Saturday, June 25, 2011

Learn Technical Analysis from the experts

CNBC-TV18’s show ‘The Informed Investor’ invited two of the world's famous Technical Analysts Yamada & Roth to explain what technical analysis is and how to use them? Must read and watch for any investor or trader aspiring to learn technical analysis.

The transcript of the conversation is given below: 
Q: How do you define technical analysis for equity markets?

Roth: Technical analysis is the analysis of the supply-demand picture for stocks and markets. Technical analysis uses four kinds of indicators. It uses price and momentum indicators, sentiment indicators, supply-demand indicators and inter-market analysis. All of those indicators are used to determine the supply-demand situation and the change in the supply-demand situation for stocks and commodities or any instrument.

Q: How does this get broken up into cycles because often in technical analysis we talk about an up-cycle or a down-cycle? How does technical analysis work in terms of equity market cycles first?

Yamada: Technical analysis is a measure of the forces of supply and demand. They do have a purpose in defining the equity markets cycle. As a market is in a bull phase - what you see as we have seen over the past years is a series of higher highs followed by higher lows.
Those higher lows represent the demand - the buying that is coming in. Yes, they definitely would define the bull cycles and the bear cycles. It’s important to understand however that what are represented there are the forces of supply which would be selling into strength or demand which would be buying into weakness.

Q: Some people criticize technical analysis in that it’s a bit of an island in terms of performance and it doesn’t iron the here and now of events. How successful has technical analysis been on calling these cycles either the start of one or the end of one?

Yamada: It’s been very successful, particularly, in 2000. As we were coming into 2000 and saw the first lower low which occurred in March of 2000 we already had an enormous amount of evidence in the indicators themselves, the advance-decline line had been deteriorating for long period of time.

We also had in the stocks themselves major patterns of distribution which looked like large frowns, the patterns were showing evidence of selling into strengths. All that technical evidence came together to allow us to suggest that the 1982 to 2000 - 18 year structural bull market had come to an end.

Q: Do the tools of technical analysis work the same when you are talking about a stock versus an index. For example - would the same rule of thumb apply when you are talking about the Dow or the S&P versus when you are talking about a specific stock and where it maybe headed?

Roth: The answer is that the analysis is the same. We are trying to determine the trend, the direction of the trend and the force behind the trend. The basic difference between a particular equity and an index is since an index is an average of some number of stocks it will tend to be less volatile than an individual stock. The only real difference will be the volatility.

Q: When we went through the most recent bear market, a lot of comparisons were made with the previous bear market that the US market had seen, how it came out of there and how long the patch lasted. Does history play a great part in determining technical analysis and calling these trends on the basis of charts?

Roth: Technical analysis is all about probabilities. There is no form of analysis that doesn’t use history. One of the criticisms that we hear of technical analysis is that you are using the past to forecast the future. There is no other kind of information other than history.
So whether you are an economist or a fundamental analyst or a strategist or a technician - you are using past data, there is other kind of data. So a technician is using price data, volume data, breadth data with the notion that a trend in force will tend to persist until it’s reversed. If you believe that trends exist then you can use trends to make some forecasts. Obviously, the only way to do that is to use historical prices.

Q: The most often used term – a bull market and a bear market. Technically, how would you define both?

Yamada: The bull phase is a period of demand whether it’s a long-term structural period like 1982 to 2000. If you look at that period in history, for the Dow, all along that cycle there were higher lows put into place all the way to 2000 and that includes the cyclical or short-term bear market of 1987. It actually held above the prior low. That is how you define the bull market cycle.

The structural bear market cycles run from about 13 to 16 years historically and can have an initial phase. The first phase which we call declining phase where you do put in place lower highs and lower lows into a pivot low whether its 1974 or 2009 or 1929.
Thereafter, you get a series of cyclical shorter-term bull markets and bear markets. Cyclical bull advances, cyclical bear declines until eventually the market is ready to embark on a new sustained uptrend in which you can define the higher lows, followed by higher highs.

Q: The one thing we hear when we speak to technical analysts is something called a stop loss and target. If a stock hits your stop loss it’s time to exit. If it hits your target again it means you have made sufficient amount of money and its time to exit. How do both these terms of reference work for a trader who is using technical tools while trading?

Roth: The first thing I do when I am analysing anything is to determine what the risk is. The second thing I do is try to determine what the potential or target is. Let me just say that coming up with a target, if we are talking about an uptrend, the steepness of the trend will be one factor. The amount of accumulation or basing that occurred before that uptrend is important and overhead resistance areas if there are any.

The risk is a chart point. If I am suggesting something on the long side, the first thing I am going to do is if I am looking for a short-term trade a month or two time horizon, I am going to be looking for at least 15% potential. I am also going to be looking to contain risk to half that or less, let’s say 7%. If I look at the chart and I determine that the potential is 15 to 20% and I see a clear risk point at 7% or less, then I am going to suggest that.

If I don’t see any clear risk point I am not going to suggest the stock regardless of how much potential there is. For the risk, I am primarily concerned with a fluctuation low. The low on a reaction is the most important kind of support for dealing with a steep uptrend. The other way to determine support is the uptrend line. So breaking the uptrend line might be another way to identify risk.

But the most important kind of stop is putting it under a reaction low because if the stock stopped at a particular price and then rallied moving back below that price is going to turn the trend down. So my stop goes at the point that determines the trend.

Q: Is there any downside risk using technical analysis because the criticism seems to be that it doesn’t take into account the fundamental conditions. So a stock maybe living through a very bad patch of news say for example - poor corporate performance or some other kind of negative newsflow but technically for many people it may still be representing a break out or a stock that can actually move higher?

Roth: You have to obey the rules. It doesn’t matter to me if you are a fundamental investor or a technical trader. You have to identify the risk and you have to adhere to trading rules. You are going to make a lot of mistakes when you are trading or investing. The idea is not to lose a lot of money on the mistakes.

Over time, if you take small losses and small profits and you will have some big winners, so if you eliminate the big losers, you will do well. The most important rule is limiting risk and not losing a lot of money on the mistakes. If you adhere to that rule, you will eliminate one of the big risk factors in any kind of trading.

I would say because of that rule - you might take a small loss in a stock that turns out to be a big winner. So, you have to be willing to buyback the stocks you sold at higher prices if necessary. You take a small loss, the stock is a whipsaw, it rallies again, you have got to be willing to buy it back.

So the risk in technical analysis is getting caught on a shakeout and the stock turning around and having another big move. If you are willing to take small losses and willing to buyback the stock at a higher price, you will do all right and you will eliminate that risk.

Q: Any correlation you would say between technical analysis and market fundamentals? Does it go hand in hand when you talk about an economic downturn in a country and the fact that the stocks within that index actually start showing you breakdown patterns or start hitting 52 week lows which becomes an indication that the market is under pressure?

Yamada: You consider fundamental analysis and technical analysis as two important tools for investing. What the technical analysis shows you is what other people are doing with their money. So, yes, there is a connection in the sense that what price is doing should be reflecting what is happening in the fundamentals of the company or the entity that you are following.

Q: From the technical charts that you are looking at, which asset class looks the most bullish?

Roth: All the markets are being traded aggressively by hedge funds and there aren’t a lot of investors operating in the market. So the markets are extraordinarily linked right now. Stocks and commodities advanced together most of the time since 2009, the dollar was weak during most of that period so we have had very linked markets.
What I see right now is the possibility of a bottom forming in the dollar, its not clear, possible minor bottom. Commodity markets and the equity markets are generally in medium-term corrections and long-term uptrends. I do not see one market going up or down dramatically compared to the other markets.

Over time, stocks continue to be more attractive than fixed income markets. The major alternatives to equities are cash or short-term instruments and bonds or long-term fixed income instrument. The return on cash is practically is zero, the return on bonds is historically very low.

Over time, investors are going to move money from fixed income investments, especially, bonds into stocks. On a longer-term basis, stocks are more attractive. But that process could take several years. So, we could be in an environment where interest rates stay low, bonds don’t do much but maybe go up a little, stocks correct and then we setup a better buying opportunity for stocks. So, I believe, in the long-term stocks are more attractive, short-term stocks are more risky.

Q: For a lot of people, it’s that in-between patch where it’s neither a bear market nor a bull market, it’s that consolidation phase. How would you define the current phase for equity markets?

Yamada: Various indices are in different stages. You have some that have been in flat consolidations that would include Hong Kong and Shanghai and even Tokyo, along with the French market, the Swiss market and the Italian market. They have all been in flat ranges where the resistance is showing selling as that price is approached and the support at the moment is showing that demand comes in at that level.
The resolution of those trading ranges will be determined by which level is breached whether support gives way or whether resistance is penetrated. The US markets along with Germany are still in uptrends. So those markets have the potential here to either regain those uptrends or move up from them or potentially to breach those uptrends and begin to show increased weakness.

Q: On the medium-term outlook especially for global equity markets, everyone wants to know where the market could be headed. So on a medium-term basis where is it that you see global equity markets headed over the next six-eight months?

Yamada: It’s a difficult question but all of the equity markets globally right now have weekly or intermediate term sell signals. Those signals from a momentum perspective can occur during an extended consolidation but we are neutral to weaker in the global markets going forward with the possibility that we have more of a corrective phase ahead of us.

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