Last Updated on August 8, 2024
Value investing and technical analysis are often mistakenly seen as being at odds with one another.
After all value investing is based on a fundamental analysis of a company’s valuation as compared to the market price of the stock. Value investors look for high quality companies that are trading at a discount and a mismatch between price and value.
Technical analysis on the other hand is primarily about charts, volume data, indicators and price action. It predicts moves in price based on probabilities without consideration of value or fundamentals.
While these two approaches are at odds with one another if you use them exclusively, a fusion of approaches can actually be complementary.
I started off purely as a value investor but I have learned technical analysis over time and have improved my skills in that area. I think it has really helped me as an investor.
I would never invest solely on technical analysis. People who do that are normally prepared to invest in any asset and are guided only by the charts and the price action. This is often used by shorter term traders.
I’m still a buy and hold long term investor and fundamental analysis is my primary tool. While I’m holding, I largely try to ignore technical analysis, short term market gyrations and market commentary.
However, when it comes to buying and selling, technical analysis can help identify the best entry and exit points. In this way it can optimise the performance of a buy and hold fundamental investment strategy.
How Technical Analysis Is Useful For Long Term Value Investing
1. Technical Analysis Helps Refine Your Entry And Exit Points
Fundamental analysis can help you build a shopping list of assets that you are prepared to buy. It can also help you identify when an asset is over or undervalued.
Buying low and selling high is the aim. You don’t have to buy right at the bottom or sell right at the top to succeed as an investor. In fact no one perfectly gets in right at the top or the bottom.
However, if you rely on fundamental analysis alone, you have very little to guide you as to how close to the top or bottom you are and when the market direction might change.
Technical analysis can help you optimise your entry point.
If you can buy closer to the bottom not only will you get a slightly better entry price, you won’t have to wait for the price to potentially fall further before it begins its move up.
Trying to time the market is often seen as antithetical to value investing. But one of the biggest risks in value investing is correctly identifying an undervalued asset only to watch it fall further for a long time.
You don’t have to time the market perfectly but it makes sense to use the tools at your disposal to try and time it somewhat and seek to protect yourself from further downside.
The same is true in reverse at the top.
As value investors well know, the market can be an irrational beast. Just as assets can be extremely cheap at times, they can also be extremely expensive.
If you have bought at an undervalued price and have watched an asset rise to the point where it is overvalued, then you have done well as a value investor.
However, many value investors get spooked at the first sign of overvaluation and sell right away.
There is no shame in that, as a profit is a profit and there is no margin of safety when assets become overvalued.
Having said that, sometimes it is appropriate to let winners run deep into overvalued territory. You might sell a portion of your gains to lock in a profit and let the rest run.
Technical analysis can help you know how long to let it run, when the momentum runs out and when the trend has changed. It can help you sell closer to the top.
Understanding moving averages is particularly helpful here.
When the short term moving average is above the long term moving average then you a in a bullish trend. When the short term moving average crosses below the long term moving average that is likely an indication of a shift to a bearish trend. The same is true in reverse.
Of course short and medium term trends can change direction within a longer primary trend, so this is an imperfect indicator. Yet it can be an incredibly useful data point.
2. Technical Analysis Can Confirm Fundamental Analysis
Fundamental analysis does not concern itself with the price action of a chart. It merely tells you how an asset is valued.
But the whole thesis of value investing is that undervalued companies should revert to the mean at some point and that you can take advantage of this by buying low and selling high.
Which means, if you get your fundamental value analysis right, then the technicals should support this view at some point in the future. Eventually the charts will confirm this analysis with bullish formation.
When this occurs, it is a confirmation of your value thesis and you are vindicated.
If the technicals have not become bullish then one of two possibilities arise. Either you were wrong about your valuation and you need to reconsider. Or you were right and just need to be more patient.
In either scenario it is worth reassessing your position from time to time if you haven’t seen any upwards movement in a value investment.
If you still think you were right then be patient. If you think you were wrong, then cut your losses.
3. Technical Analysis Can Tell You What The Market Thinks
Value investing requires a contrarian mindset. You have to go against the herd if you are to pick up high quality assets trading at a discount.
The fact that assets are trading at a discount means the market is not pricing in their fair value and you have an opportunity to buy low.
Technical analysis can give you all sorts of indications about the mood of the market and whether the bulls or bears are in control of the trend.
Sentiment and trends are very useful contrarian indicators, which valuation alone cannot provide.
Buying low normally means buying at or near the end of a bearish trend, hopefully just after it has changed direction and is at the very beginning of a new bull run. This means buying into fear when bearish sentiment still dominates.
You want to disagree with the market as a value investor, but ideally near the point where sentiment changes. You don’t want to ride the market down.
As Sir John Templeton says you should try to buy at the point of maximum pessimism, when there are no more sellers, and sell at the point of maximum optimism when there are no more buyers.
The charts can help you discern this as a chart is merely a reflection of the collective psychology of the market. Technical indicators and chart patterns are a visual representation of the behaviour and emotions of participants in the market.
Studying them tells you what the market thinks which is useful when investing against the herd.
4. Charts Help To Reduce Emotion
One of the dangers of being an investor who understands hard money is that you can get emotionally attached to the performance of gold, silver and Bitcoin.
You want them to succeed and you participate in the market with these emotions.
It’s not that much different to the hype and irrationality that can happen when people get too attached their their favourite tech stock.
You can never totally remove emotion from investment and I don’t think you should try to. But you should be aware of your emotions and try to temper them and bring them under control.
Technical analysis can help with this. It can give you a lot of emotional discipline if you can look at what the chart is telling you rather than just see what you want to see.
Because wanting and willing an asset you believe in to go up in value is very different to successfully investing in it and successfully buying low and selling high.
You have to let the chart speak to you and you need to be prepared to listen and have your thinking challenged.
5. Technical Analysis Gives You Extra Data
Investing is based on the probability of future events. There is no certainty in the investing world.
Therefore it makes sense to use many different data points to help you determine the probability of those future events.
If you rely on fundamental analysis alone you limit the amount of data you are working with.
Additionally, different fundamental valuation tools can give you conflicting signals. Using technical analysis can help you determine your course of action.
Of course different technical indicators can give conflicting signals as well. It is virtually impossible to have an asset that is going to be a screaming buy on every fundamental and technical signal. So part of the skill of the investor is to discern the different signals and make a decision accordingly.
But it makes little sense to discard a whole range of useful data points because of an ideological resistance to using technical analysis.
6. Technical Analysis Can Help Identify Long Term Trends
The stereotypical view of a technical analyst is someone who looks only at charts and invests only for the short term.
While there are plenty of traders who do just that, technical analysis can be very useful for long term investing. This is particularly the case when looking at price patterns.
Large multi year technical set-ups can be visible on charts and can be extremely helpful for the long term fundamental investor.
Take for example this cup and handle formation on the gold chart. A cup and handle is a very bullish technical formation.
As the price reaches the previous high and forms the cup, many people will take profits, causing a sell off. This sell off forms a gentle downtrend in the shape of the handle.
As these sellers take profits, new market participants step in to buy their holdings. Or existing holders load up more because the return to the previous highs suggests to them that there is continued upside and they buy the weakness.
Once those sellers who are selling the new highs are flushed out and after a period of consolidation with a slight bearish trend we are left with more buyers than sellers. This will send the price dramatically to the upside.
It is well worth learning about the basic price patterns you see in charts such as the cup and handle, flags, pennants, triangles, wedges, head and shoulders and double tops and bottoms.
It is also worthwhile understanding how support and resistance works as well as being able to identify trend lines and trading ranges.
These are just as useful when you are investing for the long term as they are in the short term.
Does Technical Analysis Really Work?
Yes technical analysis really does work.
However, technical analysis can only tell you the probabilities of future price action based on an interpretation of the charts.
In this way it is not that much different from value investing which also deals in probabilities of future price action based on reversion to fair value.
Given that technical analysis is based on probabilities, by definition it will sometimes be wrong. That doesn’t mean it doesn’t work in principle, it just means that statistically speaking, on enough trades, some of them will move opposite to the way you expected.
Either you read the chart wrong or you read it right but it just went the other way.
Whether or not you can succeed with technical analysis is based on how effective you are at interpreting charts and how consistently you are able to execute buying low and selling high.
Is Technical Analysis Hard?
My personal opinion is that technical analysis is not hard to get a grip on the basics. However, it is difficult to become a master.
Understanding support and resistance, trend lines and parallel channels is quite straightforward. Basic patterns such as flags, pennants and cup and handle are also very accessible. Technical indicators such as moving averages, RSI and MACD can also be understood at a basic level quite quickly.
Beyond that, how difficult technical is depends on how deep you want to go.
If you were a day trader or a swing trader then developing a deep education in technical analysis is a must.
However, if you are a long term value investor who is looking for technical analysis to be a useful aid, then a basic understand is sufficient.
Conclusion
Technical and fundamental analysis are both useful for long term investing.
Personally I use fundamental analysis first and use technical analysis as my secondary consideration. My primary aim is to better optimise the entry and exit points in my long term value investments.
Technical analysis certainly has its critics but it is very useful as a complement to rather than a replacement for good fundamental valuations.
If you are buying and holding for the long term you can ignore the technical analysis and noise of short term price movements and short term changes in price direction.
But when you are ready to enter and exit based on fundamental valuations then look at the technicals as extra data points that can help you make good decisions.
Sources
Palicka, John. Fusion Analysis : Merging Fundamental, Technical, Behavioral, and Quantitative Analysis for Risk-Adjusted Excess Returns. New York: McGraw-Hill, 2012.
Image Credits
Candlestick by Maxim Hopman on Unsplash
