Foundations of Technical Analysis

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I have referred to fundamental investors as gold miners, digging for valuable nuggets of information on a stock and technical investors as hang gliders, riding the winds of market sentiment looking to profit from a stock's updraft or downdraft in price.  Technical investors are often referred to as "chartists" since they graph the action of the market and/or individual stocks.  They study their graphs of price movement and trading volume, looking for trends which reveal where market levels or an individual stock price might go (up or down) based on past performance. 

Technical analysis is grounded in economics.  I think that it also relies, arguably, on a  basic law of physics.  It is governed by the economic law of supply and demand first described in 1767 and borrows from one of the basic tenets of physics: Sir Issac Newton's first law of motion, published in 1687.

The law of supply and demand provides a model for analyzing what affects price in a market.  The rules apply regardless of what the item is; consumer goods, commodities, food, tuition for college, airplanes or financial investments.  If demand equals supply and buyers and sellers agree on price, the market is in balance, also called economic equilibrium.  If such is not the case, the law states that there are four possible outcomes, depending on existing circumstances in a market, for the price of anything for sale:

1.  If demand for the item increases (more buyers) and the supply of the item (how many are for sale) remains unchanged, the price will rise.
2.  If demand  decreases (less buyers) and the supply is unchanged, the price will decrease.
3.  If the supply of the item increases (more for sale) and the demand (number of buyers) remains unchanged, the price will decrease.
4.  If the supply decreases (less for sale) and the demand is unchanged, the price will rise.

Sir Issac Newton (1642/1643* - 1727) remains one of the most famous physicists of all time.   Since I had to take four years of Latin in high school,  I can't resist giving you his first law of motion in its original version:

Corpus omne perseverare in statu suo quiescendi vel movendi uniformiter in directum, nisi quatenus a viribus impressis cogitur statum illum mutare.

This is the scholarly version (during Sir Newton's time) of, "A body at rest tends to stay at rest; a body in motion tends to stay in motion, until it doesn't."  Technical investors believe that a stock price, whether rising or falling, will continue in that direction for awhile.  Their goal is to buy in early on the trend and sell out before it stops.  The moment in time at which the trend stops or changes direction is called the point of inflection.

I think the technical form of investing rests on these two principles. We will continue to explore this strategy in further detail in upcoming blogs.

Comments are always welcome.

* I use two dates for Newton's birth year since England's accepted form of annual calendar changed during his lifetime.