Apprenticed Investor: Tracking Elephants

Here's an interesting question: If you could look at one and only one source before buying your next stock, which would you choose: a fundamental analyst's report (with no charts in it), or the chart of your choosing? While I like having access to both, I cannot ever imagine buying something without first looking at the chart.

And so we wade into the ongoing battle between technical and fundamental analysts. Frankly, it's one of the sillier debates in investing. But I've heard so many bad arguments and misleading theories about technical analysis that I decided to weigh in.

Before we wade too deeply into the controversy, ask yourself: "Why do I need to choose?" Why wouldn't you use any tool that can be shown to have value? You wouldn't build a house using only a hammer, but no drills or saws. Why limit yourself away from a tool that can assist you as an investor?

I am not a pure technician. I use technicals -- but I also look at fundamentals, sentiment, monetary policy, cycles, trend, quantitative factors, and economic data. I employ every tool I believe can help my investment process, without making it overly complex or confusing. You should, too.

The Basic Theory

There is quite a lot of conjecture about how charts work, but they all boil down to this: The actions of everyone who has done their homework on a stock shows up in the chart.

Let's take the manager of a value fund. This person's methodology relies on fundamentals. He finds a stock he is interested in. His mutual fund has an enormous research budget and tools at its disposal. They put their staff to work, visit the company, speak to senior management, check the channels -- i.e. speak to vendors, suppliers, and customers -- to see how the company's product is selling. After they run through a long checklist, they decide to add the stock to the fund's portfolio.

You could do the same sort of research -- assuming you have the time and money. Or, you could see the result of this fund's work -- its decision to buy the stock -- in the chart.

Footprints of Elephants

You see, there's a crucial difference between a fund and an individual investor. When you make a buy decision, the odds are you pick up a position of a few thousand shares (at most). That's it! The stock either works for you or it doesn't.

Funds are different. They don't merely buy stock -- they build positions; huge, enormous, institutional-sized positions. Mutual funds receive constant inflows. They are always putting their money to work, on a regular basis over time. When most investors buy a stock, it's a single decision, a single point in time. The purchasing process by large funds occurs over a much longer period. Some positions can take months if not years to build -- or unwind. Note that the process works in reverse when firms are selling a stock.

The technical terms for the process of institutional buying is called "accumulation"; institutional selling is called "distribution."

Institutions account for 90% of the NYSE stock market volume -- and half of that is done by the world's 50-largest investment firms. These funds are like elephants -- huge, and secretive in nature. They don't want the world to know what they are buying, because they fear traders will front-run them. If you could buy a stock before they can, it would cause the funds to pay a higher price, thereby lowering performance.

But elephants leave tracks in the jungle. They may be secretive, but their enormous girth means that they can be tracked. The same is true for institutions.

Don't you think that knowing what these behemoths are up to can help you in the markets? If we know that once they buy a stock, they will keep buying it, isn't it a valuable piece of information to know what they are buying? Knowing what they are selling -- and will continue to sell over many months -- is even more important.

1. Expect to Be Wrong 2. Your Fault, Reader
3. The Wrong Crowd 4. Bull or Bear? Neither
5. Know Thyself 6. Prepare for Battle
7. Bite Your Tongue 8. Don't Speak, Part 2
9. The Zen of Trading 10. The Folly of Forecasting
11. Lose the News
Check back for more of Barry Ritholtz's
Apprenticed Investor series

That's the key to looking at charts: They are the footprints of elephants.

TA: The Basics

You do not need to become an expert technician to improve your investing. If you learn only a few basic things about charts, you will enhance your returns significantly.

Think of technicals as the "when" part of your strategy. Fundamentals are very good at telling you "what" to buy, but they are less proficient at telling you when to buy. The example we used previously was Microsoft ( MSFT). In 2002, you could have paid as much as $35 (post-split) or as little as $20 per share; same company, different entry prices. The result is one investor with a 30% gain, while the other showing a 25% loss. Timing is the key to profitability.

Next week, we'll delve more deeply into many ways you can use technical analysis in your investing -- even if you rely (almost) exclusively on the fundamentals. Before then, I want to share the most important rule in all of TA: Do not buy a stock in a downtrend. You probably have heard this edict phrased differently: "Don't catch a falling knife." "Don't fight the tape." "Losers average down."

Regardless of the phrasing, it is the most basic tenet of TA. As mentioned above, institutional-size positions can take months or even years to unwind. A downtrend is nothing more than the footprints of that distribution in chart form.

If you learn nothing else about technical analysis, learn this lesson, which is visually represented by the accompanying chart of Ford ( F).

Auto Wreck
Ford's chart shows in grim detail why you must avoid buying stocks in a downtrend
Source: Barry Ritholtz

Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.

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