It's Not Prices; It's People - Some Final Words on Technical Analysis (2)

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As I wrote in the last blog, market action is really people action.

In his book, A Random Walk Down Wall Street, Professor Malkiel summed up technical analysis as follows:

Most chartists believe that the market is only 10 percent logical and 90 percent psychological.  They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave.  Charts, of course, tell only what the other players have been doing in the past.  The chartist's hope, however, is that a careful study of what the other players are doing will shed light on what the crowd is likely to do in the future.*

Conversely, he felt that fundamental analysts believe the market to be 90 percent logical and 10 percent psychological (or emotional).  It is interesting that Professor Malkiel refers to the stock market as "the investment game" and to the people trading and investing in it as "players."  With a nod to Gustave Le Bon, he also refers to them as "the crowd."

In  the book, The Money Game, the author, writing under the pseudonym Adam Smith, marveled at the fact that the very famous and controversial economist, John Maynard Keynes, also referred to investing as a game.  While teaching economics at Cambridge, Keynes successfully invested for himself and the school, supposedly only devoting half an hour a day to the task.  In his famous economic text, The General Theory of Employment, Interest and Money published in 1936, Professor Keynes described investing in a number of ways, all based on the idea that the successful investor is one who outwits the crowd.  He likened investing to party games:

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years does not even require gulls amongst the public to feed the maws of the professional;--it can be played by professionals amongst themselves.....For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs--a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops.**

Keynes went on to compare investing with a popular newspaper contest of his time.  The object of the competition was to pick out the prettiest faces from hundreds of photographs with the prize going to the contestant who picked the faces also preferred by the entrants as a group.  As Professor Keynes pointed out, the person picking the six prettiest had to decide which faces the group at large would choose when each of them is competing in the same way.  He described the problem as follows:

It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.  We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be.  And there are some, I believe, who practice the fourth, fifth and higher degrees.**

This is the essence of technical analysis.  Indeed, the goal of technical analysis is learning from charts what the people in the market have been doing previously (maybe just yesterday) with an eye to anticipating their next moves.  The chartist's strategy is to take a trading position in a stock which appears most likely to either increase or decrease in price, thereby netting a profit ahead of the investing crowd.  Yes, it is possible to make money on a stock in decline; what is called "shorting" a stock.  This is a trading tactic we will explore in greater detail in a future blog.  We will also discuss two of technical analysis' offspring in the future: market timing and momentum trading.  However, we have finished our exploration of this trading strategy for now.

* The material from A Random Walk Down Wall Street by Burton G. Malkiel, copyright 1999, 1996, 1990, 1985, 1981, 1975, 1973 by W.W. Norton & Company, Inc. is used with permission of W.W. Norton & Company, Inc.

** Excerpts from The General Theory of Employment, Interest and Money, John Maynard Keynes, copyright 1936, republished in the Great Minds Series by Prometheus Books 1997, pages 155-156

Comments are always welcome.