I’m often asked about how technical indicators work across different time frames. The short answer is yes, they work. The longer answer follows and explains how you need to use the toolkit differently depending on your time frame. Many investors get locked into a particular time frame, and then forget that they are also subject to market dynamics on other time frames as well.
Let’s say that the orange line in the drawing below represents the price of a stock on your normal investment time frame, and let’s say your investment horizon is around 6-12 months. You’re basically trying to anticipate where that orange line is headed.
What you have to remember is that the simplified price as illustrated by the orange line is not happening in a vacuum. The orange line is actually formed from a shorter time frame of peaks and valleys. This represents the short-term price action. There is also a longer-term time frame of multi-year cycles, what we might call the business cycle. This is where sectors and themes come in and out of favor. Now that we’ve added these additional components, the price illustration now looks like this:
Besides trying to anticipate where the orange line is headed, you also have to deal with the short-term fluctuations of the blue line, as well as the long-term trend of the black line. Here’s how I like to explain the uses of technical analysis across these three time frames:
In what I call the short-term market, from a couple days to a couple weeks, the markets tend to mean revert. That means they essentially move back and forth and settle into the intermediate-term trend. So if you’re focused on this time frame, you should be buying.
An indicator like RSI can be used to anticipate turning points on this time frame. Notice on the chart of AAPL how the peaks and valleys in the RSI tend to coincide with the peaks and valleys in the 5-day RSI. You’ll also notice some divergences appearing, for example the lower peaks in the RSI in September and October that line up with higher highs in price. This suggests a weakening of momentum on that final push higher in price. The intermediate-term time frame is the sweet spot for trend followers. On the 6-12 month time frame, market trends tend to persist. In other words, you should be buying strength and selling weakness. This is where most institutional investors operate, this is why the momentum factor works, and this is why most institutions are trend followers.
This chart of IAC shows how RSI can be used less for mean reversion and more for trend following. The stock entered a downtrend in mid-2015 and as the price moved lower the RSI fluctuated between 20 and 60.
Once a new uptrend emerged in 2016, the RSI moved up to the 40 to 80 range. So essentially the range of the RSI confirms the overall trend of the stock. In a bullish phase, as long as the RSI remains above 40, the uptrend likely remains intact. You’ll notice in my illustration of the three time frames that I indicated how much fundamental analysis should be used. On the short-term time frame, where markets tend to mean revert, technical analysis is essential as there is very little fundamental data that resonates for that time frame.
The intermediate term time frame suggests a “fusion approach” or a blend of fundamental and technical analysis. Here we can capture price momentum and follow trends, and also line up those inputs with fundamental factors such as earnings growth and profit margins. On the longest time frame, I would argue that technical analysis becomes less and less relevant because in the end, stocks trade to their fundamental valuation. The real benefit of technical analysis is taking advantage of the shorter time frames, where stocks disconnect from their valuations. For long-term investors, understanding the relationship between the mean reversion of the short-term and the trends of the intermediate- term will allow you to maximize returns and avoid whipsaws.