The Importance of Price Trends
The distinction between fundamental and technical indicators has to do with the source of information: financial results versus trading and price patterns. While fundamental analysis is scientific (in the sense that conclusions are based on fact), technical analysis is more intuitive (in that its premise is that market direction is predictable based on trends). To the believer in fundamentals, the technical approach lacks the logic and science that is so reassuring. However, some technical indicators—especially those used in combination with fundamentals, which we call technimental—can be very useful in portfolio evaluation and in market watching.
This is especially true when you are attempting to keep an eye on market risk—the best way to measure market risk is by testing the stock's tendency in relation to the market as a whole—in other words, its price movement history. Why is this valuable to those who follow the fundamentals? You should assume that price movement of a stock is a reflection of market perceptions, positive or negative, about the company. Those perceptions come from some form of information, which usually means information revealed in the fundamentals. So companies whose fundamentals tend to be less predictable also tend to have wider price swings. When analysts predict an outcome that is not confirmed by the fundamentals, the market price of the stock tends to react, often to overreact.
So price movement, while a reflection of immediate supply and demand, or of the market perception of value, is useful information. It is technical information that shows reaction to and perception of the company's fundamentals. Remember that price movement tends to be irrational in the immediate moment. Even so, it can be used as a means to measure market risk. This is important information about the fundamentals. Rock-solid companies whose profits and other fundamentals are predictable tend to have relatively stable market price. Companies whose fundamentals change drastically, whose fundamentals are difficult to predict accurately, and whose management is always in the news due to litigation, labor problems, product-related lawsuits, and competitive conflicts, are likely to have wider price swing histories.
The measurement of market risk is called volatility. This indicator involves subtracting the annual low price from the annual high price, and dividing the result by the annual low. The outcome is expressed as a percentage. The formula for volatility is summarized in Figure 9.5.
KEY POINT
While market price is not a fundamental indicator, the tendency of a stock to trade in a broad or a narrow range is a good indication of market perceptions based on fundamentals.

FIGURE 9.5 Volatility (rounded to one decimal)


The greater the percentage, the higher the volatility of a stock. A relatively narrow trading range will produce a lower volatility percentage—thus less historical movement and less market risk—and a broader trading range will reflect higher volatility levels.
Volatility of the individual stock, as measured in its price range, is one way to define market risk. Another method is to compare an individual stock to the market as a whole. This measurement, called "beta," compares an individual stock price movement to the Standard & Poor's (S& P) 500 as a whole. The market beta is always 1.00, so that a stock's beta is compared to that index. If a stock tends to move more slowly than the S&P, then its beta will be lower than 1.00. For example, a stock with a beta factor of .75 tends to move below market tendencies. And the opposite is true as well; a stock with a beta of 1.25 tends to move more quickly than the S&P 500. Stock price movements, of course, may occur on the way up and on the way down. So beta measures movements, not necessarily profits.
Volatility measures market risk and opportunity, which are flip sides of the same test. The greater the market risk, the greater the opportunity. And the lower the market risk, the lower the tendency for rapid price appreciation.

KEY POINT
Risk and opportunity are flip sides of the same issue: a stock's tendencies to advance or decline in price.

Technicians consider volatility and the tracking of volatility trends to be extremely important, perhaps more important than actual price movement—because volatility defines the degree of market risk. Thus, it is also valuable to the fundamental analyst, because it defines market perception of a company as well as reaction to any news about that company. A variety on the measurement of volatility involves the market as a whole. By measuring and comparing advancing issues and declining issues, technicians can judge the price movement volatility of the market as a whole. Rather than being tied to price levels, this form of volatility tests the relative degree of price-advancing stocks to price-declining stocks. It is called the breadth index. It is computed by computing the difference between advancing and declining issues, and

dividing the result by total issues on the exchange. The result is expressed as a percentage. If advances outnumber declines, the result is positive; if declines outnumber advances, the result is negative. The formula for breadth index is shown in Figure 9.6.
The broader the gap between advancing and declining issues, the greater the breadth of the market. A higher percentage of breadth indicates an increasing tendency that day—tendency on the upside if advances outnumber declines, or tendency on the downside if the opposite is true.
These measurements tell you about the current condition of the market. With thousands of shares being traded each day, and with a mix of results, any one day's results rarely provide you the kind of insight you can get from trends in volatility and beta, or, for the market at large, in breadth of the market. As with all indicators, it is the general direction of the trend that counts, especially when a trend appears to be in reversal. Trend analysis is valuable only to the extent that it provides you with one of two forms of information: confirmation that nothing is changing, or a signal that everything is about to change—precisely the kind of information that every investor needs and wants.
Such insights cannot always be found in fundamental information alone. As a fundamental analyst, you cannot afford to ignore the tech-nimental side of the market. It would be a mistake to discount entirely the value of some technical information. That would be investing in a vacuum. You will want to keep an eye not only on how a company's fundamentals change the investment value of the stock, but also on how market perception and mood affect all stocks in your portfolio.

FIGURE 9.6 Breadth Index (rounded to one decimal)

 

KEY POINT
Ignoring technical indicators altogether limits your vision of the market. Some technical indicators give you insight into mood and, of utmost importance, might help you see an emerging trend before it becomes obvious to everyone else.
Volatility is a useful indicator to use in comparisons between several potential investment candidates. Volatility can further define whether a particular stock meets your risk profile. If you are seeking aggressive growth, higher volatility may be a requirement. If you are willing to accept steady but moderate growth over many years, then lower volatility may be more desirable. Comparisons of historical price appreciation and volatility reveal the connection.