Friday, April 9, 2010

Technical Analysis: The Crowd Mentality


The Crowds Around Jesus
During Jesus' ministry, there were many instances of crowds gathering around him.  In the Gospel of Matthew, Jesus started preaching in 4:12, and not long after that, in v. 25 of the same chapter, crowds began to form around him wherever He went.  In chapter 13, the crowds were so large that he had to preach to them from a boat.  In chapter 21, as Jesus was entering into Jerusalem, the crowds laid their cloaks on the group to make a carpet for his donkey to walk on.  However, the crowds were not always on Jesus' side.  During his trial, the Jewish leaders were able to persuade the crowds to have Pontius Pilate release Barabbas, and not Jesus.  Pontius Pilate eventually succumbed to the pressure of the same crowd and condemned Jesus to be nailed to the cross.  These were the same people who had laid their cloaks on the ground a few days earlier!

What was going on?  I would attribute this to the "herd mentality" or "crowd mentality".  Sociologists tell us that people often behave the same way as their peers do.  We know all about that, don't we?  Remember when you were in highschool and your friends all dressed a certain way?  You knew you had to dress that way also in order to fit in.  A few years back, when the show "24" was really popular, a good number of my coworkers talked about it over lunch, and eventually, I got the DVDs.  While it was a good show, the reason for starting in the first place was definitely because I wanted to be able to join in the conversation with my coworkers, and not because of any objective evidence that the show was good.  (By the way, the first 5 seasons were really good!)

Crowds in the Market
It is no different in the stock market.  When others buy a particular stock and drive the price higher, you would likely feel compelled to buy as well, seeing how well the stock is doing.  When the stock is being hammered, you would also want to bail.  It's a little over-simplified, but in general, this is what happens.  Using the past price action of a stock to forecast its future price movement is called technical analysis.  Technical analysis may seem to be very scientific, using averages, standard deviations, regression, etc., but let me assure you, it is an art!  Don't be fooled!

There are a plethora of technical analysis tools available to you, from moving averages to stochastic indicators to Bollinger bands to Fibonacci retracements to MACD (Moving Average Convergence Divergence), etc.    However, in any given day, only 5 pieces of information of a stock is collected: opening price, closing price, high price of the day, low price of the day, and volume of the stock.  Most of the time, the various tools just use the same data in different ways to give seemingly different indications.  In my opinion, it's just the same information.  It's no different whether you use 1 tool or 10 tools in some convoluted combination.  This is where the KISS (keep it simple, stupid) principle really applies.

Which is the Best Tool?
I usually have something like 5 tools/indicators plotted on my stock charts, but when I reflect upon which ones I use the most, I would have to say 95% of the time, I only really look at the exponential moving average (EMA).  A little definition: a moving average is simply the average over a certain period.  So, the 50-day moving average of a stock is simply the average of the closing prices from the last 50 days.  An exponential moving average is one that simply gives more weight to the more recent data.  I like the EMA more than the simple moving average.


Above, you can the graph of S&P500.  By the way, the black and red "bars" are called candlestick chart.  I'm not going to go into candlestick charting here, but a quick google will get you started.  Learn it, it's very useful!  Sorry, where were we?  Yes, EMA!  In the chart above, you will see, in addition to the stock prices, a blue line and a red line.  The blue line is a 30-day EMA and the red line is a 250-day EMA.  The EMA lines can be considered as resistances and/or supports.  You can say that once the stock price goes pass the line, it will be more difficult for it to reverse its motion.  It's kind of like Newton's first law of motion.

With the 30-day EMA, since it is a shorter-term EMA, prices in the short term will find resistance/support.  However, it is not to be used as a long-term resistance/support.  As you can see in the chart of about 18 months, the stock price broke through the 30-day EMA multiple times.  So, I would consider the 30-day EMA a short term tool (unless if you're day trading, then perhaps you need a 30-min EMA).

I really like the 250-day EMA because I don't believe in short-term trading.  My time horizon for any given position can be a few years long.  If you look at the month of July in 2009, S&P500 broke through the 250-day EMA  Since the "strength" of the 250-day EMA is high, it is very difficult for the index to break through unless there is a fundamental shift in the market mentality.  The market is turning from a bearish view to a bullish view.  In February of 2010, the index had a correction and dipped to the 250-day EMA, but once it got close to it, it bounced right back.  This is what we call support.  So, remember, the longer term an EMA is, the stronger it acts as a resistance or a support.  So, it's big news when an index breaks a 250-day EMA!  That's why I'm currently bullish about the market.

If you are a long term investor, like me, then the EMA will get you pretty far.  There's little need for the fancy tools.  However, once you get comfortable with the EMA, it may be wise to explore a little more and see what works for you.  Having said that, EMA has worked well for me.

The one concept that you need to take away from this post is the concept of break out.  Again, I will use the analogy of Newton's first law of motion.  Essentially, Newton says, "If an object is traveling at a certain velocity, unless you exert force on it, it will travel in the same speed and direction forever!"  In the stock market, unless there is sufficient cause for a trend to reverse, it will continue in that direction.  But once you do notice a change in direction (i.e. the breaking out of a stock through an EMA or a resistance/support level), the trend may very well be over.  It doesn't always happen that way though.  The price may break through for a few days and bounce right back to where it was.  So, keep your eye on it when you suspect a break out happening.

Where Can I Get the Tools?
So where can I access these technical analysis tools, you ask?  Yahoo Finance has a pretty good interactive chart.  I also like Stockcharts.com. Either one will be sufficient.

Stockcharts.com also has a good section on chart patterns.  Give that a read when you have time.  From my experience, I like looking for patterns and has typically worked well for me.  I may write a post on that topic, but for now, give Stockcharts.com a read.

Technical analysis is an interesting topic.  Some people swear by it, following their indicators to buy and sell their stock.  Others dismiss it as a black art.  I sit somewhere in between; it's a tool for me to confirm my hypotheses.  Anyway, it is fun to read a chart and be able to find patterns in the apparent chaotic movement of the prices.

It's a little late, but I will wish you a Happy Easter (we're still in the Easter season according to the Catholic calendar, until Pentecost)!  The Lord has risen...enough said!  Alleluia!