By Steve Tepper, CFP®, MBA
Let’s take a very quick quiz. Look at the following two stock charts one at a time—wait, no peeking! And within three seconds give your first impression of where you think the stock is heading. These are actual graphs of one stock’s recent price.
Here’s Graph #1:
That’s a very big price rise in a very short time—just a few weeks. Where’s it going next? Quick! Your three seconds are up!
OK, hold that answer for a second and let’s do one more. Try Graph #2:
A big drop in price in just as short a period. What next? One, two, three. Time’s up!
If you’re like most investors, you saw in Graph #1 a stock that has rallied hard, rocketed up, hit a peak, and is poised to fall off a cliff. In Graph #2, you probably saw a stock that has fallen in price below its most recent low price and is likely to plummet from there.
So what we just did was called technical analysis. A very simple form of technical analysis, but technical analysis nonetheless. Without knowing or caring what the company is or what the market conditions are, we just looked at charts of stock prices and used them to try to determine what the stock price will be in the future.
Can that work? Sure! Does it always work? Of course not! Does it work enough to make money consistently if used as an investment strategy? We have found no evidence it does.
In this particular, admittedly cherry-picked case, it would have been a “less than successful” strategy. Both of these mini graphs are clipped from the last two years of returns for Amazon stock. Here’s the full graph, from Yahoo Finance, with the mini graphs highlighted:
Graph #1 is from the beginning of the chart at the start of 2020, when Amazon shares were selling at bargain-basement prices around $1,750 per share. By April, with the whole country shopping from home, the price shot up to around $2,400. Was that a cliff? Nope. As much as it looked like one in the breakout clip, the stock continued to rally, and by August, the price was up about $1,000 per share from that perceived peak in April.
The second graph comes from the beginning of 2021. The price zigzagged a bit, then dropped down to around $3,000 per share. Did that signal a continued decline? Not even at all. The dip was erased in about a month, and by July, the share price was around $3,700.
Of course, it’s obvious to say as a Monday morning quarterback that betting against Amazon stock would have been a mistake the last two years. But the implication of the failure of technical analysis is pretty evident.
First, it throws away the assumption that a stock is properly priced at any given time based on all known information, trading at a level where the number of buyers and sellers is equal, and where tomorrow’s new information (unknown to us today) has the same probability of causing the stock to rise or fall.
Second, the same information can be used to justify a decision to sell or buy depending on how the analyst interprets it. Some analysts trade with the trend. They will buy into the rising price in Graph #1 and sell against the falling price of Graph #2. Other traders are contrarians: They will see a rapid movement in one direction as evidence the stock is about to move the opposite way, and so they might sell based on Graph #1 and buy based on Graph #2.
So each type of trader would end up right once and wrong once.
But for the average investor, it’s worse than that. It is easy and very tempting to look at stock market charts and see doom and gloom coming no matter what the shape of the chart or direction of the price. Rising prices can’t continue and falling prices can’t be stopped! That belief system would keep many investors out of markets altogether! And that would make long-term financial success difficult.
Disclosures: Past performance is no guarantee of future results. The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations.