Extract from the introduction to 

MASTERING TECHNICAL ANALYSIS - Michael Thomsett

Introduction by Daryl Guppy

This extract copyright 2000

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INTRODUCTION TO MASTERING TECHNICAL ANALYSIS BY THOMSETT

This is not a book about charting or technical analysis indicators as commonly understood in Australia. This book concentrates on an area that many Australian private traders have yet to explore. Thomsett looks closely at broader measures of market sentiment that bring together price, and statistics about price, and combine them with fundamental accounting based data. When he writes that ‘you can track the institutional interest in a stock as one form of technical indicator’ we know he is not talking about charting and technical analysis as found in Metastock and popular charting packages.

The difference is important and best summarised by his choice of popular technical indicators. The chart traders’ top five probably include moving averages, stochastics, Guppy multiple moving averages, MACD and Relative Strength Index. None of these appear in Thomsetts' list. Instead he starts with the Insider buy and sell – directors trading reports-, the mutual funds cash/assets ratio, and moves onto the new high/new low ratio. He finishes with an absolute breadth index based on advance/decline and the block volume ratio – institutional trade orders.

His objective is to show readers how to use these relationships to compare individual stocks to overall markets as a means for judging and timing decisions for trading and investment. This is a valuable extension of skills for investors and traders.

Thomsett is an accountant so his focus is on what the numbers, and what the numbers about the market are telling the trader or investor. His objective is to use these relationships to verify or confirm broader conclusions reached via the more traditional fundamental analysis methods. The technical indicators he discusses are statistical formulas applied to the broad pattern of market activity and behaviour rather than to price activity in individual stocks. The chart trader already has access to some of these tools.

This book gives traders and investors an inside edge to understanding the type and range of analysis techniques which can be used. This book can be seen in two ways. Firstly it is an important extension to the armoury used by fundamental investors. It takes the well established methods used to analyse a single company, and discussed in his book MASTERING FUNDAMENTAL ANALYSIS, and puts them into a context of the market. This book has a greater focus on getting the market timing right so that investment capital is used more efficiently to reduce opportunity cost.

The second aspect applies to traders who rely mainly on charting and other indicator signals for their decisions. They will also benefit from a better knowledge and understanding of broader market analysis. This is sometimes called a top down approach, working down from market behaviour , to index activity, to individual stocks. This is an important trading technique but it does not take into account the psychology of the broader market.

This is where MASTERING TECHNICAL ANALYIS is useful for chart based trading. It expands our existing skills into new areas where market relationships can be explored. By merging broader fundamental analysis the trader confirms the validity of his chart based observations. This puts them into a wider context and allows the trader to develop more effective trading approaches. A better understanding of how to use the new high_new low ratio means the trader may take a more bullish position than supported on the basis of chart analysis alone. Factors like large block volume ratio – the ratio of large institutional orders – may define and validate support and resistance trading strategies.

Technical analysis of charts comes in many forms, but modern Western applications start with the Dow theory. Classic Dow theory is built for fundamental analysts. Thomsett shows how the classic theory is used to identify and confirm trends on the basis of supply and demand analysis. This forms a philosophical basis for his discussion of charting, including the emphasis placed on time and price relationships. He uses it to set a time frame for price action to develop. Dow theory in his hands becomes a way of reducing the opportunity cost of an investment or trading decision.

Thomsett aims to make better timing decisions by using the statistical behaviour of the market to identify the dominant trend created by the balance of buying and selling. He does focus on the relationships between price, time and volume as a means of making better decisions. This is not a charting approach and nor does it resemble the techniques used by Gann and Elliott.

He moves fundamental analysis towards a more objective technical analysis based on market activity. As an example, he treats the PE ratio as a hybrid analytical device because it consists of up to date and out of date data. The price component is always available and up to date. The earnings component of the calculation is an historical figure that may be out of date by three months or even longer. He shows how most people consistently fail to correctly apply and use PE ratios in decision making. Then he shows how it is used to gain a trading and investment edge.

Time is used to improve the timing of the entry point in the investment. The task is to reduce the opportunity cost, so a better understanding of the balance of supply and demand is helpful. Rather than rely on the broad measures, Thomsett explores specific statistical relationships between leading economic indicators, market news and information, and other sentiment indicators.

Risk for Thomsett is ‘defining the risk characteristic of a specific stock in comparison with the risk levels of other stocks you want to follow.’ Here we are talking about the relative risk of one choice in comparison to another, so factors like price earnings ratios, industry specific comparisons, take over and merger information, and changes in the levels of insider trading – directors trading – all become a significant part of the decision of when and what to trade.

As a trader who uses charting and technical analysis for all my trading decisions I do reject his occasional assertions that charting is a way of predicting the future. Charting, and technical analysis in both its forms, is about identifying the balance of probability so we can more effectively manage risk in all its market forms.

MASTERING TECHNICAL ANALYSIS is an important addition to the armoury of skills for both fundamental and chart based traders and investors. When combined with emerging data products available in Australia these techniques have the potential to provide an important new trading edge.