You have seen people on TV, or perhaps read an article or two, where a technician and fundamental analyst will often debate the value of their respective methods. Often, this is simply just folly. Clearly, a person should not use one to the detriment of the other.
It makes sense to know the facts regarding the stocks we buy and sell; and, of course, this includes the reasoning and methods for doing so. Furthermore, it is surely just as important to know the price action of a stock. Price reflects the actual actions of all buyers and sellers in the market. To ignore price action makes no sense. Likewise, fundamental analysis can uncover changes at the margin that can have a major impact on companies’ prospects.
Over the last few weeks I have talked about the technical picture of the market. The goal is to be bullish on stocks when the market is going up and bearish when it is going down. I pointed out some fairly easy, yet very powerful, technical tools to use to determine where we stand. When the market is going higher it is going higher. We can think it is “wrong” but our opinion is not going to have a huge impact on the market. When the market decides to turn down, get out of the way. Your valuation metrics or allocation methods won’t help you when the tide turns bearish.
In recent years there has been a drive to determine how market sentiment changes and creates big swings in the market. That drive has been labeled behavioral finance. Pretty fancy name; and some have received Nobel Prizes for pursuits in the discipline. The goal is to determine what on earth people are thinking and why do they act the way they do. This has become a large field of study in response to the efficient market hypothesis crowd. I will not get into the debate over the efficiency of the markets, however, I will say that people, who do not recognize the fact that the market can become extremely irrational at times, simply are not that bright! Have any of you ever met anyone that is rational, always! Can you see a market functioning rationally at all times when you and I and everyone else you know make up the market? I think the answer to that is quite clear.
Technicians take a different approach. They try to determine what the market is doing and leave the why to others. If a technician, who truly is a technician, sees prices in a certain market breaking out to new highs they buy. When prices break down they sell or go short. As to the factors that caused the price action; that will likely become clear over time.
Fundamentalists will tell you that is nonsense. They do too much research to rely on some squiggly lines. I do find it interesting that whenever you read fundamental research you see at least a couple of charts on each page of the research. They will tell you they don’t use charts yet their research is full of them. I also find it hard to fathom technicians that fail to follow their systems. Some will see a stock or market go down through support and then give you reasons why you should hold on. So, your technical skills are awful, but I should now trust your fundamental insights? That is probably not a recipe for success.
It appears to me that the market always knows everything. The reaction to the news is what is tough to determine. All the figures about the economy, unemployment, oil prices, etc. are out there. From day to day the reaction to that data varies. So, if we are aware of the fundamental factors that are weighing on the collective mind of the market, and watch to see how these factors are reflected in price fluctuations, we can make moves that make sense.
So, below I’ll talk about the technical tone of the market and a few key fundamental factors that people focus on. Typically, in my opinion, the technical side of things will alert us to changing market direction prior to the fundamental factors.
The last time I wrote I pointed to 1275 on the S&P, 11,800 for the Dow and 2676 for the NASDAQ as support levels. Also, I said that if 1310 on the SPX and 12,090 on the Dow are breached to the downside the first levels will be challenged. We had a years’ worth of volatility last week, and there were only four trading days in the week. The low of the S&P last week was 1294.26. Oil prices, regime changes, etc. caused a large sell off for a couple of days. As I write now the S&P is again moving higher and is at 1322, well off morning highs. One day last week all 100 stocks of the NASDAQ 100 traded down. Friday people couldn’t get enough tech. If we see closes above the following levels then we’ll see an assault on recent highs; S&P 1323, Dow 12,180, NASDAQ 2795. If the following levels on the major indexes are breached to the downside, selling will accelerate; 1294/11,980/2705. There is my technical take. If the market goes up, take all the news that is out there and give it a positive spin. If the market goes down through support, take all the information that is out there and give it a negative slant and you’ll have your why.
Fundamental analysis, at some point, has to cover Price to Earnings multiples. That is a measure of how much the market is willing to pay for a dollar of earnings. If P/E multiples are low the market is attractively valued and vice versa if the ratio is high. Also, you need to compare the attractiveness of stocks with the allure of bonds. At times, bonds are so attractive that people avoid stocks and like the risk reward of bonds. How can we quickly compare stocks with bonds?
I wouldn’t have asked the questions if I didn’t have an answer. Hopefully, you’ll see some value in the answer. I am going to use yield to determine the attractiveness of stocks versus bonds. I am going to use the inverse of the P/E ratio to determine the earnings yield on stocks. EPS/Price = earnings yield. If you take current 2011 earnings projections you get an earnings yield of just over 7%. This is a level consistent with levels attained over the last several years.
The current yield on the 10-year Treasury is 3.41% and the 30-year is yielding 4.50%. The current rate of core inflation is 1.6%. So, the real after inflation earnings yield on stocks is attractive to what you receive from the bond market. Using that as a barometer stocks are attractively priced relative to bonds.
When is the reaction to all the news going to be negative enough to drive down stock prices? Look to the charts and I believe they will give you an early read.
