Stock markets are seen as a very attractive revenue source for many people nowadays. Some of the people describes it as a gamble which has a possibility of losing of your all fortune. But some group of people believe that there are huge opportunities in it and it worth taking risks to get richer.
Frankly, the rewards of stock market for those who read it right is enormous while the penalties of it for careless investors can be calamitous. People seek for safe and sure methods to determine the state and trend of the market, right stock to buy and right time to buy it.
In the course of years of stock market study, two distinct schools of thought have arisen in order to solve the trader’s major problem of what and when. One of them is referred to as fundamental, and the other as the
technical. There is a cold war between fundamentalists and technicians. Both of them argue that their methodology is more accurate. The writer of this article believes that technical analysis makes more sense for traders. So, I will try to explain its reasons in later parts of the article and this series through using John Magee’s Technical Analysis of Stock Trends book as a guide. I am also a beginner and you can read these as a mix of my notes from the book and my opinions. My purpose is very simple, to reinforce my learnings by writing and sharing it with others as well. Let’s start the journey.
The thoughts of a stock market fundamentalist are based on statistic. He looks for the auditors’ reports, balance sheets, profit and loss statements etc. He analyzes sales data, plant capacity, management team and the competition to measure the state of business in general. He takes all of these information into account to evaluate the ideal price of a stock. If it is selling below his appraisal, he buys. As you guess, the most successful applier of that approach is Warren Buffet. This approach can be an excellent way to buy companies as Warren Buffet does, however it is not a very efficient way of buying stocks. If you are a fundamentalist, probably you raised your red flag here. But wait, do not be prejudiced and keep on reading.
Even radical fundamentalists who snobs charts and chartists, can’t hide their respect for the Dow Theory which is purely technical in its essence. So, what is technical analysis? What is Dow Theory? I will try to answer these questions.
Definition of Technical Analysis
As John Magee said in its book Technical Analysis of Stock Trends, the term “technical” refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals. Technical Analysis is the science of recording the history of trading such as price changes, volume etc. in a certain stock or in the index and then deducing from that data the probable future trend.
The technician claims that it is unnecessary to try estimating the price of a stock. Let’s go through stock prices of United States Steel company as an example. It was worth $261 in 1929, but you could buy it for only $22 in 1932. By 1937, it was selling for $126 and just 1 year later for $38. In May of 1946, it had climbed back up to $97 and 10 months later, in 1947, had dropped below $70, although the company’s earnings was near an all-time high and interest rates in general were still near an all-time low. The book value of this share of U.S. Steel, according to the corporation’s balance sheet, was about $204 in 1929; $187 in 1932; $151 in 1937; $117 in 1938 an $142 in 1946. This wide divergence between presumed value and actual price is very obvious and it is not rare.
The fact is that the real value of that stock is determined definitely by supply and demand which are accurately reflected in the transactions and price history. Of course, financial data of the company is a factor in this supply-demand equation but there are many other factors affecting it. The market price reflects not only different opinions of investors and traders, but also all the hopes, fears, moods, needs, perceptions and resources of hundreds of rational and irrational buyers and sellers which no statistic can predict. In brief, the going price, as established by the market itself, includes all the fundamental information which the analyst can hope to learn.
Prices move in trends and trends tend to continue until something happens that change the supply-demand balance. These changes are usually detectable in the action of market itself. Certain patterns appear on the charts and can be interpreted as future trend development. It must be noted, they’re not infallible but odds are definitely in their favor.
The main problem with fundamental analysis is that its indicators are removed from the market itself. The analyst assumes casualty between external events and market movements which is almost certainly false. Also, another big problem is having two steps to forecast. First of all, it requires a forecast of the fundamental data itself such as sales or profit margin estimation. He is then forced to take a second step to come to a conclusion about how those forecasted events will affect the markets. But technicians don’t have to forecast their indicators, they have only one step to identify the trend.
The most common application of fundamental analysis is estimating company’s earnings for both current year and next year and recommending stocks on that basis which is a very poor approach. As Barron’s pointed out in an article, which showed that earning estimates averaged 18% error in the 30 DJIA stocks for any year already completed and 54% error for the year ahead. According to a table in the same Barron’s article, a purchase of the 10 DJIA stocks with the best earnings estimates would have produced a 10-year cumulative gain of 40.5%, while choosing the 10 DJIA stocks with the worst earnings estimates would have produced a whopping 142.5% gain.
As a conclusion, I believe it is a futile effort to estimate a company’s earnings and then forecast market movement according to that estimation. Technicians are not interested in finding reasons but results. Prices are the real results that include all of the information in it. People are irrational and if you think they make their investing decisions by taking account into all of these financial data and estimations derived from it, you are very naive. So, this series will go on explaining technical analysis by guidance of Magee’s book.
Next topic will be “charts”, which is the most important instrument of technical analysis, and Dow Theory.