IN ECONOMICS CLASSES
across the country, just about every curriculum starts and ends with fundamental analysis, the process of determining a company's investment potential by analyzing its financial statements. It's been that way ever since Chester A. Arthur was in the White House. After making assumptions on everything from interest rates to sales, inflation to the tax code, students construct models that help to determine a historically "fair" price for a particular security. Undervalued stocks are purchased; overvalued stocks are sold or avoided.
While fundamental analysis might succeed as an academic exercise, as a legitimate investment tool I believe it falls flat. Besides the fact that evaluating a company's operations, management, competition, technology and regulatory landscape is nothing less than a full-time job, the implicit premise of fundamental analysis hinges on the assumption that a company's economic condition will ultimately be reflected in its stock price. Yet as we've seen time and time again, a company and a stock are two separate animals altogether.
And because it's the price, not the balance sheet, that we trade, technical analysis offers a significantly more useful method of evaluating markets. The basic premise of technical analysis is that the markets, like most things in nature, tend to move in trends that persist over time. So while fundamental analysis is rooted in often arbitrary assumptions and expectations, a technical approach correctly prescribes that we observe the market as it is, not as we wish it would be.
The technician understands that what we think about the market matters much less than what we see occurring within it. So while the fundamental analyst tries to predict, the technician aims to observe. And because the best indicator of the market is the market, being less opinionated and more informed leads to better investment decisions across the board.
For example, I find far too many fundamentally minded investors who are dead set on making money their way, and their way only. So instead of letting the market dictate their trading thesis, they're intent on fitting the market into their presumptions about how things ought to be.> During the 1990s tech boom, they clutched to bonds, value stocks and the high-dividend plays that should've risen, even as all underperformed growth stocks by a wide margin. Most technicians correctly dismissed those groups as weak, and avoided them even as their fundamental story became more attractive the further they fell.
If nothing else, technicians are disciplined. From what I can tell, the traders who self-destruct and cannonball their portfolios tend to be fundamentalists who can't accept a market not confirming their deeply held beliefs about the world. Technicians, on the other hand, are inherently more likely to go with the flow, accepting the market as it is and leaning to alter their approach.
I don't care how fast your fingers are, given the speed at which information is now disseminated, it's downright impossible to profitably react to a piece of fundamental news as it's publicly released. Regardless if it's employment figures or a company's earnings announcements, fundamental information is immediately absorbed by the market and factored into market price. Although there's usually volatility surrounding the announcement, there's rarely any real opportunity to actually make a buck. By the time it's out, the real move has already been made.
That presents another big advantage of utilizing a technical approach. Although it's a difficult concept for new traders to grasp, the fact of the matter is that markets generally anticipate> news rather than reflect it. So you'll often see, for example, stocks rise in the weeks ahead of a positive earnings announcement. That's also why commodities such as gold and oil strengthened for years before inflationary signs began showing up in economic data.
Because technical traders know that the market generally moves before the news breaks, they tend to operate under the premise that less is more, focusing on owning strong securities even before there's an easily digestible news peg to explain their outperformance. Technicians trust the market, knowing that in most cases the news catches up eventually to what the price action has already predicted.
Because they're overloaded with data, however, fundamental analysts are often presented with conflicting signals regarding a particular trade. They might be bullish on XYZ's new product rollout, but the company's latest earnings announcement failed to meet expectations. Meanwhile, the macroeconomic picture suggests continued strength, yet the company's management all seem to be selling the stock. The net effect: paralysis by analysis.
Importantly, I believe technical analysis helps to nullify one of the biggest drags on portfolio management: our own emotions. Trading is a mind game, and although we'd like to think of ourselves as rational beings operating in our own economic self-interest, when the money starts flying, it's all too easy to lose one's head.
When practiced correctly, technical analysis not only helps formulate what to buy, but how to buy>, presenting a disciplined, rules-based framework for allocating resources and controlling risk. As I wrote last year, even a basic 200-day moving average can give a trader much-needed structure. When XYZ crosses above its moving average, it's a buy. Should it fall below, it's a sell.
Although it's an elementary approach, it provides exactly what fundamental analysis doesn't: a concise plan for getting into and out of a particular market. Fundamental analysis tends to leave traders alone in the woods. "Good" companies are purchased and held...up until the fundamental picture deteriorates. Of course, by that time, who knows how far the stock has slipped.
And because it's the market, not our own opinion, that dictates our actions using technical analysis, investment decisions are inherently more objective, rational and level-headed. For example, when managing a stock holding we were given as a gift, or even a position in a company we particularly like, it's often far too easy to forget it's the stock we trade and not the story. There are plenty of great companies with downright lousy stocks. Technical analysis plays no favorites. When followed correctly, every security is dealt with in the same disciplined fashion.
More than a fast Internet connection or a hot stock tip, what traders truly need is a consistent and disciplined method of analysis that can be used across any number of markets or economic environments. By definition, trading is the business of speculation. No matter how much research or due diligence we do, nobody knows what's going to happen. There is no holy grail.
In the final analysis, I do believe most traders will find technical analysis to be the most useful method of investment research. Unlike fundamental analysis, it focuses exclusively on what's important: a security's price action. And because the market, and not our hunches, dictates the approach, it helps to remove the emotional obstacles that too often lead to undisciplined trading. Finally, technical analysis succeeds because even at the most basic level, it provides a disciplined code of conduct for getting into and out of the market.
It might not get respect, but more often than not it gets results. And that's all that matters in the end.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.>