Technical Analysts, Prepare to be Offended

By Derek Simon, Guest Editor,

My closest friends — the e-mailers who address me as “kind sir” and beg me to help them transfer the estates of their late uncles into my checking account — understand that, in addition to Internet scams, I love numbers.

Big numbers, small numbers — it doesn’t matter. I like them in the rain, I like them on a train; I like them in a box, I like them… well, I think one gets the picture.

Thus, it should come as no surprise that technical analysis intrigues me almost as much as the notion that eating green eggs and ham would not, could not lead to a severe intestinal disorder.

Yet I often wonder if some technical analysts truly understand the purpose of the tools they use, or if, like Dr. Seuss, they simply dazzle us with made-up words and pictures.

Take, for instance, the Fibonacci sequence.

Fibonacci Sequence

Leonardo 'Fibonacci' Pisano

Named after the Italian mathematician (Leonardo Pisano, nicknamed “Fibonacci”) reputed to have discovered it, the Fibonacci sequence is a series of numbers, beginning with 0 and 1, in which each successive number is equal to the sum of the previous two.

Hence, the sequence is 0, 1, 1 (0+1), 2 (1+1), 3 (1+2) and so on, and so on.

Now, the real power of Pisano’s discovery, Fibonacci followers say, is not the sequence itself, but rather the quotient of the adjacent terms it contains. This quotient has been called PHI, the golden ratio, the golden mean and the divine proportion, among other names, and is roughly equivalent to 0.618 (or its inverse 1.618) as the sequence approaches infinity.

According to Fibonacci fanatics, this amazing ratio expresses perfection — the subconscious embodiment of beauty and contentment — and can be seen throughout the natural world.

For example, the family tree of a honeybee drone (a bee hatched from an unfertilized egg) closely correlates with Fibonacci’s magical sequence; each spiral of seeds on a sunflower has a diameter approximately 1.618 times greater than the one before it… and the list goes on.

So what does all this have to do with the stock market? Well, supposedly, these same key numerical relationships observed in nature can also be witnessed on Wall Street.

Some technical analysts even use multiples of the golden ratio to express levels of support and resistance (arcs, fans and retracements) and also periods in which major price moves are likely to occur (time zones).

Which brings us back to the writings of Dr. Seuss: Frankly, I think the Fibonacci sequence — at least as it applies to investing — is largely “gluppity glup” and “shloppity shlop.”

Despite what some believe or have read in a Dan Brown novel, there is no mysticism in numbers — they don’t explain anything, they only describe what is or what is not. As Albert Einstein once said, “Mathematics are well and good, but nature keeps dragging us around by the nose.”

In other words, fitting data to a theory, rather than the other way around, is like trying to summarize a book by reading the last page — there is no context, no understanding, no progression of ideas.

I learned this lesson the hard way.

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Avoid Using Methods

Many moons ago, during the running of the dot-coms, I made my first major stock purchase on a technology issue that my research convinced me looked promising.

Trying to be the wise and prudent investor that I wasn’t at the time, however, I decided to limit my potential losses by putting a stop order on the stock, which I set at 10% below my purchase price (based on the teachings of a well-known financial author).

Of course, readers who remember those turbulent days know that the market was volatile and that technology issues, in particular, recorded more highs and lows than a barbershop quartet… bungee jumping… from a roller coaster.

Not surprisingly (in retrospect), the stop was triggered and I watched from the sidelines as my former holdings promptly doubled in value in a matter of months.

Following another, similar debacle a few weeks later, I made a vow to never again take a cookie-cutter approach to investing, which is precisely what I think certain technical “tools” like the Fibonacci sequence encourage.

These days, I try to let each stock tell me when to buy, when to sell and where to place my price targets and stop orders. Because, let’s face it, no investment is exactly alike, and one’s analysis should reflect that. Even within the same industry, there can be vast differences in a stock’s volatility and overall trading patterns.

Even when the stocks are very similar, there are variances that can make or break an investment. As an example, let’s take a peek at Apple (AAPL:NASDAQ) and Microsoft (MSFT:NASDAQ).

Apple Chart
View larger chart

Microsoft Chart
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Notice that their 30-day charts look almost identical. Yet, based on my analytical techniques, I see slightly more upside in Apple (price target of $403, stop at $375) than I do in Microsoft (price target of $27, stop at $24) over the next month, although I wouldn’t invest in either at the current prices.

The point is, there are no shortcuts to making money on Wall Street — no cute formulas, no mystical number sequences, no set rules (though history can provide some pretty decent guidelines).

In the words of Peter Lynch, investing “is not like pure science where you go, ‘Aha’ and you’ve got the answer. By the time you’ve got ‘Aha,’ Chrysler’s already quadrupled or Boeing’s quadrupled. You have to take a little bit of risk.”

This means avoiding miracle market methods… especially those not thoroughly proven to bolster one’s bottom line.

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