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Dabbling in the Dark Art of Chart-Pattern Reading


It's advisable that investors continue to maintain a cautiously bullish approach to stocks.

I've stated several times that I'm not a chart-pattern guy. I've found that trying to predict the future of any asset via the patterns its chart reveals yields, for me, a 50/50 proposition. Yet, there's some merit to chart-pattern recognition -- many others do follow the dark art. Therefore, since the name of the investment game is to outwit your unseen investment opponent (that's how you generate alpha), seeing what they see (and possibly, believe) can be a productive exercise.

To illustrate, let's look at a basic chart of gold (GLD).

The 2 areas I wish to bring to your attention are the longer-term trend line and the prospective head and shoulders.

The long-term trend line makes my case for why chart patterns have such a high unpredictability factor. The violation of the trend in late 2008 (arrow) would have driven an investor to sell. However, doing so would have resulted in a sale at the pullback/correction low and, in the process, would have denied the investor the upside run that followed. Such violations are common and, in my opinion, render chart pattern recognition a 50/50 proposition, at best.

The prospective head-and-shoulders bullish pattern is noted because many investors who do adhere to the chart-pattern approach will likely herald an upside break of the neckline. And, as I've noted before, that's the real value in chart patterns -- that many investors do follow the dark art.

If chart pattern recognition has such limited value, is there a technical-analysis tool using charts that does offer a higher predictive value? The answer is yes -- divergences. But even here, divergences can mislead if not properly used. To illustrate, let's consider the Dow Theory signal that some have celebrated this past week.

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No positions in stocks mentioned.
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