Thursday, March 10, 2011

Is technical or fundamental analysis a load of bull or bear crap?

One of the blog that I read occasionally recently wrote a post lambasting stock market technical analysis as a "load of bull crap and bear crap".

Just because someone hasn't found a trading technique that's satisfying them in making them thousands or millions of dollars in profit or whatever they're seeking to gain, doesn't mean they should just write something off as crap. Just because a technique hasn't worked for you doesn't mean it's a bunch of crap.

Have you ever heard of the phrase self fulfilling prophecy?

This is an important concept and can be applied to your own personal life and also to your investment life. In Wikipedia, self fulfilling prophecy is defined as,
A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior.
If you tell a child that they are smart and will grow up to be successful, there's a greater possibility that the child will grow up into your expectations of them. If however, you tell them every day that they're dumb, stupid, useless and will amount to nothing, then there's a higher chance that they will grow into that type of person (unless their character is defiant enough to prove your wrong).

How does self fulfilling prophecies affect technical or fundamental analysis (known as TA and FA)?

Stock prices aren't insular, as such, technical or fundamental analysis does not work perfectly in pricing a stock. You can churn out all the financial ratios, analyse everything you want, and or apply technical analysis and find out the support and resistance points blah blah blah - then you draw a fully informed conclusion that the stock that you want to trade or invest in is worth $X but the market doesn't price the stock at $X just because technically the stock should be valued at $X.

Instead, the stock could spike beyond $X, exceeding your expectations or they can drop below $X, disappointing you. Why? Because the market moves as a result of several thousands or millions of investors out there with different expectations at what $X should be. Also, when a group of bearish investors outnumber a group of bullish investors, the the market will generally swing towards the bearish end. Investors and traders expectations change from day to day. This is why there's stock market volatility.

FA is good for determining what the value of the stock should be. TA is commonly used by traders to predict roughly how the stock is trending, whether up, down or sideways.

If you perform your FA due diligence and then trade using TA, why does the stock that you're analysing differ from your expectations that it should be $X?

Because that stock isn't insulated from the market. If FA and TA points to the stock being priced at $X but then tomorrow, President Barack Obama makes a sudden announcement that the US has been incorrectly accounting for the deficit. That instead of a $11 trillion dollar national deficit, the national deficit is actually $20 trillion, then expectations of the whole market in the US and everywhere around the world will turn bearish. Because of negative expectations, people behave negatively, they cut their spending, then businesses cut staff hours, then the government collects less tax revenue and cuts back on infrastructure and budgetary spending, which sees government employees made redundant and so on and so on. The stockmarket crashes and the negative expectation becomes a self fulfilling prophecy. It works conversely as well.

For example, if I decided to trade in CCL shares at $11.82 cents each and the stock market had a bearish month, causing CCL to drop to $10, does that mean that fundamental analysis is a load of crap? No. does that mean technical analysis is a load of crap? No.

Both FA and TA have evolved over the decades as a measure of valuing the price of a stock. TA evolved as a method in predicting price movements, particular for support or resistance. If enough people believe in those methods, then those methods will be influential on the stock market. If there are a lot of stock market traders who use TA thinks that CCL will find support at $10, they'll submit buy orders at $10 and then the moment that CCL drops to $10, traders activate their buy orders creating a floor. Large buy orders will indicate demand and CCL's price doesn't drop below $10. Again - a self fulfilling prophecy.

All stock prices are affected by several factors. With FA, you can identify a good stock that can survive recessions and any difficulties so that once the economy picks up again, they'll be back into a growing, profitable business again. TA is good as a general guildline to trade with but does not help in identifying which stock to buy and hold for the long term.

TA is superficial. If there's enough traders around using TA, then the stock price will behave roughly in line with expectations.

Basic technical analysis in action:

Technical analysis is also known as charting. Why? Because you use a bunch of charts and statistics to draw conclusions and trend directions for stock price.

Chartists use such measures as: Simple/exponential/weighted moving averages, Bollinger bands, volume analysis, stochastics, MACD, prices from open/high/low/close, line charts, candle charts, percentage change etc

You can have a perfect TA trading technique that makes you money regularly but if suddenly September 911 happened again and the stock market crashes - does that mean TA is rubbish? No.

TA is a rough guide, no matter what chartists' insist. Remember, share prices are not insular. They react to the entire market and if you just pay attention to your charts in performing TA without paying attention to the stockmarket (nationally and internationally) as a whole along with the general mood/behaviour of the population then you'll never know what hit you when your technical analysis fails.

Following on with the CCL example:

I've got a screenshot of CCL and drew in some rough support and resistance lines. This has some classic TA evident on the graph. This graph here demonstrates that chartists are around. CCL was $10.67 at its lowest point in June. In December, as the CCL stock price dropped, there would have been a bunch of buyers with buy orders to be excuted when CCL price reaches $10.67 or thereabouts. This creates a floor for CCL, meaning that in future, provided CCL doesn't get banned from sellling their drinks in China or India or where ever, then if CCL drops down again due to general market bearish behaviour, it's likely that once again, there will be a bunch of buyers waiting to buy around $10.67 again.

I've drawn in four resistance lines. They're all suppose to be green but I was too lazy to fix it up. For technical traders, they get twitchy when the stock price approaches any price resistance levels so they set their "sell" order at or just before those price resistance levels.

The current price is $11.80 If you bought today, provided there aren't any dramatic worldwide events or CCL didn't get banned from selling Coke in China, you would be looking at the following scenarios based on TA:

i) Buy at $11.80
ii) Market is bearish, potential loss is $11.80- $10.67 (floor price) per unit
iii) Market is bullish, potential sell order can be placed anywhere near any of the top three green resistance lines. Although the middle two green resistance lines have been reached a lot more frequently so as a TA, you would likely place a sell order close to those prices.
iv)CCL shares however has been generally trending sideways over the past 12 months. They're a blue chip stock though and if you're expecting capital gains like the ones investors got from Apple, VM Ware and Google then you're better off looking for a chart with good FA and an upward trajectory.

Along with those simplistic TA conclusions, TA will also look at volume and various other charts to analyse market demand. I personally prefer to start off all investments or trades with FA and then use TA, particularly the candlestick charts with the high/low/open/close prices on them or the simple line chart above. I also like to look at the 365 day price list with open/high/low/close prices. For intraday trades, buy and sell volumes are really useful. Although the biggest determinant of stock price movement is the general enconomy and the population's expectations.

The stock market reacts to future positive or negative expectations. All the FA and TA in the world won't predict the stock prices accurately which is why all the large investment banks, trading firms and hedge funds have economists to try and predict the general behaviour of the country. Or else they have contacts inside government organisations so that they know whether the Federal Reserves' Ben Bernanke or the RBA's Glen Steven will be raising or decreasing interest rates. Changing interest rates change consumer behaviours and as a result, that changes consumers' discretionary spending and this is what ultimately affects companies' bottom line, which affects their profits/expenses and ratios in the future and thus, their share price.

A question from one of the comments on that blog:

There is no one in the world who can perfectly predict how the stockmarket will react unless they're Barack Obama or Ben Bernanke for example (only because they control monetary policy which wields a lot of power and influence). Anyway, this is what someone wrote:
I have spoke (sic:spoken) to many people that claim they are millionaires from the stock market without disclosing how they did it. If you have made millions from the stock market please share your tactics here. What stocks would you recommend, what investment company (e-trade)? Do not answer if you haven't made millions in the stock market!
*The traders or investors who made millions from trading the stockmarket probably had just as much capital to start off with.
*Typically the millionaires from trading are the hedge funds and traders working for the investment banks, not the small investors who started off with $20,000 or whatever
*To amass capital gains of a few millions from just a few thousand dollars would mean trading frequently and as such, impossible to simply just "share" without including pages and pages of buy/sell history
*Why would millionaire traders "disclose" their entire strategy to you for free? What would they gain from you?
*They could recommend a great stock for you to buy today but that will be valid for today and today's environment. If you bought that 'great' stock today and then next week, Obama states that unemployment in the US has gone up to 15% and the sharemarket crash - who will you blame for the advice?? Will you tell them that it was poor advice?

In the long run, I've worked out that a simple buy and hold strategy works just as well as trading, if not better! Because of the 50% CGT tax deductions from holding a stock beyond 12 months and also holding the stock through interim and annual dividend periods means that I also get franking credits (although these are only applicable in Australia - I mention this because there are a several readers from America on this blog and I don't want to mislead you).

Related posts to stockmarket investing:
* Calculating break even for stock investing or trading
* Stock investing fundamentals and a slice of my portfolio
* Quiz to determine your risk profile
* Breakdown of my retirement asset
* Picking low hanging fruits first

1 comment:

  1. I think you did the right thing by commenting, The stock market is hard enough as it is with out all the bull.