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What Works in Equity Markets?

Investors come in many different flavours. At one extreme you have high frequency traders who rely on technology to allow them to place orders with lightning speed and eke out a small percentage profit on huge numbers of small trades in the margin between buyer and seller. At the other extreme you have patient, long-term value investors who are happy to leave a good stock in the bottom drawer for years or decades, and allow compound returns to work their magic. In between these extremes, there are perhaps as many different investment styles as there are individual investors.

One of the big areas of difference between investors is the one that divides technical investors (or chartists), who work on the assumption that historical price movements reveal likely future movements, from fundamental (or value) investors, whose focus is future profitability and cash flow. Certainly, there are investors who employ both, but most people tend to identify with one camp or the other, and working out where you sit is one of the more important choices an investor makes.

The two approaches enjoy different levels of acceptance in different parts of the market. One of the features of charting is that it can be a relatively simple process to arrive at a conclusion on the investment merits of a company. This means that time-poor investors can make decisions more easily, and at the same time – that entrepreneurs can package up trading “systems” that can be sold to said time-poor investors. As a result, charting enjoys good support amongst retail investors, and receives quite a few column inches in mainstream media.

In the professional funds management arena, the norm is for analysts and portfolio managers to spend large amounts of time studying the details of company financials and business models. Montgomery Investment Management – along with most of our colleagues in the industry – sits very much in this fundamental camp. We do this in the expectation that investing the time and effort into having deeper insight into a business will yield better investment decisions.

A good question for investors and fund manager clients to ask is: does this extra effort (and cost) add enough value to be worth the candle? If a simple approach delivers reasonable results, do I really need to do things the hard way?

There may be no single right answer to this. Any investment approach really needs to fit the personal style of the investor using it. For example, if you have perfectionist tendencies and time on your hands, you will want to follow a different path to someone with a short attention span and better things to do. However, there are some reference points that are relevant to all investors.

Firstly, returns. How much value can be delivered by charting? Many people have a strong view that it adds either: a) zero value, or b) quite a lot of value, but based on academic research, the correct answer is probably: c) neither (depending on exactly what we mean by charting). 

Over the years, charting has generally not enjoyed a high level of credibility in academic circles, but a seminal piece of work on the topic was published in August 2000 by Andrew Lo, Harry Mamaysky and Jiang Wang at MIT. Using sophisticated techniques, these researchers examined the merits of a wide range of shapes and patterns, and what they found included a few surprises.

Their work confirmed the widely-held view that traditional charting concepts like support and resistance do not have practical value. However, they showed that two technical indicators – momentum and reversal – do have value. Put simply, they (as well as other researchers) confirmed that stocks that have performed well in the recent past (typically up to 12 months) tend to perform well in the future, whereas stocks that have performed well over longer periods of time (3-5 years) tend to underperform in future. These so called “anomalies” are now widely accepted as real, and it is possible to construct profitable trading strategies that exploit them.

On this basis, there is value in technical analysis. However, that value is somewhat limited. Different studies show different results, but as a general observation, after allowing for trading costs and risk it is not entirely clear that reversal strategies work in the real world, and there have been extended periods when momentum strategies haven’t worked (notably around the time of the GFC).

To summarise, while esoteric concepts like “head and shoulders” patterns are very unlikely to help you in the real world, there probably is merit in the old adage “the trend is your friend”, and having a disciplined approach to trend-following appears to be a simple and legitimate way to generate returns that beat the market by a noticeable margin.

However, the upside is less than compelling, and there is another old adage about rich chartists being a very rare breed. While it is easy to draw up a long list of spectacularly successful and wealthy fundamental investors, coming up with a list of comparable technical analysts would be rather more challenging.  Accordingly, if your aspirations for investment success lie beyond “a noticeable margin” then you may be better off putting in the hard yards of fundamental analysis, or find a good manager to do it for you.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!