GuruFocus has recently launched its technical indicators with improved features. While the main thrust is providing tools for fundamental analysis, as well as guru investor holdings and activity, it is worth learning about technical analysis as well.
According to the father of value investing, Benjamin Graham, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Basically, he means that while in the long run stock prices are mostly as a result of fundamental factors, in the short run technical factors rule. This is because short-term stock price and volume are the result of investor sentiment and psychology. Warren Buffett (Trades, Portfolio) has said he does not have the faintest idea what the market will do on Monday morning. At Berkshire Hathaway's (BRK.A, Financial)(BRK.B, Financial) 2022 annual meeting, he said, "I don't think we've ever made a decision where either one of us has either said or been thinking: We should buy or sell based on what the market is going to do, or, for that matter, what the economy is going to do." Buffett and Munger are 100% fundamental investors.
Fundamental analysis and technical analysis are two different methods used for researching and forecasting future trends in stock prices. Fundamental analysis evaluates securities by attempting to estimate their intrinsic value by examining financial and economic factors such as company earnings, balance sheet, competitive set, product performance and impacts from the broader economy.
On the other hand, for technical analysis, traders look to statistical trends and patterns in the stock's trading price and volume. Technical analysis seeks to predict price movements by examining historical data, mainly price, volume and volatility.
It is a given and observable fact that collective investor psychology can have a significant impact on stock prices. The stock market is driven by supply and demand, and investor psychology can influence both of these factors. For example, if investors are optimistic about a company's future prospects, they may be more likely to buy its stock, which can drive up the price. Conversely, if investors are pessimistic about a company's future prospects, they may be more likely to sell its stock, which can drive down the price.
The number of investors active in the market also has a big impact. Investor psychology can also influence market trends. For example, if investors are generally optimistic about the economy, they may be more likely to invest in stocks, which can drive up prices across the board. On the other hand, if investors are generally pessimistic about the economy, they may be more likely to sell stocks, which can drive down prices across the board. There are many factors that can influence investor psychology, including news events, economic data releases and political developments. It is important for investors to stay informed about these factors and to understand how they can impact market trends. The price and trading volume of a stock can offer important insight on investor psychology with respect to a particular stock, industry or even the market as a whole.
Understanding candlestick charts
While technical analysis is a large and complex area, I think it is worth learning a little about it. While I plan to stick with my value investing and fundamental investing style, I want to supplement my research with selected technical tools. I plan on using fundamental analysis to inform my overall strategy, while using technical analysis for tactical purposes to inform my buy and sell decisions. To start my learning process, I will bite off a little at a time, understand the concept and move on to other topics. Today I will examine candlestick charts.
Below is a three-month price chart for Procter & Gamble Co. (PG, Financial) from the Interactive chart.
Once I add any technical indicator (in this case, I added the relative strength index (RSI), but it could be any), the chart changes to something called a candlestick chart. The objective of this discussion is to take a deeper dive into the concept of candlesticks and candlestick charts.
A candlestick chart is a type of financial chart that shows the price movement of securities, presenting them as a pattern of two dimensional elongated boxes with fixed widths but variable lengths with wicks at either end, resembling a candle. Candlestick patterns typically represent one whole day of price movement, so there will be approximately 20 trading days with 20 candlestick patterns within a month (but they can be of any fixed periods, like minutes, hours, days, weeks or months). They have their origins in the centuries-old Japanese rice trade and have made their way into modern-day price charting. Some investors find them more visually appealing than the standard bar charts and the price action is easier to interpret. A candlestick chart consists of individual “candles” that show the opening, closing, high and low prices each day for the market they represent over a period of time. The body of each candlestick represents the difference between the opening and closing prices for that day, while the wicks or shadows on either end represent the high and low prices for the same period. The color of each candlestick can also be used to indicate whether prices rose or fell. If the candlestick is green or white, it means that prices rose during the day; if it is red or black, it means that prices fell.
The shape of a candle can tell us a lot about the trading day for the stock. For example, a long candlestick represents a large price move from open to close and can indicate strong buying or selling pressure. As such, a long green candlestick indicates that prices rose significantly during the day, while a long red candlestick indicates that prices fell significantly. Conversely, A short candlestick represents a small price move from open to close and can indicate weak buying or selling action. The wicks at either end of the candles show the high and low price for the day. For example, a long green candle with two short wicks would indicate the stock rose strongly during the day between the open and the close, but the high and lows during the day were close to the open and the close price. Similarly, a short red candle with a long bottom wick but short top wicks tells us that the stock price fell during the day. Each candle represents a battle between supply (sellers) and demand (buyers) in a given period.
A candlestick or a set of candlesticks can, at a glance, help investors get some short-term insights about sentiment. For example, if you see a pattern called a doji (a candle which looks like a cross), it means that investors are undecided (a doji is labelled "neutral bullish or bearish" in the graphic below. A solid long candle would indicate strong buying or selling pressure, and so on. 
Source: Pinterest
Investors typically look at a set of candles over multiple days to decide if the stock is going up or down or if investors are undecided. To follow are a few of examples of bullish and bearish mutiday patterns. We can find scores of such examples of candlestick patterns all over the internet. But the basic principles are the same; we are using individual candlestick shape and multiday patterns to guess at the direction of the stock and the market.
Source: www.ig.com
The hammer (above) is a candlestick pattern formed by a short body with a long lower wick and forms at the bottom of a downward trend. A hammer shows that although there were selling pressures during the day, ultimately a strong buying pressure drove the price back up. The color of the body can vary, but green hammers indicate a stronger reversal than red hammers.
Source: www.ig.com
A inverse hammer is a similar bullish pattern, but with a longer upper wick.
Source: www.ig.com
The hanging man pattern (above), also called reverse hammer, is a bearish reversal pattern. It is the reverse of the bullish hammer pattern.
Conclusion
Candlesticks are fun to learn, but I think their predictive value is limited and short term. Unlike fundamental analysis, I do not know of anyone who became rich using just candlestick analysis. It is just another small mental model. When combined with fundamental analysis, I think it can be a useful tool for buying and selling as well as getting an edge. I like the fact that candlesticks give a small window into crowd psychology. For example, in the recent bank crisis, many banks fell precipitously, including good ones like JPMorgan Chase & Co. (JPM, Financial). If you were following JPMorgan, a clear bullish signal in the form of a hammer candlestick occurred on March 24. In hindsight, this would have been a good time to go long in the few days following as the stock had bottomed. A few days later when earnings were released, the stock kicked higher. Candlestick charts are particularly useful when we are trying to determine the reversal of a prevailing trend.
