Dredd Approach to Technical Analysis

In accordance with a few changes that we've stated we're making around better organization of the blog (we actually should consider a complete website, but that's for another time) and redefining our approach to the content, this article will focus on the purpose and usage of technical analysis.

As we described in the article Dredd Market Analysis: Our View of the World, we use a combination of several different concepts, including economic theory, fundamental analysis, historical precedent, cyclical analysis, and technical analysis to determine what's going to happen in the market and when it is likely to occur.

Economic theory and fundamental analysis tell us what is going to happen, or perhaps more precisely, what is likely to happen. Economic theory teaches us how the "machine" that is the economy functions and how policy makers are likely to react to certain events. Fundamental analysis tells us of things like supply and demand that exist that will drive the markets in one direction or the other.

Historical precedent, cyclical analysis, and technical analysis tell us when it is likely to happen. Historical precedent and cyclical analysis specifically give us a broad sense of what to expect at some point in the future based on how a similar series of events unfolded in the past. Essentially, they point create "windows of opportunity" for when things are likely to happen. For example, every time the stock market "crashes" in history, it falls for a given number of months, rebounds, crashes again, rebounds, then crashes to its final low point. If the crash is caused by a debt collapse, the pattern has a specific look to it that is consistent across all cultures and all periods in history for which we have data. Similarly, there are cyclical patterns, like seasonal cycles in the retail markets driven by the Christmas holiday season, which have a very strong influence.

Again, though, these two concepts only create "windows of opportunity" where specific events are likely to occur. A relevant example is our current situation where we are near the end of the summer trading season and about to enter the September/October months. Historically, these months are brutal on the stock markets. In times of stress (like last year), these months tend to start new cycles of crashes. Since we still have a considerable amount of risk in the credit markets due to over-the-counter derivatives and a very bad economy, there is a "window of opportunity" for the stock market to crash. But then again, it may not. So how do we know if the "window of opportunity" for an event becomes an actual event before it wipes out our investments? This is where technical analysis becomes important.

Most of the charts we show on a daily basis are for technical analysis. Every day we must look at the whole of the economy, the policies in place, the movements of the markets, and geopolitical events to best determine if we need to sell things we own and/or buy new things (like stocks, commodities, cash, etc). The nightly charts we look at give us some expectation of things that are likely to come.]

Here's a loose definition of technical analysis that we can use:

Technical Analysis - A collection of various methods of analyzing securities (like stocks, bonds, commodity prices, and currencies) based on factors such price and volume movements in those securities and mass market psychology to determine future price movements in those securities.

There are a wide variety of technical analysis techniques including, but certainly not limited to, classical analysis, Japanese candlesticks, Elliott Wave, and Dow Theory.

The premise of all technical analysis systems is the same: all available information about a given security is contained within its chart, which is a reflection of of supply, demand, and investor psychology. Think about it. "The market" is just a vast collection of people. They are individual investors, pension funds, companies, foreign governments, and all sorts of other people buying and selling things and trying to profit from it. Many of these investors are experts in their industry. So the fundamental theory of technical analysis is that the price of a security (be it a stock, a bond, or corn futures) represents the consensus view of all that is known about that security. So if you watch where the prices and volumes of buying and selling, you can predict where investor sentiment is going and make your decisions accordingly.

Does it work? It's certainly not a crystal ball. In our opinion, it improves the odds and helps with timing, particularly over the next few weeks to several months. It also requires constant observation to try and determine what the market prices are saying. Without the greater context of economic theory, fundamental analysis, and the rest, technical analysis has limited meaning.

It is outside of our scope to try and teach technical analysis in this blog, and there are already many web sites and books on the topic. But we will provide our interpretation of events as they unfold.

With all of this said, beginning with tonight's Market Update, we will try to summarize our position in the market more clearly in addition to the typical analysis and provide a section whereby the casual reader can better understand how we are interpreting the market action for that day as well as its short, mid, and long term implications.