Fundamental Vs Technical analysis: A brief look

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  On the other side, the techies as I’ll call them think of fundamental analysis as blind and outdated.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.

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5 Responses to Fundamental Vs Technical analysis: A brief look

  1. Antoine says:

    Hi!

    I might not understood you well but it looks like your analysis is partially based on ex-post data. When you look at your indicators like SMAs and others, it seems it encompasses future data that a trader at this point of time did not have.

    Furthermore, as a single trader, you must know that thousands or even millions other people have access to the exact same information. So, how could you ever make money by looking at the same charts than others? To come back to your comparison between fundamentalists and techies. Implicitly, you make the assumption that every techies follow the same strategy? So, if your trading strategy/rules is used by all techies, how could you possibly win money? You gonna sell when people sell and buy when people buy so where is the profit? Selling cheaper and buying higher?

    As far as I know, technical trading does not allow to make significant gains. Many researches have been conducted on the subject and they ended up with that conclusion: Even though some patterns may be recognized and used on the very short run, transaction costs will destroy any benefits. However, some hedge funds or large brokers are sometimes able to take advantage of it by investing huge amount of money in order to significantly reduce transaction costs. If you look at financial institution that make the biggest profits, you won’t find any relying on technical trading. Finally, a last study showed that techies, on average, don’t make any money.

    Of course, that’s my view as business school student with much more academic background than professional experience.

    Have a good day,

    Antoine

    • applenickel says:

      Hi Antoine,

      You are correct is saying that people following technical analysis do not all use the same techniques. It is because of the fact that there is such a variety in schools of thought that the volatile price movements and liquidity we have today occur. It is true that most people who use technical analysis lose money. But there are a few reasons for this – the first and most important is that it’s easy to get into it, but extremely hard to master. I know many fundamental traders who also don’t make any money for the same reason; it’s extremely hard. Financial institutions use fundamental analysis for the very reason you stated. Because they are so huge, any move they make moves the market. They are behemoth giants that take days and days to get in and out of positions. Also it’s important to mention that the biggest traders today aren’t even human! Most of the volume comes from algorithmic and high frequency trading. They don’t use any fundamentals at all, it’s all technical setups that they themselves created (for HFT trading at least).

      I’m pretty sure that if you did a study on most independent traders, whether technical or fundamental you would get similar results. It comes down to the fact that no school of thought in trading is right all of the time. Each have a certain percentage of success. The professional traders that make money have a success rate of 45%, the masters have a success rate of 55%. The art is in risk management, cutting losers quick and letting winners ride.

      It is true the business schools love to hate technical traders, as do financial institutions. But remember those places are run by people who were mostly involved in the markets before high speed internet and processing was available personally. It is a different world now, and technical analysts have access to many many more tools.

      Trading is a game where most people lose so that few can win. It seems most of life is like this as well.

      Cheers,

      – Jeremy

  2. Antoine says:

    Hey!

    Even though information technologies provide huge amount of data and processing power, it still does not explain on what relies these equations/rules. Why should a stock enter a rally when its price is over its 20days SMA?
    Furthermore, and I think it’s the most import point to consider, technical trading is based on privious patterns and models. BUT, and that’s a fatty huge butt, whatever is the model you use, you’ll always be able to “fit the model to reality”. What I mean is that, as I stated earlier, if you don’t explain what the model relies on, you’ll always find a calibration that matched privious series. However, it does not mean it will apply for the future.

    Moreover, when doing fundamental analysis, your assumptions are based on a concrete understanding of what is going on. That’s somehow, the difference between believing and rational thinking.

    You mentionned that fundamental traders don’t take into account a large specter of factors. That may be true, but it still rely on facts and no mathematical superstition.

    About the few who make money and the others who break even/lose money. It looks to me that it’s a pure statistical distribution.

    Regards,

    Antoine

    • applenickel says:

      Well basically it comes down to this – Fundamental analysis is based on data sets of sectors and relative strength to that sector usually. Which in itself it technical. How many fundamental investors have you heard base trades on P/E ratios etc…? I don’t base any trades on any technical indicators other than price. My trades are based purely on the psychology and human nature of other investors. Both fundamental and technical investors must use a rigid stop loss system to protect their assets. Using those levels is the key to trading off their psychology. No one likes to lose massive money so they will sell if they lose a certain amount, and the more significant a level is, the more people will have their stops there.

      I would like to say that I don’t discount the value of fundamental analysis completely. I think it certainly has a place, and I do use it in my trade decisions. For example, for shorting I will pick stock that have relative weakness in a weak sector – for example currently the energy sector is weak and FE is a good stock to short. That said, I will also look at market fundamentals combined with technical analysis to gage the overall health and directions of the markets. But to use PURE fundamentals is blind, and using pure technicals is lame. All available tools should be utilized.

      About the last statement, I know some fundamental investors that consistently lose money, as well as successful technical investors… It’s a matter of personal discipline and intelligence.

      Cheers,

      – Jeremy

  3. website says:

    Mate! This blog is cool! How do you make it look this good !

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