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Reading Tea Leaves

Jonathan Clements

BURTON MALKIEL, in his bestseller A Random Walk Down Wall Street, recounts showing a stock chart to a friend who was a devotee of technical analysis.

“What is this company?” the friend asked Malkiel. “We’ve got to buy immediately. This pattern’s a classic. There’s no question the stock will be up 15 points next week.”

Problem is, the chart that Malkiel shared wasn’t that of an actual stock. Instead, it was the result of flipping a coin and then assuming the share price rose or fell each day depending on whether the coin came up heads or tails. In other words, the “stock” truly had followed a random walk.

Malkiel’s book—which was first published in 1973—devotes a fair amount of time to debunking technical analysis, which might surprise today’s readers. But back then, technical analysis was widely used. Even Warren Buffett, in his youth, used to chart stocks. “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer,” he’s reported to have said.

So why am I writing about technical analysis? It seems this nonsense never entirely went away. Exhibit A: cryptocurrencies. Whether it’s trading platform Gemini, data firm CoinMarketCap, charting platform TradingView, researchers Investtech or countless other places, there’s endless blathering about Fibonacci ratios, stochastic oscillators and moving average convergence-divergence indicators.

The obvious question: If technical analysis doesn’t work, why do so many folks still use it? I think there are three key reasons. First, we’re hardwired to search for patterns—an instinct we inherited from our hunter-gatherer ancestors—and technical analysis appeals to that instinct. Even those who have never heard of technical analysis often imagine they see patterns in market movements and then bet their money accordingly.

Second, we hunger for a sense of control. Because financial markets are driven by news—which, by definition, isn’t known ahead of time—short-term price movements will always be unpredictable. But for many, that’s an unpalatable thought, so they grasp at ways to divine the future, whether it’s technical analysis, the Fed Model, a Wall Street strategist’s musings or some other gibberish.

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To be sure, with bonds and stocks, we can get some reasonable handle on their fundamental value. How? We can look at the cash these investments will likely return to owners in the years ahead, and then calculate how much these income streams are worth in today’s dollars. This won’t tell us whether the next move for a particular stock or bond is up or down, but it can give us confidence that we own something of value.

That brings me to the third reason I believe technical analysis remains so popular. For investments that don’t kick off a stream of income and never will—and hence there’s no way to calculate a fundamental value—technical analysis is all that’s left. Holders of stuff like bitcoin and gold are stuck looking at their charts and asking, “Is there any reason to imagine the price will rise, so I can unload this turkey at a profit to some greater fool?”

To be fair, even stock investors often fall back on this mode of thinking. They ignore a stock’s fundamental value—or perhaps don’t even appreciate it exists—and instead think like technical analysts, extrapolating price gains, expecting reversals, seeing ceilings to a stock’s rise or imagining there’s a support level below which the market won’t fall. This sort of thinking infects much of the market commentary we hear on TV and read in the news media. But it’s all nonsense, and it can lead us to make foolish short-term decisions that torpedo our long-run results.

The value of corporations—and hence their shares—lies in their earnings, which then allow these companies to return cash to shareholders by paying dividends and buying back shares. If you’re a stock investor, that’s what you should focus on, because that’s what matters. Analysts at S&P Dow Jones expect reported corporate earnings to rise an astonishing 97% in 2021, as company profits rebound from last year’s economic shutdown, and another 8% in 2022. Earnings growth is the reason you want to own stocks—and that’s what’ll drive long-term share price gains.

What about bitcoin and ethereum? For all I know, they’ll also climb in price. But given that they have no fundamental value, I couldn’t possibly tell you why. The moving average convergence-divergence indicator, perhaps?

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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Ormode
Ormode
1 month ago

However, actually analyzing the financials, business processes, and management quality of companies actually works…..in the very, very, very long run.

Gary Palmer
Gary Palmer
1 month ago

Crypto currency has value, as a unit of exchange, simply and only because someone else has agreed to accept it, until they don’t.

Roboticus Aquarius
Roboticus Aquarius
1 month ago
Reply to  Gary Palmer

Just like any fiat currency. People on Twitter like to claim that “BTC solves this” about everything from inflation to money supply/demand imbalances. Of course the plain truth is that it solves nothing.

I suspect it will hit $100,000 well before it hits $0…. but also suspect it will hit $0 in a decade or two. Innovative as bitcoin is, there will be other solutions that better suit the requirements of actual currency.

Ben Rodriguez
Ben Rodriguez
1 month ago

Malkiel’s defenestration of the chartists was my favorite part of that book. I can’t believe they’re real.

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