Understanding market mechanics puts you way ahead
Technical analysis is the process of analyzing historical market action, primarily through the use of charts, in an attempt to determine the most probable direction of future price trends.
This definition makes a clear distinction between two terms, market action vs price action. While the terms can sometimes be used intechangeably, market action encompasses all primary sources of information available to a technical analyst, that is price, volume, time, and, in the case of futures contracts, open interest.
By contrast fundamental analysis suggests that investment and trading opportunity is to be understood by analyzing macro and micro economic fundamentals. While fundamental analysis does play and must play an important role in the decision making process, we believe a fundamentals-only approach can at times be very flawed. It is well-known that markets can stay “irrational” way longer than traders can stay solvent so the necessity to properly fine-tune the timing of the investment and trading decisions cannot be understated.
In reality, we believe that the connection between market fundamentals and market action is a very profound one. We disagree, however, with the assumption of perfect correlation at all times and with the benefits of linear extrapolations. First off, the importance market players assign to specific fundamental variables is different in time and from variable to variable. Sometimes the unemployment numbers are more significant, other times international trade or the overall GDP of countries matters most. Like everything else, the perception regarding the importance these fundamental numbers have for the markets changes. Secondly, anybody that has been around in the market for long enough will have understood that the reaction to good or bad fundamental data differs in time: sometimes great data leads to a big rally, other times it barely moves the market and at times it is viewed as “priced-in” and it in fact triggers a significant correction. Linear extrapolation of past events and the assumption of perfect correlation can thus lead to major errors of judgment. Instead, our forecasting model reconciles market technicals and market fundamentals at various points in the market and economic cycle. In other words, the method we use reconciles the true nature of economic fundamentals with people’s perception towards them, revealing both the background and the actual manifestation of patterned mass psychological trends that we contend drive both the markets and the economy.
Technical analysis is based on three assumptions:
Technicians believe that all known market influences are fully discounted in prices. In other words, there is little edge to be gained by doing further fundamental analysis. All that is required to forecast the prices is nothing but a study of prices themselves.
Benefits of charting
Understanding the rationale of technical analysis is obviously the first step in understanding what the benefits of charting are. In simple terms, technical analysis provides superior flexibility, improves your market timing and removes a good deal of subjectivity from your investment decisions.
One major benefit of charting is that the same set of rules and guidelines can be applied to study any market, in any time frame. That is, whether the analyst is inspecting a USDollar index quarterly chart or a five minutes E-mini S&P 500 chart, he will guide himself around by the same principles. By contrast, fundamental analysts usually employ different methodologies and analyze separate types of data sets to arrive at forecasts in different asset classes. The convenience of analyzing the same type of data by the same type of guidelines implies that technicians, as opposed to fundamental analysts, can quickly chose to move from one market into the other and profit from the most attractive market swings within the entire financial spectrum, regardless their investing time horizon.