Every so often, I hear about someone challenging "technical analysis" as not being at all worthwhile for picking stocks … or any security for that matter. For some, spending time analyzing the technical movements of securities – basically just monitoring shifts in price and volume – is useless in deciding what to buy and when to buy it. To them, it is all "just a bunch of charts" or merely "hocus pocus" and has no part to play in the investment world.
Online, there is usually someone who pipes in to say, "Yeah, but do I have to give all the money back?"
As more people have come to understand what "technical analysis" really is, the voices calling it a waste of time have become significantly fewer. More and more diehard "fundamentalists" – people who focus only on the fundamentals of a company, such as the earnings and balance sheets -- have come to recognize that keeping an eye on those volatile price movements is not such a bad idea.
First, let us discuss the purely fundamental view of securities, in this case, for example, stocks. When you are buying shares in a company, you a purchasing a right to the future income streams of that enterprise. If you own all the shares of a company, you own the rights to all the future profits. If you sell all or part of these shares, you would sell them at the "present value" of those income streams – risk adjusted, of course.
And here is where fundamental analysis comes in: determining the risk factors on those future income streams and adjusting the present value accordingly. Inflation is one obvious factor. A change in the Consumer Price Index will certainly affect the price of bonds and other fixed income securities, but it also affects companies and their expected future earnings. New products or a new management team could signal an increase in future profits and therefore the present value of the company. A change in the company’s operating ratios – such as inventory turnover or cash flow – could also indicate a change in future profits. All of these, and many more are classic measures of a company’s fundamental health and prospects for future growth and are to be measured against competitors and the market as a whole.
In a perfect world every security would be priced at its fair market value based on the risk-adjusted, net-present-value of its future income streams. In a perfect world every investor has equal access to all this information and every investor would run the same basic calculations to know that ACME Corp. is fairly priced at $20 and a hell-of-a bargain if it dips to $19. So we would all scoop up every share we could get below $20 until the price rose to that FMV.
The fact of the matter is that just as economists cannot agree what will happen next in the economy when they all have access to the same data, investors do not all agree how much a company is worth at any given time. Highly active stocks like Microsoft, Dell and Intel will change in value billions of dollars a day – up or down. Does that mean that the earnings picture or balance sheet of these companies changes that often? Of course not. So why do prices change more often than the fundamentals of company?
Supply and Demand drive the technical moves in today’s fast-paced markets
Here is where technical analysis comes in as a valid tool, and why a purely fundamental view cannot explain all the market’s price movements. Just like we do not live in a perfect world, we do not invest in a perfect market. The realities of supply and demand, not just a fundamentals-based, efficient-market-theory model, move the market.
If a company like the one graphed below, Network Peripherals, a small-cap network equipment manufacturer, trades an average of 300,000 shares a day, the price will remain relatively the same unless there is a news report or analyst recommendation that changes the street’s perception of the company’s future earnings. So without any major news, why did NPIX go up so much from 2/96 to 6/96? It is obvious the increase in volume meant that demand for the stock grew, but with an average "inventory" of shares traded per day of around 300K, the interested buyers had to bid up the stock to get people to sell. In the negotiated and auction markets of the NASDAQ, NYSE, and others, buyers and sellers are always trying to get the best prices they can. If it is your 1000 shares, and you believe you can get an extra ¼ point because the market is moving up, you will wait for it.
In the case of NPIX, this increase in volume drove up the price as someone or a group of people were trying to acquire it. As was later covered in a news article, a mutual fund was acquiring NPIX during this period. If the fund had wanted to acquire all its shares in a week, it would have paid far more than it did by spreading its demand for the stock over a longer period instead of just a week.
Stocks moving "technically" in response to increased demand is just one side of the equation. For when the demand slacked off, you can see that the price dropped in each instance. In technical analysis terms, the stock returned closer to its average selling price from a high or low too far off the mean. In the chart above, we have a 30 day "moving average" overlaid on the daily prices, and you can see that volatile swings in price are usually followed by a move in the opposite direction toward the moving average.
Let’s talk about mutual funds a little more and their impact on a technical market. The average investor may not appreciate the "little" advantages he or she has over the funds when investing. Here are two of them: The big players on the street have information and resources to their advantage over individual investors but have a weakness when it comes time to move. Why? When a fund decides to move into a stock, that fund may have to "move the market", like in NPIX above, to acquire enough shares to be of value for a $100+ million portfolio. Does an individual, even a high net-worth individual, move the market when putting 2-5% of his/her money in a single stock? Usually not. But a fund can rarely help it, especially when investing in small and mid-caps.
The second "advantage" individuals have over large funds is the little known fact that today most funds require their managers to stay fully invested in the market. That is, when $5 billion a week in new money is showing up in the PO boxes of fund managers across the US, their own rules say that they need to invest it promptly. This is because investors do not want to pay mutual fund managers to manage cash. They invested in those mutual fund shares so the managers would beat the street and find good stocks, not keep 20+% of the fund in cash to "wait for a good buy".
But as an individual, you can wait for a good buy, both fundamentally and technically.
The funds represent the "buy side" of the market, but keep in mind that the "shorts" can also add to volatility and technical movements. When short-sellers – those who have sold stock they do not own in anticipation of a drop in price – see their shorted stock rise suddenly, they can be forced to buy in a rising market to prevent further losses. This increases demand and, therefore, prices further and is another time when a market technician with the right tools can pick securities ripe for quick movements up or down.
With all the factors that can lead to technical movements in securities regardless of the fundamentals, it is no wonder that all the big houses on Wall Street have a Chief Technical Analyst. If thousands of investors and traders across the country have computers that simultaneously suggest selling a security … and everyone does sell, the realities of the market will drive down the price and make it a good decision to have sold at that point in time.
The fact that securities markets are not purely efficient is true in more than just the North American stock exchanges. In fact, Christopher Neely, an economist at the Federal Reserve Bank of St. Louis says that,
"Technical analysis is the most widely used trading strategy in the foreign exchange market. Traders stake large positions on their interpretations of patterns in the data. The weight of the evidence now suggests that excess returns have been available to technical foreign exchange traders over long periods." Review, 9/97.
Today’s PC based investment software packages offer the power and market data previously only available to professionals. What is best for new and experienced traders alike is that the programs come with the ease-of-use of today’s graphical interfaces. All of this allows you to use as much or as little technical analysis as you feel necessary and you can combine that with your favorite approach to fundamental analysis.
Here’s an example:
Using
a program with the ability to automate trading strategies into computerized
"trading systems", you can take technical analysis to its full
potential – letting the computer suggest the precise times to buy and sell a
specific security based on the assumptions of the system and the incoming market
data. But before following this computerized guidance, you will want to backtest
your strategies on historical data. All robust trading packages today offer not
only this "testing" capability, but offer an historical data CD for
you on the whole market. Most will also ship with a number of trading systems
already programmed into the package. Adding more systems and strategies can be
as easy as programming an Excel macro, or as complicated as regular computer
programming in Basic or Cobol. Do not be intimidated by the customizability of
these programs, because most offer analysis templates and a host of features
just a "right-click" away with your mouse.
In the chart above, the computer "found" a trading system that tested as being very profitable in trading Netscape since it went public – a 122% annual rate of return. We let our computer backtest all the trading systems that shipped with this particular program and ranked them in a list so we could determine which was the most successful. The computer was used for what it does best – lots of repetitive calculations – and that saved us countless time. Had we not found something profitable, it would have only cost us seconds, and we could move on to testing another security, whether it was corn futures or bonds.
But since fundamentals are probably still important to you – say Netscape went down recently for a reason, even though a buy signal has been triggered technically – you can still use your investment software to aid in this trading decision:
Use your program to examine fundamental data, both current and historical. And some programs will even let you set up market filters for your unique criteria for finding other buying opportunities. The screenshot below shows a custom "scan" on the market. We are requesting securities that have a relatively clean balance sheet (Current Ratio > 2.0), that are currently profitable (EPS > 0) and have a record of earnings growth (>25%), and the owners have a significant interest in the company (>30%), but the institutions are not majority owners. Whatever fundamental analysis you want to apply could be done – even by market sector or industry group.
The power of these two analysis techniques – both fundamental analysis and the technical -- comes to light even more when you use them together. The best approach as a prudent investor or trader is to use all the tools available to improve your success. This is the "rational" approach and is also the term used to describe using fundamental and technical analysis in concert – rational analysis.
Because you will be at last looking at both sides of the market, you minimize your risk and increase long term profits. Start with one form of analysis, and then let the other determine the best pick from your narrowed list. Considering a buy on the recommendation from your friend or broker? Take a look at the technicals to see if it is likely to pull back from a recent run-up.
Combine the two techniques using your own investment knowledge, experience, and style, and you will be trading with the same tools and techniques of the pros. Whether you trade part-time or full time, evenings, weekends, or intra-day … it is truly the rational way to improve your success in the markets.
Sean M. Davis is Vice President of Window On WallStreet, Inc. in Richardson, TX. He can be reached at (972) 783-6792, fax – (972)783-6798.
|