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"Why" Doesn't Matter to the Technical Trader
by: Michael Covel
Still trying to decide between fundamental and technical
analysis? The author takes a firm stance and shows you why
technical analysis is not for dummies.
May, 2007
Originally profiled in the book Market Wizards (HarperCollins, 1988) by Jack D.
Schwager, Larry Hite is a noted hedge fund manager with a long career. One of Hite’s
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strengths is his ability to break down complicated trading jargon and concepts for the
layperson. He sees trading and speculation in stark but simple terms. Accordint to
www.hitecapital.com, he says, “Every bet that we make involves a trade-off based on
a decision to pay or risk something of value (time, money, emotional involvement, a
The World Bank: Reversing Poverty by
Investing in Poor Countries
bunch of bananas) for the uncertain prospect of gain. Placing winning bets in investing,
as in life, therefore, requires the development of a strategic ability to make better bets
Learning to Be a Trend Detective
(i.e., critical tradeoffs) between and among financial and non-financial outcomes.
Where most of us tend to trip up, often unwittingly, is when we fail to grasp the
complete extent and true nature of the tradeoffs implicit in what always comes down to
choices.”
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Although Hite hits the nail on the head about where our energies should go, (risk
management), the unfortunate reality is that many traders seem to focus on other
issues. And of those, traders seem to spend the most time debating fundamental
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Analysis
analysis versus technical analysis. It is an argument that may be the single biggest
dividing line between the average investor and the professional winning hedge fund
manager.
The Basic Debate
Before adding fuel to this already overheated fire, it is useful to demystify the jargon
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with a couple of definitions. In my book Trend Following, (Pearson, 1995), I define
fundamental analysis as the study of external factors that affect the supply and demand
of a particular market. Fundamental analysis focuses on factors such as weather,
government policies, domestic and foreign political and economic events,
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price-earnings ratios, and balance sheets to make decisions. By monitoring supply and
demand factors, or “fundamentals” for a particular market, followers believe they can
predict a change in market conditions before that change has been reflected in the price
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of the market. The vast majority of Wall Street is clearly a proponent of fundamental
analysis.
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Technical analysis operates in stark contrast to fundamental analysis. It is based on
the belief that, at any given point in time, market prices reflect all known factors
affecting supply and demand for that particular market. Instead of evaluating
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fundamental factors outside the market, technical analysis looks at the market prices
themselves to make decisions. Technical traders believe that a careful analysis of daily
price action is an effective means of capitalizing on price trends. However,
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understanding technical analysis gets tricky. There are essentially two forms of
technical analysis. One is based on an ability to read charts and use indicators to divine
the market direction. These so-called technical traders use methods designed to
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attempt to predict a market direction.
Prediction, whether fundamental or technical, is not what great traders do. On the
contrary, great traders technically react. Instead of trying to predict a market
direction based on some form of technical analysis, their strategy is to react to the
market’s movements whenever they occur. These traders make decisions based on
what has happened rather than anticipating what will happen. They keep their
strategies based on statistically validated trading rules. This enables them to focus on
the market’s movement and not get emotionally involved with the unknowns of
predictive technical analysis or for that matter fundamental analysis.
Are the Numbers Made Up?
However clear these definitions may appear on the page, the sad truth is that for most
people, Jim Cramer and his nightly fundamental calls on CNBC’s “Mad Money” is still
the advice that sounds most credible. For them reality is a smart man with an
overwhelming amount of information about every company under the sun. He appears
to be able to look into the future and make sound predictions. Why not buy into
Cramer’s advice every night?
There are problems. Consider feedback from one of my blog readers Chuck Cain:
What do fundamental analysts analyze? It doesn’t make sense to base an analysis on
data containing errors. Example? Banks can set earnings in quite a wide range by
changing the period’s addition to ‘reserves for loan losses.’ You wouldn’t believe what
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gets done to this poor number when the trial balance bottom line doesn’t look good. The
IRS won’t let banks use this number; the IRS requires actual loan losses instead. It
doesn’t make sense to base analysis on numbers which are made up. Example?
Worldcom, Enron, enough said. … How do fundamental analysts know which numbers
are wrong, are estimates, have large error margins or are completely bogus? What is
fundamental analysis worth if these numbers aren’t screened out? If they are screened
out, what’s left?
Michael Gibbons, a technical trader who reacts to price movement, expanded on the
old saying, garbage in, garbage out: “I stopped looking at news as something important
in 1978. A good friend of mine was employed as a reporter by the largest commodity
news service at the time. One day his major story was about sugar and what it was
going to do. After I read his piece, I asked, ‘Gary, how do you know all of this?’ I will
never forget his answer. He said, ‘I made it up.’”
Haven’t you ever felt that way when hearing some fantastic Wall Street prediction?
Deep down you heard the prediction and knew it was baloney but were afraid to say so!
Why not stop the debate once and for all by performing this simple exercise: Go to a
stock trading forum and find a bunch of hot fundamental stock tips. Study the
fundamentals of those companies until you know everything you can possibly know
about them. Get intimate with the P/E (price/earnings) ratio, the book value, the profit
margins, etc. Do you feel better now? Are you now more fully prepared to make your
trading decisions? Of course not! Why then do people persist in searching endlessly for
a fundamental understanding even if it never brings them any closer to the truth of
knowing when to buy or sell or how much to buy or sell? An excerpt from Yahoo!
Finance makes my point:
The main rule for selling is to sell what you see, not what you think. This rather difficult
concept is counterintuitive, because stocks often climax and fall off the cliff even while
their fundamentals, earnings history and future look spectacular. Chipmaker Marvell
Technology Group (MRVL) breezed past Thomson First Call consensus estimates in
each of the past 13 quarters, by 2-11 percent. Earnings bounded 50 percent or more and
sales went up 31 percent and higher in the past eight quarters. Double-digit earnings
and sales growth are expected through next year. Profit margins have also been strong,
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while cash flow has been growing. So why is the stock 52 percent below its all-time
high?
You don’t need to know why it is 52 percent off its all-time high. Who really cares? You
just need to know where it is now and what you need to do to profit. So what keeps
people trapped in this futile quest for fundamentals? An associate of mine believes that
people persist in preferring fundamentals, because they want intellectual stimulation.
“You don’t sound very interesting at a cocktail party if you say Glaxo is going down ‘just
because it is;’ whereas if you can talk about cancer drugs, people think you are
interesting. Goldman Sachs salespeople can talk for hours about cancer drugs, the
Chinese GDP and U.S. housing data—they too like to seem intelligent. You have to ask,
what are you trying to get from markets, money or perceived intelligence?”
The Cocktail Party Theory
The cocktail party theory has struck a cord when it comes to helping people understand
human nature. Another reader wrote me: “That cocktail quote is bang on. I was
involved, as a partner, in a management company, which oversaw the commercial
hedging side of a large group of hog producers. Our futures positions were initiated and
exited based on a set of rigid criteria. We became a broken record constantly
repeating, ‘When we get this much profit we put this many positions on …’ At some
point their eyes would glaze over and the conversation would dry up. I think it’s just
human nature for people to want the fundamentals. It gives them a sense of
accomplishment—however false.”
Exactly. Many people like those feelings. I recently gave a presentation to a group and
afterward spoke with a reporter from Reuters who covers the hedge fund industry. He
was questioning me because he just wasn’t getting it. I drew a simple chart on a white
board that showed a trending market going from 50 to 150 (price-based technical
analysis). Then I asked if he cared what the market was as long as it went from 50 to
150 and he could be on board. He agreed that he would not care as long as he could be a
buyer. Seconds later, he asked, “but how do we know why it went to 150?” We went
round and round. He kept coming back to the idea that there must be a need for
knowing why the market moved. He rationalized that if he knew the fundamentals, he
could surely use that knowledge and do even better. His point left me confident that he
had missed all of my points. He did not see that there was no connection between
knowing all the fundamentals and making proper buy and sell decisions. I kept thinking,
but not saying to him, “Where are all the people who can do that successfully? Where
are their track records?”
Focus on the Critical Questions
Instead of trying to assemble all of the fundamental analysis that purports to tell you
why and what price is doing, why not just follow price from the beginning and make
decisions off that? No matter how heated the fundamental versus technical analysis
debate becomes, there are still, as Larry Hite would remind us, only three critical
issues:
1. What can I win?
2. What can I lose?
3. What are the probabilities of each outcome?
Of course, you can choose fundamental analysis over those three questions, but be
prepared to always be chasing your tail.
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May, 2007
Volume 6, No. 5
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