Fundamentals or technicals — what to go by?

Of late, financial markets across the globe have wreaked unprecedented havoc on investors. Right from the little guy in the street to the big professional money managers of the Wall Street, everybody is caught on the wrong foot and searching for a holistic approach, which can help steer through the recession.

The questions being asked are: What works in the market? Which form of analysis guides investments better? Is fundamental analysis better of should one go by technical analysis.

Fundamental analysis
This form of analysis has been the corner stone of investment analysis for decades. Its genesis can be traced to the publication of security analysis by Benjamin Graham and Prof Dodd of Columbia University in 1934. Their work gave birth to the concept of value investing.

This form of analysis is popular with the Oracle of Omaha (Warren Buffett). Fundamental analysis involves studying financial statements like balance sheet, profit and loss account, cash flow statement, etc. The focus is on how the cash flows of a company are positioned vis-a vis its share price. These analysts study macro trends in the economy and try to analyse its impact on a particular sector or a company in turn. The accuracy of this form of analysis depends on the accuracy of the data. If the source of the data is not reliable, it will lead to another Satyam or Enron kind of fiasco.
But, does the market react to this type of data analysis? Unfortunately, the answer is ‘no’.

So what drives the markets? Edson Gould, who worked as a technical analyst in the USA in the 1920s, offers an answer: “Stocks sell at the price not because of any systematic evaluation of their networth, but because of what mass investors think they are worth.” Thus it is the perception of the masses which determines the price.

One aspect of technical discipline is to explain the gap between the valuations and the current market price. If the value of stock ‘x’ is Rs 100 on the paper, based on discounted cash flows, projected growth and overall economic conditions, why is it trading at Rs 120? The difference lies in the market perception of the stock. Investors pushed up the price based on their expectations. It may be the reason why tech companies were quoting at three-digit price earning multiples in 2000, irrespective of their fundamentals. It may be the reason why market cap eroded by one-third in a single day in October 1987 crash of Dow despite no drastic changes in the world fundamentals.

Technical analysis
As people’s perceptions change quickly, traders react quickly to deal with such situations. This type of quick reaction is not possible with fundamental analysis alone. Technical analysis is perfectly suited to handle this kind of situations.

Technical analysis came into vogue when Charles Dow, editor of the Wall Street Journal in 1900, presented a radically novel idea when he showed that beneath the fluctuations in individual stocks, there was at all times a general trend of the market as a whole. Dow’s expression of market behaviour was only through his editorials written during the period of 1900-1902.

After his death in 1902, his observations were refined and given a shape by his successor at Wall Street Journal, William P Hamilton, who authored the magnum opus Stock Market Barometer in 1922. The collective market wisdom of the duo later came to be known as Dow Theory, which became the grand daddy of technical analysis.

After the demise of Charles Dow, the subject was picked up by Schabacker, who is widely regarded as the father of technical analysis. This young man held prestigious editorial positions during the 1920s and 1930s with influential publications such as the Forbes magazine and The Analyst, which is the weekend section of New York Times. Schabacker’s works include Stock Market Theory and Practice (1930); Technical Analysis and Stock Market Profits: A course in forecasting (1932); and Stock Market Profits (1934).

In contrast to fundamental analysts, a technical analyst exclusively focuses on the study of historical price behaviour of individual securities. A technician is not worried about financial statements or other economic data. He works on the assumption that market discounts everything in advance. This is the reason we find markets not reacting after particular event has happened. Most of the time, the market factors this news, thereby giving an advantage to the technical analyst.

By studying the historical price relationship, a technical analyst tries to identify turning points as investor behaviour is repetitive in nature given similar circumstances. He also studies indicators and oscillators (which are price derivatives), supports (areas where buying is expected) and resistances (areas where selling is expected), trend line studies, chart patterns like triangles, rectangles, flags, head and shoulder, etc. Explaining these concepts is beyond the scope of this article.

Technician has an edge
The knowledge of technical analysis comes to the rescue of investors/ traders in the sideways markets such as the one witnessed during 1966 to 1982 in Dow Jones or our own Sensex movement from 1992-2000 with significant price swings. Whereas the buy and hold guys will play the role of spectators as they can’t react to these short-term price swings based on fundamental analysis.

None of the above approaches is infallible. Each method has its own pros and cons. Many will swear by fundamentals and an equal number will stand by technicals. Investors shall not leave their circle of competency and stick to the method they are comfortable with. Nevertheless, a working knowledge of technicals proves handy for anyone who wants to invest his hard-earned savings in the financial markets.
The writer is a technical analyst with Darashaw & Co, Mumbai.