If a stock was trading at forty dollars three years ago but today is forty-four, we say it increased in value by ten percent. Objectively valid, right? No, and that’s the flaw in fundamental and technical analysis. Because when your yardstick is a fiat currency, it isn’t accurate, objective, or unchanging. Since 1959, we’ve experienced a forty-six-hundred-percent increase in the money supply. Forty-six-hundred percent. But almost no analyst will mention this flaw that all their work is based on.
A fiat currency isn't accurate, objective, or unchanging.
So how do we fix this? Couldn’t we control for inflation by measuring against the Consumer Price Index? Well, if you believe the CPI or any government metric can accurately compensate for money growth, you’re welcome to the consequences. The problem runs much deeper: asset price inflation and money supply growth aren’t perfectly correlated over time or across asset categories. My solution begins with Bob Farrell, the famous Merrill Lynch analyst, whose first rule of investing was this: markets tend to ‘return to the mean.’ I agree, but markets also oscillate the mean.
Markets also oscillate the mean.
A mean is a moving average of price. And if we measure price action in relation to its own moving average, the nominal price is no longer our primary concern. We’re looking at a market’s relationship to its own moving averages and the structures it forms around them. That way, we have a unit of measure that’s primarily a function of a market’s action, not so much the constant distortions in the money metric. When we oscillate the price of a market around a mean, previously unseen trends and structures emerge.
In 1975 I was a futures broker at E.F. Hutton, and “Technical Analysis of Stock Market Trends” by Edwards and Magee was the first book I read on technical analysis. It was published in 1954 and remains the bible of price chart analysis. In the intervening sixty-three years, there have been dramatic improvements in other fields but there haven’t been any major revolutions in technical analysis. Yes, a few bells and whistles have been added to our quote screens, but price charts are still the core of technical analysis. It’s time for an evolution.