger than 2 per cent of the portfolio size.

So is there a way to reconcile technical analysis with a fundamentals-driven approach? Might they just be two ends of the pantomime horse we call markets?  

There are a few reasons to think so. First, what technical analysis is good at highlighting – but often fails to accurately diagnose with sufficient consistency – is the role of psychology within markets.  As John Templeton wrote, “bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria”. An appreciation of sentiment – and what it might be overweighting, forgetting or masking – matters to both those who care about price action and valuations.

Without this recognition, Spiroglou argues, fundamentals-led investors may also overlook the prospect of price swings away from a company's intrinsic value. Equally, by focusing on long-term value, fundamental analysis can fail to recognise the importance of well-timed entry and exit points on returns, or potentially lucrative short-term trading opportunities.

Third, is a heightened sense of the way trends don’t always unfold as you’d expect, whether this concerns price swings or a wide discount to net asset value (NAV). “Not all deviations from the mean result in reversion,” notes Spiroglou. “Mean reversion is grounded in statistical analysis, showing that, over long periods, prices tend to revert to the mean. However, this is probabilistic, not deterministic.”

And when it comes to results, while goals and strategies may differ, the two schools may be closer than you think. Some technical traders, for example, define the quality of a trade in terms of its risk profile, not how it performs. This isn’t dissimilar to the average buy-and-hold portfolio: ‘good’ performance, though desirable, is meaningless without a sense of the risk required to achieve it.

What’s important, as with any investment product or strategy, is to use it if it makes sense to you. Then again, it isn’t always a bad idea to follow what works, even if it doesn’t make sense.