In this era of elaborate scavenger hunts, hidden messages in famous paintings, and forensic thrills shown nightly on television, many people would like to play the stock market using fancy tools without knowing or caring about the facts of the companies they're investing in. Like Tom Cruise's character in Minority Report, these investors like to whiz around charts with a lot of bells and whistles to come up with moneymaking ideas.
The use of charts to determine probability has long been a part of many endeavors outside the stock market, whether predicting population trends or illustrating the weather. In the stock market charts are part of technical analysis, which is the use of historic price movements to predict future price movements.
In the 1990s, technical analysis through the use of charts became extremely popular, and charts continue to be the primary investment tool for individual investors. However, the professionals on Wall Street have only grudgingly given credence to the use of charts. The majority of professionals still consider the implementation of charts in the decision-making process to be nothing more than voodoo.
The great thing about charts, particularly during a roaring bull market, is they allow you to suspend common sense. If the chart says a stock is going higher, then the stock is going higher, no ifs, ands, or buts. Whether the stock deserves to change hands at newer and higher levels is inconsequential. In short, the chart justifies a stock being higher and so the stock goes higher. New highs beget new highs, which occur as part of a breakaway bull market anyway, but the move supports the use of charts and the charts validate the move. The roaring bull market provides the perfect symbiotic relationship. That is why so many investors and even some professionals began to incorporate charts in their decision-making processes.
The funny thing was, and still is, that few investors consider the consequences of negative chart formations when the time comes. The same folks who bought on technical breakouts didn't sell when the stock is breaking a series of key support points.
I don't blame charts for the trillions of dollars investors lose. I blame the exclusive misuse of charts—ignoring clear sell signals, eschewing fundamentals and plain old common sense. I believe charts have a role to play, albeit in conjunction with fundamental analysis, to successfully outperform in today's stock market.
Unfortunately too many individual investors are relying solely on their charts to make investment choices. It's really nuts. I actually believe that people who rely solely on charts have lost more money in the market on their own in the last 10 years than all the losses from corporate malfeasance and Wall Street's complicity combined. The interesting thing about technical analysis is that it can be really simple. Following are some of the typical pitfalls of relying only on charts for your information.
Too many people treat charts as a science, rather than art, yet many folks see different things when viewing the same chart. For me, charts give an idea of where a stock price can potentially go if a series of things happen. The thing about technical analysis is it doesn't consider the fundamentals or facts of a company. The charts can make a sloppy company with poor execution look like the greatest stock in the world, or the greatest company can look like junk on the charts.
Another problem with charts is that they're open to interpretation. There are some rules to charting, but for the most part their value lies in the eyes of the beholder. I've spoken to investors about charts that they've hit me with. The jargon and words sounded good on paper, but in the end they were using the charts as excuses to hold stocks or buy more. And yet there is no denying the uncanny coincidences of stocks to come out of certain formations and make moves that are later justified by fundamental news.
Charts tell a story about supply and demand, human behavior, and psychology. When I look at a chart, I feel like I'm looking at a history article, and history does repeat itself, although not in a fashion that can be so easily predicted. I know when the company is a young whippersnapper, and I can see when a company is going through growing pains. I can see when the stock somehow becomes a favorite of the hot money crowd and there is ridiculous speculation. Charts tell some important parts of the stock story.
I love charts, but I am also afraid of the influence charts have on investors. It pains me when people think they know the stock market because a couple of chart formations have worked for them in the past. It bothers me to no end when someone loads up on a stock armed only with the confidence that the chart looks good. I also can't believe how many times people will let moneymaking opportunities pass them by until the chart looks good.
Because there are so many people relying so much on charts, technical analysis has a greater impact than it's ever had. So monitoring charts has become a useful tool for gauging emotions and human behavior. Whether professional investors or sophisticated pundits have disdain for average individual investors and their ability to play the stock market, based on charts, there is no denying their collective influence—particularly on a short-term basis.
Remember, emotion can lead to terrible mistakes in playing the stock market. When the crowd is making those mistakes, you can use charts either to take advantage or simply to get out of the way. Of course, fundamental work supersedes technical work, but there are times when the charts are screaming that a stock is a buy, based on a breakout with strong volume, or a sell, based on serious risk.
In a nutshell, fundamental analysis tells you what to buy and technical analysis tells you when to buy.
You can make decisions based on chart patterns or signs that could help you take your emotions out of the game. Often folks will ignore internal developments that suggest a company isn't executing, is losing market share, is losing pricing power, and so on. Charts can help underscore the declining fortunes of a company. By incorporating both fundamental and technical work, you have a one-two punch that can make you see the light.
Of course, there are going to be times when the chart is saying one thing and fundamental data says another, telling you a completely different story. In this circumstance you should defer to the facts first—they tell a better story of the future than the charts, which tell a historic story, and they hint at the near-term direction of a stock.
I've spoken with many fund managers and expert investors who would never give charting any credibility in public or with their clients, but they do glance at the charts from time to time. I think they consider charts much the way many investors do, as a means to back up a hunch or investment they've already decided on. In fundamental work the numbers are the numbers. They aren't subject to vastly different interpretations (although their rationalization could be twisted).
The Bottom Line
Charts are great tools, but so is a jackhammer. Use either of these the wrong way and it's curtains. In fact, you'd be better off stubbing your foot with a jackhammer than getting caught using only charts with your real investing money. (If you are using only charts for trading, then there is less risk—but I think playing the market only as a so-called trader is a road to disaster, too.)
Charts are subordinate to fundamental research. No matter how complicated you make your chart work, please don't forget this. Charts are to be used to gauge trading range and supply and demand points, and as a proxy for the emotions of the crowd.