Thursday, April 14, 2005

TECHNICAL AND FUNDAMENTAL ANALYSIS

TECHNICAL ANALYSIS AND FUNDAMENTAL ANALYSIS

Technical analysis. Technical analysis is predicated on the belief that price and volume patterns can predict future price movement. The first known forms of technical analysis include 13th century Japanese rice farmers, who devised a technique known as “candle stick” analysis to predict movements in the price of this important commodity. Later visual and mathematical techniques were developed by western traders to predict movement in the stock and commodity markets. One difficulty with technical analysis is that, since market participants are themselves included among the factors that determine prices, and may themselves learn to predict prices on the basis of technical analysis (if valid), then predictive patterns may lose their efficiency as they become broadcast to and acted upon by sufficient numbers of market participants. It is thus appreciated by believers of technical analysis that important segments of the market advisory community (e.g., The Motley Fool website) decry technical analysis as superstitious tea leaf reading. In fact, however, in the short term especially, markets probably can be predicted because the actors in markets tend to be emotional. For example, if a stock hits a new high, no one who has ever bought it will have (yet) lost money on it, and so the general feelings associated with the stock are positive; if, on the other hand, the stock has traded for years at higher prices, then many people who own the stock will have lost money on it, and have a negative feeling associated with such loss. If this second stock rises to levels where many people bought it previously (technically known as “resistance” ), they will be more likely to sell in order “to get even” or “to get out without a loss” than those in the new-high stock. Because technical analysis can identify such factors probabilistically associated with emotions such as hope, fear, greed, desperation, and panic—and because these human emotions, magnified by crowd behavior—are not likely to disappear any time soon, then it seems likely that at least some of the patterns recognized by technical analysis as predictive will continue to be valid. Nonetheless, these emotional verities that can be found in price patterns on charts probably only exist when stocks are strongly trending, which is estimated to be the case only about 30% of the time. Moreover, the patterns that reveal such trending or reversal at emotional climaxes may be relatively simple to identify—in contrast to some of the very complex systems and methods sold under the rubric of technical analysis. Finally, although computers can be programmed to match past price patterns perfectly, past exactitude does not correlate with future accuracy. Trading on the basis of trends, which does not try to predict future price so much as recognize current direction, is closer to technical analysis than to the academic theories above and the fundamental analysis below, but is so important it will be treated in another section.

Fundamental analysis. This is the determination of the “real” value of stocks based on factors such as managment quality, price to sales ratios, yield (if the stock pays a dividend), price to earnings ratios (if there are earnings), and so forth. The most successful fundamental analyst practitioner is probably Warren Buffet, the “sage of Omaha” who has used his never-split stock Berkshire Hathaway to buy undervalued companies and hold them, sometimes forever. Buffet’s method advocates buying a stock with a margin of safety (i.e., on sale) and holding it indefinitely; if the stock declines in value by 50%, twice as much stock is purchased. Although this technique is diametrically opposed to the “buy high, sell higher” method of technical analysis, it shares with it a studied reluctance to indulge in the emotions of the crowd. Some traders, such as hedge fund manager George Soros, combine technical and fundamental analysis—although this is not recommended for most people, as the two techniques, as stated, can lead to confusingly different standpoints.

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