Why I finally learned to appreciate technical analysis

It looks like we’re back to full-out war with Iran again.

That news sent oil up and the markets down yesterday, which makes sense. Who knows what’s going to happen with the Strait of Hormuz now… or for how long.

Will inflation reaccelerate? How will the Federal Reserve react? Can consumers take much more of this?

Even the world’s best economists and military strategists don’t have definitive answers to those questions. As Stephen Hester wrote last month, “the experts [can] sound confident that their forecasts are precise. Yet it’s all close to worthless.”

And as Nick Ward wrote last week, “It’s impossible to predict the future.”

That’s why successful investors don’t even bother. Instead, they analyze all the resources they can to make the most logical conclusions they can about as many companies as they can.

Ultimately, I believe the greatest resources investors can work with are the fundamentals. That includes analyzing a business’ balance sheet, management team, competition, valuation, strengths, and weaknesses.

Still, I have to recognize that every related (and sometimes unrelated) headline, economic data release, and geopolitical event eventually finds its way into a company’s share price – often sooner than later. And so, after 30 years of investing, I’m changing my mind about technical analysis.

Studying charts should never replace fundamentals. But it can play a useful role in stock selection – rather like an indicator light on your car’s dashboard can tell you to look under the hood.

When one of those symbols pop up, it doesn’t tell you anything about the engine’s power or whether the vehicle is built with quality parts. It just indicates that something might need your attention.

When traders treat technical analysis as crystal balls, they can find themselves losing out. A lot.

But as I’m starting to see, when we know how to keep fundamentals in focus… those charts and levels can be put to good use.

Trend following is one of the most useful types of technical analysis – particularly when it involves the 200-day simple moving average. As its name suggests, this tracks the average price of an investment over the last 200 trading days.

That can be helpful for anyone prone to short-term distractions… which is pretty much everyone.

We all know the saying that markets are driven by fear and greed. But what that means is they’re emotional, reacting to extreme possibilities instead of more reasonable scenarios.

The 200-day moving average prompts people to look past that day-to-day volatility and answer a much more important question: Which way is the long-term trend moving? Higher or lower?

If a stock, asset, or index is trading above a rising 200-day moving average, it’s generally a bullish sign. If it’s trading below a declining 200-day moving average, it’s generally a bearish sign.

The longer the trend line is in either direction, the more reliable the signal. Though investors can also watch the 50-day moving average to measure shorter-term momentum if they’d like.

This all might seem obvious, and it is to some degree. But again, emotions have a way of messing with our powers of observation if we don’t keep reminding ourselves to stay above the fray.

And sometimes visuals, like graphs, simply work well in that regard.

Now, when the S&P 500 is trading above both its 50-day and 200-day moving averages, it stands to reason that short-term and long-term momentum are in sync. However, there’s another possibility called “divergence” that happens when they start falling away from each other.

That can be an early indication of incoming changes, whether positive or negative. For instance, if the S&P 500 keeps making new highs yet its moving averages are flattening or even rolling over, it could be in for a correction.

Another possibility is a death cross, which happens when the 50-day moving average falls below the 200-day. This suggests that short-term momentum has weakened enough to deteriorate any longer-term patterns.

Momentum indicators, another type of technical analysis, answer another simple question: What’s working and what isn’t?

One of the most common momentum indicators is the Relative Strength Index (RSI), which can also be broken into varying lengths of time. This includes the 14-day RSI, which tends to be the most followed metric.

Regardless, the Relative Strength Index measures the speed and magnitude of price movements on a scale of 0 to 100. Any result above 50 suggests positive momentum; anything below that suggests otherwise.

Naturally, the more extreme the reading, the more trustworthy it is. However, RSI followers should keep in mind that this technical tool – or any other investment indicator – needs to be used wisely.

Never evaluate it in isolation.

After all, great companies can be “overbought” for long periods of time as institutional investors keep flocking to their business practices and outcomes. Likewise, cheap assets can stay cheap if they’re operating with compromised fundamentals.

In short, as I began by saying (and I’ll reiterate shortly), it should always come down to the fundamentals.

Another useful concept to consider is support and resistance, which aims to capture buying enthusiasm.

Support represents price levels where buyers have been stepping in to elevate a stock price. Resistance happens when more sellers have emerged. And oftentimes, those levels are sticking points, with stocks trading within a certain range.

As such, this line of thinking looks for “floors” or “ceilings”: price points or zones that indicate a stock has dropped too far and is therefore ready for a rebound or risen too high and likely to fall. So basically, it’s a form of market timing.

However, when coupled with an actual understanding of the companies being tracked (i.e., the fundamentals), it can be useful.

Will a company continue to trade within pre-established floors and ceilings? It happens often enough for some investors to make an entire art out of it.

But I imagine that the most successful support and resistance watchers are those who first understand the companies they’re tracking. Fundamentally strong businesses will usually break out of their trading patterns eventually to hit new ceilings.

Those struggling to keep their balance sheets balanced tend to break out the opposite way.

Price is what you pay. Value is what you get.

And these seven high-quality stocks are valued well.

Join me and Nick Ward as we explore potential portfolio picks such as a 175-year-old money transfer giant trading at a 50% discount… the animal health leader that just experienced an unfair selloff… and two healthcare blue-chips with 18% or higher annualized return potential

Click here to watch us discuss all that and more on the latest episode of The Wide Moat Show.