Anyone involved in investing for a decent amount of time will know about these two camps. Like ying and yang these different views on how to trade the market often comes to a clash depending on the situation. I often hear of fundamental supporters completely disavowing any value in technical analysis. On the other side, the techies as I’ll call them think of fundamental analysis as blind and outdated. So what is the truth? how have we gotten to this point? Here’s a brief look at my take on the issue:
First it’s important to see where we all come from. Before the advent of powerful person computers and high powered internet connections it was quite difficult to use technical analysis. Many of the most famous and established investors such as Warren Buffett made a fortune with fundamental analysis. The most vocal of these today, made the bulk of their fortune between 1980 and 2000 when the dotcom bubble bust occurred. Let’s take a look at the charts from that period. (Please click to enlarge)
As you can clearly see, the markets were generally in a very strong uptrend during this period. The old fundamental saying of “buy and hold” would produce massive gains for almost anyone with a little patience. The only exception would be if the company went bankrupt which explains the strong emphasis on buying companies with strong balance books and good management.
Now let’s take a look at what happened next:
Starting at the end of 1999 a major failure of fundamental analysis occurred: the dotcom burst. Internet companies who had exploded in value in the late 1990’s were discovered to be based on assumptions of value rather than tangible fundamentals. The markets became violently choppy and many people lost a lot of money. Though as we can see the buy and hold fundies were again proven right as the markets recovered starting in 2003 and soared past the previous highs of the dotcom burst until the end of 2007. This of course, is the time we discovered that the fundamentals behind the 4 year bull market were all smoke and mirrors based on gross overvaluation of real estate assets which caused the largest crash since the great depression which we are in the throws of today. As a side note this time it wasn’t just investors that suffered as many everyday people got suckered in the quick and easy profits real estate was producing and almost all of these were left holding the bag with mortgage loans at higher values than their home.
So to recap that is two major failures of fundamental analysis since the end of 1999. The latest whipping out a large amounts of retiree’s accounts and causing untold damage to the national and world economies. Why did this happen? Simply because fundamental analysis cannot possibly take in all of the facts, many of which only become known after it’s too late. And most importantly it discounts the effects of psychology in the markets which after-all drive the prices of equities higher and lower.
Here is where technical analysis comes in. Technical analysis is not based on fundamentals, it is rather a response to the psychology of the market participants. It promotes risk management and agility in the markets and requires the utmost discipline in order to be successful at.
Let’s take a look at what a techie might see when looking at the same time period:
This is a quick chart drawn up to show what long term trend trading technical analysis would produce starting in the beginning of the 1990’s to present. Starting in 1992 each red line shows an area in which a techie would enter a trade and the green lines show areas techies would take profit. See my previous posts for an explanation of why that is. The black arrows show the points at which technical analysis would start to favor an opposite strategy of what was being used, from long to short or vice versa. As we can see, the risk in technical analysis is severely limited and the outlook is quick to reverse as an answer the price action. The technical analyst’s motto is “trade what you see, not what you think”. That is letting the market dictate the action and direction, no matter the fundamentals. Thus during the dotcom boom, a techie would be long, during the crash, they would be short, and so on.
Now one might say that the techies don’t get the ultimate tops and bottoms of the market movements, but I say so what? The meat is in the middle. The lowered risk is worth missing out on the maximum ranges of the action. The fundamental players dictate the action through their trading, but the techies follow up by reinforcing those moves. As news comes out, techies can get in or out with great agility if they follow a rigid trend following and risk management system.
Where does that leave us today? Fundamentals of the economy are quite mixed, some pointing to a recovery and some looking quite bleak. Some say it’s a meat grinder, impossible to trade in the long term. Fundamental analysis obviously has no place here since no one knows the direction we will take. Looking at the same long term charts even technical analysis is having trouble here since the highs of the latest rally was put in in April 2010, a lower low in June bucked the uptrend and caused the markets to be in a Stage 3 on the long term charts. A big decision is going to occur soon where if we successfully take out the April highs we will be on our way to a full recovery, but if we take out the June lows we might he heading for a double dip recession. My humble opinion is that only supple techies can survive such a situation without putting themselves at great risk.