Charting Your Way To Better Returns

By Matt Blackman AAA

Market participants can be divided into three camps - the fundamentalist, the technician and a strange but rare hybrid between the two called the technimentalist. Let's take a look at how the three are different and why the last group has a distinct strategic advantage over the other two.

See: Technical Analysis

When it comes to money, everyone has an opinion. This is one reason why few so-called experts can ever agree on what to do with it. This is true even when they are from the same school of thought. Have you ever heard two economists agree on what the economy will do next? Try asking two analysts from the same brokerage firm which company is the best investment. Odds are high that their answers won't be the same.

So it's no surprise that when fundamental and technical analysts get together, the end is always the same, regardless of how long they discuss the methodology for making money in the market. At best they cordially agree to disagree.

Fundamental Vs. Technical
Fundamentalists argue that the best way to invest is to research exhaustively a company from stem to stern, carefully dissecting annual statements, determine top and bottom line growth for the last umpteen years, compare price to earnings and a whole host of other ratios, interview management, study markets and the competition and then, and only then, can you know if the company is a buy or sell. For fundamentalists, determining what a company will be worth in the future by looking at its stock chart is like trying to drive a motorcycle in traffic while facing backwards. They say price gives you no idea where the stock is going, only where it's been.

Technicians, on the other hand, would argue that putting a company under a fiscal microscope is a complete waste of time. By the time you have access to the data, the stock has already reacted. And how can you guarantee that the data are accurate?

There is some convincing evidence for the technical analyst's argument. Look at WorldCom or Enron, for example. The poor investors who relied on financial disclosures from those companies saw stock portfolios decimated. But the market knew: by the time disclosures of financial misfeasance were made public, stock prices in both companies had already plummeted. Technicians only have to look at a stock chart to know what to do.

Finally, fundamentalists are longer-term investors while technicians are generally short to medium-term traders. In the eyes of each, the other could not be more wrong. But if one is east and the other west, shall never the twain meet?

Marvelous Match – Technimental Analysis
It's a match made in heaven for the technimentalist, who understands that there are fundamentals but that the market's reactions depend on the emotions of fear and greed. The technimentalist also realizes that the individual will likely never have access to all the facts in time to react before the market. Nor can he or she predict future market sentiment or the price swings that it causes. For this reason, the technimentalist understands that stock price is the best indicator of all. Covering the bases, fundamental analysis tells this hybrid investor what to buy or sell, and technical analysis to tells him or her when.

The Discipline of Technimental Analysis
No one would argue against doing your homework on a company before investing. But technimentalists believe that more important than getting tied up on past performance numbers, financial reports or corporate structure is an examination of the trends.

Are corporate revenues declining, stable or increasing? How effectively is the company competing? Is it gaining market share or losing it? Is the company experiencing growth and is that growth from top-line expansion (selling more product on increasing margins) or bottom-line cuts (laying off workers, cutting expenses or selling assets)? A company can lay off workers and cut expenses for only so long before its ability to compete is seriously diminished.

Another factor to examine is the activity of corporate insiders. If insiders such as directors and executives or institutions are selling their stock like there is no tomorrow, it is for a reason: they may believe that the stock is overpriced or they may be responding to other deep-rooted problems. Why should you buy stock in the company if those closely associated with it are selling large blocks of it? On the other hand, if insiders suddenly start to buy or are increasing holdings, it could indicate that corporate fortunes are improving or a promising new technology or product is having a positive effect on the bottom line.

The next step is to examine the charts. Have you ever heard an analyst sing the praises of a company only to see that it has a chart that looks like a ski slope into oblivion? It might have an attractive price-to-earnings ratio and a healthy balance sheet, but do you want to invest your hard-earned money on a bet that the stock will turn around immediately after you jump in? Traders call that practice catching a falling knife for a reason. It is a sad but true fact that thousands of investors will buy a stock based on such a recommendation without taking so much as a glance at the chart.

One of the main tenets of technical analysis is that stocks move in trends. Another is that a trend will continue until an equal or greater opposing force acts on the stock. An unexpected change in earnings, the loss of a large contract or any number of countless reasons could be a force significant enough to change investor sentiment. Betting on a trend reversal is far riskier than betting that it will continue.

Let's take a look at Nortel Networks back in 2000. The stock soared to over C$120 before a negative earnings report came out to reverse the stampede. In two months the price dropped in half, but many investors were prompted to buy the stock as analysts argued that the valuation had become more attractive. The investors thought that the trend would reverse again, but they were wrong. It eventually hit a low of 67 cents before reversing again more than two years later (see Figure 1).

111203_1a.gif
Figure 1 – Weekly chart of Nortel Networks (NT.TO-TSX and NT-NYSE) showing three dominant trends. They are the accumulation before the top, the distribution for the next two years where it dropped to 67 cents and the new accumulation phase again. Investors who bought in when the stock price dropped in half based on the more attractive valuation argument were in for a painful ride over the next 22 months. Chart provided by MetaStock.com

There are countless other examples of stocks that dropped even though analysts presented sound fundamental arguments to buy. For those listening to the valuation arguments, Enron became more attractive as its price plummeted: the more its price decreased, the more attractive its multiples became. So many continued to buy it. And what is it worth today? Zero, zilch, nada.

Conclusion - Putting It All Together
While investors with any experience would never buy a stock without researching the fundamentals of the company, many will completely ignore the technicals. But relying solely on fundamentals to buy or sell ignores two major market forces: the emotions of fear and greed.

By studying the fundamentals - such as the direction of revenues, margins, insider sales and other key factors-you can determine what companies to buy or sell. But by following the direction and trend of the stock chart to monitor sentiment and by waiting for all to agree, you can determine exactly when to make your move

comments powered by Disqus
Related Articles
  1. The Five Biggest Stock Market Myths
    Investing Basics

    The Five Biggest Stock Market Myths

  2. How To Decode A Company's Earnings Reports
    Fundamental Analysis

    How To Decode A Company's Earnings Reports

  3. Identifying Market Trends
    Active Trading Fundamentals

    Identifying Market Trends

  4. Introduction To Technical Analysis Price ...
    Trading Strategies

    Introduction To Technical Analysis Price ...

  5. The Essentials Of Corporate Cash Flow ...
    Retirement

    The Essentials Of Corporate Cash Flow ...

Trading Center