What is technical analysis? It is the use of stock price charting patterns and is a common form of analysis utilized by a particularly large number of Chinese retail traders and investors. Very few academics and equity portfolio managers utilize technical analysis for their long-term investment decisions. Fundamental analysis of the economy, industries and individual companies is predominantly used by institutional investment professionals to select over- and under-valued stocks – and it is the methodology that economic theory and empirical evidence support.
The Chinese stock market is largely driven by unsophisticated retail traders, who believe that charting or technical analysis is the best method to select stocks. The truth is that it is an ineffective and unreliable basis for investment decision making. It is mainly responsible for the large swings in the Chinese stock market during the past year.
There is overwhelming, robust empirical evidence from reputable peer-reviewed studies that support my contention that technical analysis is unreliable and likely to lead to irrational market movements and losses for the majority of investors who use it. And that helps explain the ridiculous and crazy movements of the Chinese stock market over the past year. The fear of a Chinese economic slowdown – which could lead to contagion into the developed economies (i.e. United States, Germany, Japan, United Kingdom, etc.), is overblown and the stock markets in the major countries will soon return to normalcy.
Academic research has consistently shown that individual investors managing or trade their own money lose on a relative basis approximately 50 basis points (1/2%) per month in raw returns plus an additional cost of 20 basis points due to higher turnover. These 70 basis points of total costs per month is a significant under-performance compared to other investors who utilize stock market indexes (ETFs) and mutual funds.
The situation is worse for those individual "investors" who use technical analysis. The cost of using technical analysis for high turnover traders has been estimated to be 140 basis points per month plus an extra cost of about 30 basis points due to additional transaction costs associated with technical analysis generating more trades. That can amount to net returns being 20% below the market averages over the course of one year.
The current market selloff started with concerns about global growth forecasts, especially in China and oil exporting countries. Evidence does exist that points to a slowing of economic prospects for China and other countries in the emerging world, along with weak growth in Western Europe and Japan. Fundamental factors, such as earnings and capital investment, do point to a global slowdown, but not a global recession. U.S. growth will remain below 3% annually, a lower than normal rate, but decent compared to Western Europe and Japan.
The selloff in China was accelerated by retail investors, who primarily employ technical analysis, fleeing the market. Pundits can talk about Chinese government policy makers not able to respond quickly enough; however, markets eventually find their equilibrium levels
I believe that the U.S. markets will be fine and that investors should not panic – and above all, not sell at the market bottom. I believe that China and some of the emerging markets will still be in for a bumpy ride, but that ultimately the stock prices will catch up with the fundamentals and they will stabilize.
The lesson for retail investors across the globe should be to avoid technical analysis and focus on long-term fundamental based investing. And if you don’t have enough time to do your own analysis, then by all means utilize mutual funds or ETFs, and remain focused on the long-term. The current stock market chaos will soon disappear and we’ll be back talking about Donald Trump and the upcoming football season!