Over the last three years we have experienced what could possibly be the greatest trend following market in history. As the S&P 500 made one final last gasp rally in May 2008 the major indices made lower highs and the stage was set for one of the most vicious 10-month bear markets ever. Each and every rally was a selling opportunity, although there were a few powerful snapbacks along the way, they all eventually failed as the sellers overpowered a dwindling cadre of bulls.
Since the market bottomed in March 2009 the steep ascent of virtually all risk assets (commodities, equities, high-yield debt etc.) has been breathtaking. The past two years have been a trend followers dream, those who employed appropriate risk management were able to sell into strength and accumulate during pullbacks. Meanwhile, even this market (although it has been very forgiving) has punished the over-leveraged with a few vicious sell-offs (Flash Crash, Egyptian panic etc.).
Technical analysis works because it effectively captures the collective decisions of market participants. Think about one of the simplest chart patterns in existence, the bull flag. A bull flag comes about because there are one or more eager buyers of a particular security. They move the price up aggressively but then realize they are moving the price up too quickly so they pull back and lower their bids. This effectively causes the flag pattern, but the buyers are still there laying in wait, ready to pounce once they have accumulated enough shares at lower levels to satisfy themselves. This simple concept is what makes the bull flag a logical and highly effective technical pattern. The trading in $BTU on Friday excellently illustrates the effectiveness of the bull flag/ascending triangle patterns:
There can be no doubt that technical analysis in the hands of skilled technicians has risen to the occasion superbly in the current bull market. Whereas, there have been numerous so called fundamentalists who have been left behind with an assortment of bearish economic misgivings. However, in my opinion there is a clear distinction between a fundamental analyst and a subjectively biased observer. I do not consider the latter to be a true fundamental analyst.
A true fundamental analyst should remain objective and check their opinions of Fed monetary policy or government intervention in financial markets at the door. Throughout 2009 and 2010, many fundamentalists were unable to shift their psychology away from the financial crisis destruction of 2008/early 2009 to the Fed/Treasury promoted reflationary economic recovery. Whereas, market technicians who properly practiced their craft were able to capture the vast majority of the rally from the March 2009 low.
Fundamental equity analysis can essentially be divided into two main categories, one legal and one illegal. The mosaic theory involves collecting public, non-public and non-material information about a company in order to determine the underlying value of the company’s securities. Whereas, insider trading is the use of material non-public information to gain an illegal unfair advantage in the securities markets.
Technical analysis works because the charts are driven by fundamentals. Fundamentalists leave the foot prints of their buy/sell decisions in the charts for the entire world to see. It is the technical analyst’s job to discern what these buy/sell decisions were and whether they were indeed correct and worth following. Let’s take a look at a few charts in order to get a better picture of how both fundamental and technical analysis affect markets:
(Click to enlarge charts)
For a fundamental analyst to buy $RIMM after the March 25th earnings induced gap down they must have believed that the vast majority of market participants had misinterpreted the earnings release and conference call. A decision to ignore the bearish technical implications of such a large gap lower on huge volume requires the investor to have at least one of the following:
- ‘Special’ information as to the future prospects for RIMM and/or a belief that the market is currently mispricing RIMM shares
- The investor believes that he understands RIMM’s valuation better than the analysts who downgraded the stock and large institutions who sold the stock following the earnings report
- A willingness to lose money by stubbornly disregarding overwhelming evidence indicating that RIMM’s prospects are much worse than the market had previously believed
Would a technician have bought $LVS at $1.38 in March 2009? Probably not, within two years LVS was a 40-bagger from those levels.
What about $NG at .37/share in November 2008? NG would also turn out to be a 40-bagger within two years.
Fundamental analysis enables an analyst to determine a fair value range of an equity using an assortment of equity valuation methodologies. Some of the assumptions and projections that must be made in order to form a fundamental valuation model are particularly challenging and often prove to be off the mark. As Yogi Berra so succinctly stated, “It’s tough to make predictions, especially about the future”.
Market bubbles perfectly illustrate situations in which technical analysis and market psychology (herd psychology) trump fundamentals. Fundamental analysis attempts to quantify everything and is rooted in the notion that market participants behave rationally. Meanwhile, market participants can often behave in a highly irrational manner with rational fundamental valuations taking a backseat to powerful positive feedback loops resulting from the madness of crowds. The innate human emotions of greed and fear have been well known to overpower rational thought throughout market history. The thought of missing out on a major bull market plays on our inner most desire of greed. While the fear of further financial loss during market declines has often provoked investors to capitulate and sell at market bottoms.
More on the psychology of bubbles later...
