The Fundamental vs. the Technical in Stock Buy and Sell Decisions

Positive technical signals tend to precede good financial reports from a company.  That is, the technical patterns precede and anticipate the fundamental reports.  Stock price patterns reflect the buying and selling of all the people who have intimate knowledge about the company.  The rest of the investment world creates the noise in stock behavior that accompanies the pattern created by those with knowledge.  That is why sell strategies based on fundamentals are too slow in a volatile market.  

Before the crash in 2000, many investment managers had relied on "fundamentals" to tell them when to sell.  However, as the market crash approached it was often the case that by the time the company announced that earnings were going to be "soft," the stock had already declined.  Sell strategies based on fundamentals (earnings, cash flow, order backlog, etc.) turned out to be much too "sluggish" in relation to market action and in comparison with sell signals based on technical analysis (volume & price patterns of the stock).  The problem was compounded by the fact that analysts were often far from accurate in their forecasts regarding the financial prospects of companies.  Some of the shortcomings of fundamental analysis are addressed by technical analysis.

Technical analysis offers its proponents the opportunity of responding in "real-time" to a stock's behavior.  Technicians do not have to wait for the next quarterly report from the company.  In other words, technicians can quickly respond to what is (current stock behavior) rather than wait to see if what ought to be (projections by fundamental analysts) actually happens (if the company actually generates the earnings expected by analysts).  Each company has links with suppliers, competitors, officers, and employees.  These in turn have families and friends.  Many of these people are investors.  There are also outside investors, thinkers, reporters, and others who are watchers of these people and their companies.  The total knowledge of all these people is reflected in stock behavior.  The cumulative effect of all the buying and selling activity of these people, and of those who watch these people, defines the regions of supply and demand (resistance and support) evident in the market activity of the stock and consequently in the patterns evident in the stock's behavior.  

That is why stock behavior often precedes a company's announcement about earnings performance over the last quarter.  The suppliers of a company know if that company has been increasing or decreasing orders for the supplies, equipment, or support needed to produce products or deliver services (people associated with these suppliers and their friends buy and sell stock).  The competitors of a company know who is exerting the strongest pull on customers (people associated with these competitors and their friends buy and sell stock).  Family members of employees and all their friends also have a general "feel" for how well a company is doing even without the use of "insider information" (these people and their friends also buy and sell stock).  The sum total of all this "knowledge" is reflected in stock behavior much faster than analysts can get their next quarterly report written and published.  Statistically, their combined actions reduce "noise" ("noise" is created by the actions of the uninformed) and increase order or "pattern" in stock behavior.

After the last market crash, portfolio managers and strategists proclaimed that the old "buy and hold" philosophy of investing is no longer viable.  They said, "the market is simply too volatile for that kind of approach.  Even well-established companies can go bankrupt.  The slightest bad news can cause a stock to plummet."  Lately, some managers are once again investing with the prior intent of holding all positions for several years (though some do say they will sell if the fundamentals change).  It is as if they have learned nothing from their recent experience.  Such an attitude tends to lock an investor or advisor into a pattern of thinking that all losses are only temporary, and everything will be fine five years from now anyway.  

The problem with this mentality is that it reduces vigilance.  Why bother to watch a portfolio closely or even to think about strategy issues if everything will work out in the long run?  What are these advisors being paid to do?  We know from past experience that everything may not turn out okay in five years.  We can recite a very long list of stocks that have dropped over 60% from what they were five years ago and they still have not come close to recovering (I actually named a number of these companies in another article).  Many of these stocks no longer exist or are now virtually worthless.  

The point is that all these stocks looked good to many of the analysts who studied the fundamentals of these businesses.  There were, after all, some honest analysts who joined the dishonest ones in repeatedly recommending their purchase and who gave glowing reports about their prospects.  These stocks were touted as great investments at prices that later proved to be much too high (they did not seem particularly high at the time because they had been much higher before that).  Nevertheless, some of the analysts who studied these companies really believed that they were very good picks.  They kept recommending these stocks even though they kept falling.  Why?  They did so because they concluded that these stocks ought to go higher.  Technicians who study price, volume, and various other stock behavior patterns, on the other hand, sold when their stop-losses were triggered or when technical sell signals were registered.  They did not argue with themselves that these stocks ought to go higher.  They acted on what was, not on what ought to be.  They were the smart ones.

Yes, some day these stocks may recover.  However, an investor who ejected himself from these situations could have been accumulating profits during the following years rather than watching his stocks decline or hoping for a recovery some day.  Those who merely hang on through "thick and thin" are the real gamblers.  Contrary to their own opinions of themselves, they are not really investors but speculators guided by hopes and dreams.  They have no real sell disciplines.  They merely buy "good companies" and blindly hold on with no plans for selling except "someday, at a profit."  It is far better to get rid of losers and to keep the winners.  If you do not "weed your garden," you will end up with nothing but "weeds."  If you keep pulling the weeds, your garden will have only flowers.  The same is true of your portfolio.  It is the percentage of time that most of a portfolio is invested in rising stocks that determines how good performance will be.  Eject the losers and the winners will lift the portfolio.   

We prefer to invest in companies whose long-term financial prospects are good because, in the long run, it is earnings that drive stock prices.  In other words, a stock that is in an up-trend because the company is doing well financially (good fundamentals) will tend to hold that up-trend better than a stock that is rising only because of unjustified momentum.  However, as the basis for a primary selling discipline, fundamentals leave much to be desired.  They tend to evolve at a rate that is inherently too sluggish for them to serve in that capacity, especially in volatile markets.  Poor fundamentals still give us a good reason to sell.  However, a stock will usually give a technical sell signal long before the company reports the poor fundamentals.  Stockdisciplines.com traders prefer to respond to whatever signal they get first.  You can benefit from their experience by using the same approach.  They found that the first sell signal is almost always technical rather than fundamental in nature.  If you make it a practice to sell only when the fundamentals are deteriorating, then you must reconcile yourself to much larger losses.

The same things may be said regarding the buy side of investing.  We usually see technical buy signals before the company makes a positive earnings report.  In other words, all those "watchers" of the company mentioned above know the company is doing well so they have been buying its stock and have therefore caused the technical buy signal to be generated.  The profile of a stock's accumulation pattern can reveal much about whether there is something substantive behind the new buying activity.  When the fundamentals are released, those who bought the stock because of the technical buy signal will benefit from the new surge of buying that follows the release of positive fundamentals.  

Even so, we have a very high regard for fundamentals. If we get a technical buy signal, we like to check the stock's fundamental profile in Value Line, Morningstar, or in The Valuator before we make a purchase.  If the technical signal is good but not outstanding, then outstanding fundamentals can make a big difference in how we see a stock (fundamentals tend to have momentum).  However, if a stock has a lousy technical profile, we are not going to be interested regardless of how attractive a stock is fundamentally (it doesn’t pass the "smell" test).  There are also times when a stock's technical pattern is so compelling that we can feel justified in basing our buy decision on technical measurements, patterns, or signals alone.  Good financial reports often follow in the wake of positive technical signals.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com