How Technical Analysis Works
By now you may have recognized a theme running through this book, that value investing works well in the medium to long term but not necessarily in the short. In trading and short-term investing, timing is crucial and technical analysis can help with it.

Technical analysis involves the study of past share prices or indices and, for timing purposes, is helpful in showing you when a stock price is out of kilter with the past. There are technical systems for setting stop losses and assisting with money management, which is a crucial part of trading.

The dedicated technician analyses the charts and indicators to forecast future share price and index movements. Some use technical analysis as an alternative to fundamental analysis, and cynics say it is popular because it is easier to understand than company accounts. Nobody could accuse investment software providers of not rising to the challenge.

There are technicians who apply their art in its purest form, and take pride in reaching conclusions based only on share price movements, without knowing the surrounding events or the stock fundamentals. If several patterns and indicators point to the same outcome, it is much stronger than if only one is behind it. Some use technicals to support, but not replace, fundamental analysis. Fidelity fund manager Anthony Bolton is in this camp. Trader Alpesh Patel believes both are valid, and the proportions of use depend on the investor’s own comfort zone.

However much it is used, technical analysis remains controversial. Among experts, the critics are more numerous than the supporters. They say that past share price movements do not repeat themselves in the same form, on the same time scale, and that most technicians make little money.

The true technicians dispute it. US share trader Marty Schwartz used fundamental analysis for nine years and it did not work well. He switched to technical analysis and became rich. US fund manager William O’Neil said: ‘Just as a doctor would be foolish not to use X-rays and ECGs, investors would be foolish not to use charts.’

What is not in dispute is that it is possible to earn a living writing and lecturing about technical analysis, and making technical forecasts. The more publicity technical analysis receives, the more trading it generates, which helps the cause. Cynics say that technical analysis becomes a self-fulfilling prophecy.

Some of the penny-share promoters relish the fact that technical analysis may be applied to newish companies with no track record as much as to those with better fundamentals. It means more investor interest.

Dow Theory
Dow Theory is behind most of modern trend theory. Financial journalist Charles Dow started developing the Theory in the late 19th century after he noticed that stocks tended to rise or fall together. He introduced, and based Dow Theory around, two stock market indices: the Industrial Average, which consisted of 12 blue chip companies, and the Rail Average, which had 20 railroad companies.

Dow Theory says that the share price reflects everything that is known about a stock. There are three trends in the stock market and they may all be operating simultaneously.

The primary trend lasts between one and several years in three phases, and to assess it is the priority for successful speculation, according to Dow Theory. The secondary trend lasts from about three weeks to three months and retraces between one- and two-thirds of the gain or loss on the primary. A tertiary or minor trend lasts for between one day and three weeks and shows daily fluctuation. It is significant only for very short-term traders.
One way in which a trend will end is when the share price fluctuates for two to three weeks within a five per cent range, which creates a line. The longer and narrower the line, the more powerful will be the breakout. To validate Dow

Theory, the line should arise on either or both of the Industrial and the Rail Averages, depending on which version you follow. If it is on both indices, the message is stronger, and which gave the first signal is unimportant.

Trading volume counts but is a secondary consideration, according to Dow Theory. An overbought market has lower volume on rallies and higher volume on declines. An oversold market has the reverse.

Taken over the first half of the 20th century, shares bought on Dow indi¬cations beat the market massively, even after trading expenses. But Dow Theory is not infallible, and was never intended to be. Its signals come late, which means that early potential profit is reduced. The Theory attracts the criticism that it is out of date but the loyal say that the Averages have modern equivalents.