The efficient market theory (from academics) has three versions – the “weak,” the “semi-strong,” and the “strong.” All three forms espouse the general idea that except for long-run trends, future stock prices are difficult, if not impossible, to predict. The weak form attacks the underpinnings of technical analysis, and the semi-strong and strong forms argue against many of the beliefs held by those using fundamental analysis.
I. Technical versus fundamental analysis:
1. Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks.
2. Technical analysis is essentially the making and interpreting of stock charts. Thus its practitioners are called chartists. Most chartists believe that the market is only 10% logical and 90% psychological. They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave. Charts tell only what the other players have been doing in the past. The chartist’s hope, however, is that a careful study of what the other players are doing will shed light on what the crowd is likely to do in the future.
3. Fundamental analysts believe the market is 90% logical and only 10% psychological. Fundamentalists believe that eventually the market will reflect accurately the security’s real worth. Perhaps 90% of the Wall Street security analysts consider themselves fundamentalists.
II. What Can Charts tell you?
1. The first principle of technical analysis is that all info about earnings, dividends and the future performance of a company are automatically reflected in the company’s past market prices.
2. The second principle is that prices tend to move in trends: A stock that is rising tends to keep on rising, whereas a stock at rest tends to remain at rest.
3. As John Magee wrote in the bible of charting, Technical Analysis of Stock Trends, “Prices move in trends and trends tend to continue until something happens to change the supply-demand balance.”
III. The Rationale for the Charting Method
To me, the following explanations of technical analysis appear to be the most plausible.
1. Trends might tend to perpetuate themselves for either of two reasons. First, it has been argued that the crowd instinct of mass psychology makes it so. When investors see the prices of a speculative favorite going higher and higher, they want to jump on the bandwagon and join the rise.
2. Second, there may be unequal access to fundamental info about the firm. When some favorable piece of news occurs, it is alleged that the insiders are the first to know and they act, buying the stock and causing its price to rise. The insiders then tell their friends, who act next. Then the professionals find out the news and the big institutions put blocks of the shares in their portfolios. Finally, the poor slobs get the info and buy. This process is supposed to result in a rather gradual increase/decrease in the price of the stock when the news is good/bad.
3. Chartists are convinced that even if they do not have access to this inside info, observation of price movements alone enables them to pick up the scent of the ‘smart money’ and permits them to get in long before the general public.
IV. Why Might Charting Fail to Work?
1. First, the chartist buys in only after price trends have been established and sells only after they have been broken. Because sharp reversals in the market may occur quite suddenly, the chartist often misses the boat. By the time an uptrend is signaled, it may already have taken place.
2. Second, such techniques should ultimately be self-defeating. As more and more people use it, the value of any technique depreciates.
V. The Techniques of Fundamental analysis
1. The technician is interested only in the record of the stock’s price, whereas, the fundamentalist’s primary concern is with what a stock is really worth. His most important job is to estimate the firm’s future stream of earnings and dividends. To do this, he must estimate the firm’s sales level, operating costs, corporate tax rates, depreciation policies, and the sources and costs of its capital requirements.
2. Because the general prospects of a company are strongly influenced by the economic position of its industry, the obvious starting point for the security analyst is a study of industry prospects. Indeed, in almost all professional investment firms, security analysts specialized in particular industry groups.
VI. Why Might Fundamental analysis fail to work?
1. There are three potential flaws in this type of analysis. First, the info and analysis may be incorrect.
2. Second, the security analyst’s estimate of “value may be faulty”.
3. Third, the market may not correct its “mistake” and the stock price might not converge to its value estimate.
4. To make matters even worse, the security analyst may be unable to translate correct facts into accurate estimates of earnings for several years into the future. Even if the security analyst’s estimates of growth are correct, this info may already be reflected accurately by the market, and any difference between a security’s price and value may result simply from an incorrect estimate of value.
5. The final problem is that even with correct info and value estimates, the stock you buy might still go down. Not only can the average multiple changes rapidly for stocks in general but the market can also dramatically change the premium assigned to growth. One should not take the success of fundamental analysis for granted.
VII. Using Fundamental and Technical analysis together
Many analysts use a combination of techniques to judge whether individual stocks are attractive for purchase.
1. Rule 1: buy only companies that are expected to have above-average earnings growth for five or more years. An extraordinary long-run earnings growth rate is the single most important element contributing to the success of most stock investment. The purchaser of a stock whose earnings begin to grow rapidly has a chance at a potential double benefit – both the earnings and the multiple may increase.
2. Rule 2: never pay more for a stock than its firm foundation of value. Generally, the earnings multiple for the market as a whole is a helpful benchmark. What is proposed is a strategy of buying unrecognized growth stocks whose earnings multiples are not at any substantial premium over the market. In sum, look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus – both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy – both earnings and the multiples drop.
3. Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air. The above rules seem sensible; the point is whether they really work? – Not really (However, the author uses these rules as advice for those investors who want to pick stocks by themselves, though he strongly recommends investors to buy index funds, please refer to Chapter 15)!
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel