Thursday, October 4, 2007

Technical Thursdays: When Technical Analysis Doesn’t Work

Every prior edition of Technical Thursdays espouses the value and benefits of Technical Analysis (TA). In today’s blog posting, I wish to highlight a different aspect of TA – when it doesn’t work. Case in point: the yield on the 10 year US Treasury.

Employing the first of the two primary charting tools I use – moving averages, the above chart of the 10 year* is a hodgepodge of erratic price movement that is matched by the frequent crisscrossing of price to moving average (50 and 200 day) as well as the moving averages to themselves (50 crisscrossing the 200 day). Of course, one could argue that the trend is range bound. That is clearly evident. But the predictive value in the moving averages principles (noted on numerous prior Technical Thursdays) rests not on forecasting the sideways action of an asset (which it cannot do) but on its ability to forecast sustainable up or down mega trends. In other words, when it comes to the 10 year yield, there is no up or down trend predictability using the moving averages principle (use the label link below to see prior Technical Thursdays for examples).

As for the second charting tool – momentum and MACD, the timing value of these tools is rendered largely (but not completely) useless as the divergences principle (trend highs or lows not confirmed by momentum and MACD) that works so well in other situations (again, use the label link below to see prior Technical Thursdays for examples) is of limited value here. For example, the August decline in yield produced several non confirmations in both momentum and MACD before the yield finally turned higher. The net investment/trading effect would have been a loss or at best a breakeven transaction.

Investment Strategy Implications

Perhaps it is the single issue aspect (versus markets, whole sectors, industries, or styles) that nearly eliminates the predictive value of the two tools. Or perhaps it is nature of the instrument with all its external influences (economic and political) that reduces the ability to predict its future price action. Whatever the reasons, the fact is that certain TA tools do not work in all situations.

The moral of the story: Knowing the limitations of any predictive tool is just as valuable as knowing its strengths.

*To view a larger version of the chart, click on the image.

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