Be careful of small cap technical analysis
Good Bank Holiday Monday, MINING AIM, and welcome to my thought of the day.
I was chatting to a technical analyst type over the weekend - the sort of guy who wouldn't recognise a balance sheet if it hit him in the face - and while he was rambling on about flags and champagne brands, it got me thinking about the dangerous overreliance small cap investors and traders have in technicals, when taking a position.
Here's the thing.
To start with, plenty of small caps are effectively illiquid. Really low trading volumes creates high price volatility and wider bid-ask spreads; and a technical pattern based on a few trades a day is not reliable.
Technical analysts presume that supply and demand are the key drivers behind share price movements, such that if you analyse price and volume data (how often shares are changing hands), you can predict changes of supply and demand to predict price movements.
This doesn’t really work in practice within the small cap space, as low volume doesn’t mean a company is undesirable — especially if there are large gaps between relevant news. Shareholders are often just holding on to their assets, only buying or selling on the next piece of news.
And because small caps are just more volatile in general, technical indicators just aren't as effective because volatile price swings can create false indicators.
Then there's the market manipulation. Someone picks some god-awful microcap with the fundamentals of the average LSE post, pumps it up across social media, the technicals make it a screaming buy, the traders flood in...and BAM! Rug gets pulled, stock collapses, and all the Bollinger Bands in the world aren't going to assuage your losses.
Anyone who has been in the market for more than five minutes knows this. There's a different pump every other week - and they all end the same way.
But it's actually more fundamental than this. I don't care what your shampoo brand says, all the technical analysis in the world can't predict a game changing RNS (for better or for worse!).
Personally, I prefer to analyse companies by considering the following fundamentals:
Financials — including the balance sheet, income, and cash flow
Earnings growth — historical and projected earnings
Margin — profitability of the revenue
Valuation — p/e, p/s, and dividend yield
Management — is the CEO/CFO/Chair competent/trustworthy?
Rivals — market share, economic moat, advantages
Macroeconomy — monetary and fiscal policy
Risks — geographical, legal, company-specific
This isn’t an exhaustive list, but hopefully you get the idea. The key point is that fundamental analysis relies on the assumption that a stock’s price doesn’t fully reflect the value of the company when compared to publicly available data. In the long run — and this can be years — the stock price will reflect the fundamentals; hence I refer to myself as a long-term investor.
But traders rely on technicals: support and resistance levels, breakouts, breakout confirmation, moving averages, Fibonacci retracement, Bollinger Bands, relative strength index, MACD, oscillators, breakdowns, head and shoulders, double tops, triangles, wedges…
The list goes on and on. If you decide to engage in leveraged trading, there’s even more technical jargon — trading strategies like long strangles, iron condors, and the long butterfly spread. The more it sounds like it came straight out of the Jabberwocky, the better.
In blue chips, this can and does work. I've seen some of the most qualified traders in the world at the top of their game - and fortunes are there to be made. But in the small cap world, it seems to me that traders shout noisily about their wins and quietly forget about the losses. A lot of the assumptions just don't ring true; blue chip information and analysis means that a chart may well start to form a reliable pattern, but down here on AIM, the same analysis is just not there to support the concept of an informed market.
Further, technical analysis presumes that historical price patterns and trends tend to repeat, meaning you can forecast future price movements. The idea is that fear and greed is intwined with market psychology such that movements can be predicted. Again, this is a reasonable assumption with blue chips, but not with penny shares.
This is because many AIM companies all have their share prices dictated by one flagship asset. And often, the aim of these companies is to sell the flagship asset for multiples of the share price — this only happens once, and often without warning. Alternatively, the flagship is revealed as worthless, and if you're long because the crystals told you to be...good luck.
For context, technical analysts can only generate decent profits by riding out a trend until new evidence suggests that there will be a reversal. For example, if you see a downtrend, you leave a short trade position open until the technicals suggest a reversion to the mean — at which point you exit. The problem with this is that unlike a blue chip, a singular positive or negative RNS can send the share price soaring or tanking, in a way that is rare among blue chips outside of earnings season.
Of course, as a proponent of fundamentals over technicals, it’s likely that I have some strong bias. And yes, there will be some small cap technical traders making tons of profit. But even as a high-risk investor, I know that trading on leverage and forsaking the SIPP and ISA tax shelters, is perhaps not the best idea.
For context, roughly 75% of retail accounts lose money when trading spread bets or CFDs — it’s written in bold writing on every UK leveraged trading website before you open an account, so you can’t say you aren’t properly warned. Even if you generate a profit, it's taxed.
And if you’re in for long-term investing over several years, the fundamentals eventually shine through.
- Charles Archer 26/8/24