I was fooled by this cunning, seductive mistress. Technical analysis is the fools gold of finance. It is an illusion that is as real as Michael Jackson’s face. But to quote Levar Burton’s Reading Rainbow: “You don’t have to take my word for it”.

The most eye opening book I’ve ever read on finance is hands down Benoit Mandelbrot & Richard Hudson’s The (Mis)behavior of Markets. Who is Benoit Mandelbrot? He is the father of fractal geometry. A mathematician who looks at the markets as a form of organic randomness. But the markets can’t be random, can they? No. Markets are not random. However, understanding randomness is essential when judging technical analysis.

Technical analysis attempts to predict future price movements based on movements in the past. This is done through averages, equations and charts. This data is then used to determine when to buy/sell a stock.

There are a couple of problems with this philosophy.

Firstly, there are a large number of individuals who believe that the past does not reflect the future. Lets say you were thinking of buying 100 shares of Coca-Cola. What is important to you, what the stock did yesterday, last month, or last year? Or is it what the stock will do tomorrow? You probably care about the next earnings report, the next news article, the next executive decision. What happened in the past is done with and already built into the share price. The market is forward looking and all about future expectations.

The second problem with technical analysis has to do with human deficiencies in perception and randomness. It is human nature to look for patterns, even when patterns aren’t really there. In experiments conducted by Mr. Benoit, he created random charts using his fractal geometry and gave them to technical analysts with real charts using market data. The analysts were blind to the fact that some of the charts were computer generated, as they all had no identification, time, or price scales on the axis. The result? The analysts found trends in the random charts. How can randomness have trends?

They don’t. But we think they do.

Another example:

Our parent company runs a website called ConquerClub, an online game of world domination that involves “virtual dice”. When programming the dice they wanted to ensure complete randomness so the programmer turned to random.org as source for the data. Study after study has concluded that the dice rolls on ConquerClub are random. However, the largest complaint from users is that they are *positive* that the dice are in fact not random. They call them streaky.

Streaky dice & Stock trends.

It’s the same thing. An illution created by our brain in an attempt to understand randomness.

So now we know technical analysis is junk. Why is it still important?

It has become a self fulfilling prophecy. 

People are the ones making investment decisions. If many people believe that a stock will go up once it crosses a $35 dollar barrier, what happens? They buy the stock! When people buy the stock, it drives the price up and the system works! Another successful technical analysis prediction.

So go on looking for trends you crazy technical analysts, you control your own destiny.

Microsoft is turning into quite the hussy. Shortly after breaking up with Yahoo! before they even officially dated, Microsoft has been seen holding hands with Facebook…. and they might even kiss.

I never liked the proposed Yahoo merger. This one, however, might have legs.

Firstly, lets ignore the $15 billion valuation that Facebook claimed to have in October. That number is just silly. Facebook is still a new kid on the block, they’re still working on a business model that will work in the long run.

Although it is still growing like vile weed, I have noticed that fewer and fewer people on my Facebook account update their profiles in a regular basis. Facebook could just be an Internet trend. A flash in the pan. Not a $15 billion dollar company.

Microsoft could bring a lot of help to ensure that Facebook becomes a long term juggernaut on the Internet. They have the reach, the knowledge, the experience and most importantly, they are just as evil.

Facebook has built a reputation for having poor privacy controls and whoring out users to advertisers. Microsoft has a reputation for whoring out user’s rights to media lobbies. Together they can ruin your online experience and share it with the world.

Seriously though, these two firms would benefit from each other. Microsoft would gain a growing Internet database of consumer information, Facebook would get a grownup to steer it in the right direction.

I say go for it! 

The firm’s investment banking division lost $17.3 billion in the first quarter. You can bet that the majority of job cuts will be from that division.

The 5,550 jobs represent about 7% of UBS’s 83,800 worldwide employees. That number is actually less than the rumored 10% cut that was floating around the market yesterday.  

This newest round of layoffs brings the total reductions in the industry to over 53,000 since this whole mess began. There is still no sign that the credit market has turned around, so expect more cuts to come during the next few months.

May is not doing too shabby either. Two days into the month and the Dow is up 1.4%. Aren’t we supposed to be in the middle of a Bear Market with a looming recession? What gives??!?!

What gives is that prior to April, the market went down too much, too quickly, thereby attracting buyers. From October 1st to March 31st, the Dow tumbled almost 13%. That’s quite a haircut for a 6 month period. Based on where we are today, the market still needs another 8.3% in gains just to break even with October’s numbers.

So here’s the big question: Is this just a blip correction, or do we call out the bulls and shout recovery?

 Lets take a look at what we know based on data from the last few weeks:

- The US Federal Reserve has been slashing rates. This usually leads to a boost to stocks, as companies will be able to borrow for less, and consumer get access to cheaper money (so that they can spend it).

- Job numbers for the month of April weren’t as bad as expected. The results were a quarter of the street consensus.

- GDP also topped analysts expectations in April.

- Oil & Food prices continued to rise rapidly, with no real end in sight.

So overall there’s been more positive than negative economic news this past month. However, and this is a BIG however, the continued rise in oil and food prices can lead to high inflation, which can undo a lot of the positives from the past month.

The good news is that things aren’t so bad after all, but we’re not out of the woods yet.

“In the worst start to a year for more than a decade, most money managers had retail outflows, and even stalwarts such as American Funds and Vanguard suffered a drop in assets, of 6.6 per cent and 4.3 per cent respectively.” Via (Financial Times).

Translation from business speak into English:

“People are taking money out of mutual funds”

This shouldn’t surprise too many people. The Dow Industrial Average went from over 13,000 to 12,300 during the first three months of 2008. Couple the market turmoil with the new year when people traditional re-evaluate their portfolio, and you have your explanation.

There is a nugget of good information towards the end of this article.

“….long-term assets do not include money market funds, which have seen big inflows”

Translation: “People are simply switching from equity funds to money market funds” (money market funds are simply short term highly liquid and secure parking spots for cash that yield a bit of interest)

Why is this good news?

Because it shows the problem in the 1st quarter was just market confidence. People aren’t dipping into their investments to pay for bills. If we saw a drop in equity assets and money market, that would be an alarm bell.

After reading a heated discussion in a personal finance forum earlier this week, I thought it would be a great idea to write my thoughts on one of the most intensely debated and discussed issues in finance. This is a question that I ask MBA grads during 1st round interviews. You’d be surprised how often very smart people can sound very stupid when asked if markets are efficient, and what to do about it.

There are two basic schools of thought in regards to investing in the stock market. In one corner we have the active investor. She believes that markets are inherently inefficient. An inefficient market is one where prices do not accurately reflect the value of an asset at that point in time. Therefore, some stocks will be “cheap” and others “expensive”. The goal of the active investor is to purchase the “cheap” stocks and then sell when they match/exceed their true value.

On the flip side we have the passive investor. He believes that the market is efficient and all prices accurately portray the true value of an asset. There are no “cheap” stocks. Everything is priced to perfection for that point in time. Depending on how far the investor is on the passive scale, they either base purchases purely on future expectations, or opt for the ultimate in passive investing: indexing.

Which is the better approach?

Both have pros and cons and I will try to point out just a few as some food for thought. Since this is such as touchy and personal subject, I know many will disagree with me and I encourage you to sign up and debate it out in our new forums.

Firstly: Are markets efficient?

No.

No, they are not. They never were. They never will be. If every human acted like a robot, then maybe they would be. Humans are not robots (yes, even the one’s at MIT) and do not all react to produce the same output when given an identical input. My favorite example is the after hours equity market during earnings season. When a company reports its earnings, investors are given some time to digest the news before trading is allowed to resume. What often happens are huge price fluctuations as the market “feels itself out”. The next morning when regular trading resumes, the stock can end up going in the complete opposite direction from the night before. How is that logical? Every participant got the same information at the same time. If the market was truly efficient, the pricing should be relatively stable after the news was made public.

Active Investing
Pros

• More fun – This might seem like a silly and illogical pro. People invest to make money, not for fun! That’s not really true though. Most active investors love the thrill of researching companies in order to find the gems that they believe will make them money. It can be fun, although potentially misleading.

• Diversification – Through active investing, you can create custom portfolios that provides hedges and diversification that can insulate a portfolio from market instability.

Cons

• It usually doesn’t bring better gains. When looking at the performance of money managers over the long run, the vast majority under perform the index. There are often specific reasons for this, I’ll leave that for another feature.

• Cost. Running an active portfolio often results in more transactions and different positions, creating a larger costs through commissions and fees.

Indexing (The ultimate passive approach)

Pros

• Easy. There’s no research to do. Just pick up an Indexed product and hold it.

• Cheap. Fees on indexed products are significantly lower than active products.

• Performance. The index will outperform most managers, so why even bother with the high fees and lower performance?

Cons

• Diversification Risk. Indexes are not perfect diversification tools. Sometimes the weighting of a sector or even a specific stock can cause a massive skew in the composition of the index. One stock or sectors collapse can cause massive damage to the index and your portfolio.

In the end, it really depends on which strategy suits what kind of investor. If you don’t want any professional help and don’t have the time to research, then indexing might be your best bet. If love the thrill of stock chasing and picking, you’re probably already an active investor.

Best of Luck!