A Random Walk Down Wall Street - HOW THE PROS PLAY THE BIGGEST GAME IN TOWN

A Random Walk Down Wall Street 

Investment Management
 

Chapter 6

Technical and Fundamental Analysis 

PART II – HOW THE PROS PLAY THE BIGGEST GAME IN TOWN

Part II of A Random Walk Down Wall Street concentrates on how professional work the investments game…and then how academics have concluded that the professionals aren’t worth the money you pay for them.

“…the profession of high finance is certainly one of the most generously compensated. ”  

• The stock market in the late 1990’s and early 2000’s has become “ one of the biggest games in town.”
• Players in the game are among the most highly paid people in society
• Academics study the work and results of professionals and draw conclusions about their effectiveness…academics study markets and prices and draw conclusions about their behaviour…efficiency…and espouse new theories to explain what is going on.
• This chapter introduces you to the ‘two schools of thought’ in the investments game…chartists or technicians who try to predict the future studying past trends in graphs of stock prices…and fundamental analysts who try to estimate a current intrinsic value (or inherent worth) of a stock based upon forecasts of the future in terms of cash flows, discount rates, growth rates, etc.

Technical Versus Fundamental Analysis 

• 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.

Technical Analysis 

• Chartists study both the past movements of common stock prices and trading volume for a clue to the direction of future change.

UNDERLYING ASSUMPTION

• That the market is only 10 percent logical and 90 percent psychological
• The key to the game is to anticipate how other people play the game.
• Chartists hope that careful study of past behaviour will shed light on what the crowd is likely to do in the future.

Fundamental Analysis 

• Fundamental analysts seek to determine an issue’s proper value.
• Value is determined through forecasts for growth, dividend payout, interest rates and risk.
• The goal is to identify undervalued securities that can be purchases prior to their rise to the proper value…or short sale of overvalued securities prior to their fall to their proper value.

UNDERLYING ASSUMPTION

• That the market is only 90 percent logical and 10 percent psychological
• The key to the game is to be a superior analyst capable of identifying unrealized value…that eventually be discovered by the street.

What Can Charts Tell You? 

Principles of Technical Analysis:

• A chart showing past prices and volume of trading contains all of the information that a security analyst needs to know.
• Prices tend to move in trends (moving market prices have ‘momentum’ and stocks at rest tend to remain at rest.)  Trends tend to continue until something happens to change the supply-demand balance.

Chartist Vocabulary 

• Double bottoms
• Breakthrough
• Violating the lows
• Firmed-up
• Big play
• Ascending peaks
• Buying climax
• Head and shoulders

• Areas of support
• Areas of resistance

The Rationale for Charting 

“…we can never hope to know “why” the market behaves as it does, we can only aspire to understand “how.””

Magee, ‘Technical Analysis of Stock Trends’ 

Possible explanations for why trends might tend to perpetuate themselves:

• Crowd psychology causes people to lose their individual sense of what is right and wrong.  Crowd behaviour can be predicted.
• Information asymmetry ( there may be unequal access to fundamental information about a company)…hence the people ‘in the know’  move first causing prices to change…and then slowly the rest of the market begins to join in allowing the price to show momentum.

Further Rationale for charting 

• Chartists claim the public remembers what price they paid for a stock…and make decisions with respect to that point of reference….
• This gives rise to “resistance areas”  and “support levels”

Why Might Charting Fail to Work? 

1. Chartists react only to price trends…so the trend must be established first, before they will act…with sharp reversals…they will miss most of the opportunities.
2. Chartist techniques are self-defeating…in that if a chartist makes money with a ‘system’  then others will attempt to copy this…no buy or sell signal can be worthwhile if everyone tries to act on it simultaneously.
3. Traders try to anticipate technical signals…and tend to buy before, not after, it breaks through.
4. The market is driven by highly motivated, self-interested individuals making it a highly efficient mechanism…if some people know that the stock price will go to $40 tomorrow…it will go to $40 today.  (Prices may adjust so quickly to new information as to make the whole process of technical analysis a futile exercise.)

From Chartist to Technician 

• Chartists was the term applied to people who used stock charts in the past…with the advent of computer databases, computer statistical analysis programs and graphical user interfaces…chartists have now ‘morphed’  into technicians…
• Technicians are able to convert stock price and trading volume data into a wide variety of forms and analyze this information…for example:
• 200 day moving averages
• Relative strength indicators
• Primary, secondary and tertiary waves, etc.

The Technique of Fundamental Analysis 

• The fundamentalist strives to be relatively immune to the optimism and pessimism of the crowd.
• The fundamental analyst believes there is an intrinsic value (or inherent worth) and that the price may occasionally not be equal to that…the fundamental analysts believes, however, that eventually the market will become ‘efficient’  to the mistake and that the price will move to the intrinsic value (achieve equilibrium).
• The fundamental analyst believes that there are key factors that influence the value of a stock…dividends, growth, risk and the level of interest rates.
• The higher the risk…the lower the p/e (price earnings) multiple.

Why Might Fundamental Analysis Fail to Work? 

1. The information (data) and analysis might be incorrect.
2. The security analyst’s estimate of ‘value’ might be faulty
3. The market may not correct its mistake.

Using Fundamental and Technical Analysis Together 

• Rule 1 – Buy only companies that are expected to have above average earnings growth for five or more years.
• Rule 2 – Never pay more for a stock that its firm foundation value
• Rule 3 – Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.

Key Lessons Learned 

• Understand that there are two radically different schools of thought followed by professionals in the investment industry…and be able to recognize those in each camp through their words and actions

“the market hasn’t discounted the recent growth in earnings in the stock price as yet” 

“the stock price will encounter a zone of resistance at the $20 level”
 

Key Lessons Learned 

• Understand the there are two radically different schools of thought followed by professionals in the investment industry…and be able to recognize those in each camp through their words and actions

“the market hasn’t discounted the recent growth in earnings in the stock price as yet” (fundamental analyst) 

“the stock price will encounter a zone of resistance at the $20 level” (technical analyst) 

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