Historical versus Current Information

One way to distinguish between fundamental and technical analysis is on the basis of point of view. Fundamentals are historical; technical indicators are current or forward-looking. Of course, the technical indicators are not based on any reliable historical information, so the entire premise of operating from the current date forward, is flawed—if it takes place in isolation.

The Dow Jones Industrial Average makes the point well. If the average moves more than 100 points in either direction, that causes a reaction among large numbers of investors. Some see the direction of the move as a sign of a shift in market sentiment; others believe the shift will be reversed the following day, Many investors track historical movement of the market and what they believe it means for the future. For example, some believe that if the index goes up in January it will go up for the entire year, and vice versa. Others believe that market movements are dictated by whether the National League or American League team wins the World Series.

All of these attempts at forecasting are flawed and cannot provide any long-term wisdom. You cannot predict "heads" or "tails" for a coin toss based on the trend, because each toss is a separate and random trial with a 50-50 possibility. Most of us know that. But when it comes to the market, the desire for reliable and easily identified indicators is strong. Ultimately, even the technician comes to grips with the problems of forecasting and returns to the fundamentals. The flaw in many technical indicators is that historical information is misread or misapplied. The same thinking about trying to predict coin tosses should be kept in mind. A chart reader, for example, will see a pattern of a stock's market price moving up, then down, then up, and will reason that based on that pattern, the next movement will be downward. This is not supported with any economic theory whatsoever. Three things can happen to the market price of a stock: it can rise, it can fall, or it can remain unchanged. So even the wildest of theories will turn out right at least one-third of the time.

Where does technical historical information help? Some of the information we learn from technical indicators is useful, but primarily because it is actually a hybrid of technical and fundamental information. For our purposes here, we've named this hybrid "technimental." We define technimental analysis as any form of analysis based on technical indicators, but containing elements of fundamental analysis; or that provides useful information of a fundamental nature.

The most obvious example of technimental analysis is the trading range seen in the technician's chart (see Figure 1.1), notably a long-established range with a clear resistance level (the highest expected price the stock has traded) and support level (the lowest expected trading price in the range). The trading range provides us with a fundamental view of the stock's supply and demand. Remembering that the stock price itself has nothing to do with book value per share, nor with long-term prospects for the stock, what can you hope to learn from an analysis of the trading range? As a long-term investor, you do need to keep an eye on your portfolio and long-term decisions have to be maintained (or changed) based on a study of short-term trends. While this refers primarily to the information on the company's balance sheet and statement of income, the trading range can be useful in identifying one of two important changes: (1) buying opportunities or (2) selling signals.

The trading range is a reflection of the market's perception about the stock. As a broad observation, such perceptions are based on long-term understanding of the fundamentals, and daily changes are not especially useful. That's where resistance and support levels can provide a signal of possible change, especially when the trading range has been long established or has been changing only gradually. A breakout may be temporary, or it may mean a significant change in the market's entire perception about that company, thereby raising the resistance level or lowering the support level.

Example: You have been watching one company's stock for several months, studying the fundamentals and thinking about investing. You also have observed the gradual climb in the stock's market value over time. At the same time you have observed a gradual change in several financial trends, indicating the possibility that the company is taking a leading position within its industry. A breakout above resistance level could serve as the final indicator inducing you to take action and buy the stock.

In this example, a breakout following a long-standing trading range serves as a technimental indicator. Because fundamentals work long-term, you should be cautious in using technical indicators for such decisions. In the example, the breakout served to confirm a trend already being observed. This is the only situation in which technical indicators should be relied on—when they confirm what seems to be occurring and is already indicated in the fundamental trend.

eKEY POINT

A technical indicator should be relied on for making a decision only when it confirms the trend already seen in the fundamental analysis.

Another example demonstrates how such information can be used to make a "sell" decision:

Example: You have held 200 shares of a company's stock for four years. Recent fundamental trends seem to indicate that the company is beginning to lose its position as industry leader. However, you are reluctant to sell until you are certain that the indications are correct. You also have been tracking the chart of the stock's movement and you notice a gradual decline in the trading range, but dependable support levels over many months. However, the stock then fell through the support level and declined to a new low. It recently recovered, but it is apparent to you now that perceptions of this company's value have fallen. You decide to sell.

This is yet another example of basing a decision on both the generally indicated trend in the fundamental tests, and confirmation from a long-standing technical indicator. This shows how technimental information can be used in combination with fundamental tests for managing your portfolio.

The market price of the stock is far removed from the fundamental value of the company. The justification for using technical indicators is to confirm trends recognized by fundamental tests. Even the most ardent fundamental analyst needs to recognize the reality of the market: Stock price is the reflection of the market's perception of value. The price is the result of auction activity between buyers and sellers. So even when the price is entirely unreasonable based on the fundamental facts of the matter, the market price cannot be ignored.