Technical vs. fundamental analysis

A fundamental analyst spends his time calculating the value of the business that any given stock represents. He evaluates company earnings, competitive position, management, and other factors. Fundamental analysts of commodities study supply and demand for their markets. For example, when the country’s orange-growing regions expect a severe frost, fundamental analysts know that the value of the surviving crop will increase and prices will follow. The big questions then become what portion of the crop is likely to be lost and what will happen to demand in response to a price increase.

A pure technician may not care about the earnings, the frost, or a heat wave. All he wants is the ticker or a symbol and a history of transactions going back some time. He expects to pull some repetitive pattern out of that history and trade it for profit.

Purity and other forms of extremism may attract beginners, but a more mature individual is not likely to see the markets in black and white. It is perfectly normal to feel more attracted either to fundamental or technical analysis. At the same time, an experienced trader, be he a fundamentalist or a technician, does not reject the other point of view but tries to look at the markets with both eyes.

Whether you feel inclined towards fundamental or technical analysis, you have to be curious about how the other side lives. The great Warren Buffett, probably the top fundamental analyst and money manager in the United States, says that people who do not look at prices are like card players who do not look at cards. My own heart is in technical analysis, but whenever I become interested in a stock I like to ask several fundamental questions. I definitely want to know to what industry it belongs. I’d much rather trade a stock in a growth industry, such as nanotechnology or telecommunications, than in some old sluggish group. Also, I tend to stay away from shorting energy stocks and futures, because of my concerns about Hubbert’s Peak1 which calls for a tightness of energy supplies in the coming years.

Figure 1.1 The Difficulty with Fundamental Analysis

The fundamentalist’s dilemma: this daily chart of IBM shows that while the value of the company is increasing, the uptrend is anything but steady. You can see violent moves in the direction of the trend as well as against it. Day after day, prices change, with the company valued 1% more or 1% less, in the absence of any meaningful news. Prices are attached to values with a mile-long rubber band, making a fundamentalist’s lot a hard one!

The problem with fundamental analysis is that values change slowly but prices fluctuate all over the lot. One of my students summed up this problem when he said: “Prices are connected to values by a mile-long rubber band” (see Figure 1.1).

While fundamentalists search for value in the long rows and columns of their spreadsheets, a technician can quickly identify values in any market using a few simple tools. My favorite method for discovering value is to use an exponential moving average—two moving averages, to be exact.

Moving averages identify the levels at which most market participants agree on value (see Figure 1.2). A rising moving average shows that value is increasing, and a falling moving average tells us that value is decreasing.

A trade is an agreement between a buyer and a seller. Since they transact in the midst of the market crowd, their trade represents a momentary consensus not just between the two persons but for the crowd as a whole. If every tick on your screen represents a momentary consensus of value, then a moving average represents a composite photograph, a longer-term consensus.

Moving Averages

A single price does not tell you whether the crowd is bullish or bearish— just as a single photo does not tell you whether a person is an optimist or a pessimist. If, on the other hand, someone brings ten photos of a person to a lab and gets a composite picture, it will reveal that person’s typical features. If you update a composite photo each day, you can monitor trends in that person’s mood.

A moving average serves as a continuously updated composite photograph of the market—it combines prices for several days. The market consists of huge crowds, and a moving average identifies the direction of mass movement.

The most important message of a moving average is the direction of its slope. When it rises, it shows that the crowd is becoming more optimistic—bullish. When it falls, it shows that the crowd is becoming more pessimistic—bearish.

A faster moving average represents a short-term consensus. A slow moving average represents a longer-term consensus. I call the area between the two lines “the value zone.”

Using moving averages to identify value helps differentiate between two different types of trading. A trend-following trader wants to buy when prices pull back towards a rising moving average. A countertrend trader recognizes when the prices get too far away from the value zone, and gets ready to trade the snap-back.

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