Date: Apr 11, 2011
There are many forms of security analysis on which to build an understanding. Buff Pelz Dormeier discusses the two most common methods of analysis: fundamental analysis and the technical analysis.
- "This is one of the most important points I've had to learn. For me, at least, 'why' is the most expensive and least valuable information. When you get 'why' wrong (and act accordingly), you lose lots of money. You only can know 'why' for sure after the fact (when it is useless). You gotta learn to live with the reality that there are things that are beyond the individual's ken. The search for 'why,' whether right or wrong, can just as easily lead you to irrelevancies, or, worse yet, to valid data that will not impact on the market. The best analog is arguing with your wife. Being right is often totally valueless if not counterproductive."
- —Mike Epstein (1931–2009) Quoted on June 21, 2006
Building a Firm Foundation
We start our journey by getting acquainted with the basics, the fundamentals of technical analysis. These fundamentals are so self-evident that they are often overlooked. However, a rock-solid foundation is critical to understanding the volume analysis perspective. Your ability to succeed ultimately depends on your ability to discern. Every day, causal investors attempt to employ complicated indicators in their analyses of the market and individual securities; however, they generally do not fully understand what information the indicators are designed to reveal. When the markets turn and investors' indicators no longer work, they're at a loss.
Even when these investors experience short-term success, they are often building on sand because blind success reinforces poor practices. The difference between being wise and foolish is neither information nor intellect, but a depth of understanding. A thorough understanding of the basics enables investors to develop the necessary perspectives to build a cause for action. Building a cause for action is what analysis is all about.
As one of these investors yourself, a solid understanding of the basics is the bedrock that builds your perspective, shapes your beliefs, and influences your ideas. You can either seek to build a perspective on a solid foundation or be consumed with the moment—continually seeking the hottest tip, trying out the latest indicator, or reading about the newest five-step program to success. You can continue searching for the Holy Grail of market success or you can develop the understanding required to start believing in your own ability to discern, and thereby, gauge the market.
Two Legitimate Approaches
- "It is the glory of God to conceal a thing, but the honor of kings is to search out a matter."
- —King Solomon
There are many forms of security analysis on which to build an understanding. The two most common methods of analysis are the fundamental analysis and the technical analysis. Acknowledging these two approaches, the Financial Industry Regulatory Authority (FINRA) recognizes two types of research analysts: the Chartered Financial Analyst (CFA) and the Chartered Market Technician (CMT). Although the two schools of research may be used together effectively, they stem from vastly different perspectives. Your perspective of the market, what it is and how it works, plays a major role in your investment success.
Early in my career, while studying for my CMT designation, I taught technical analysis to many of the top brokers at the major brokerage firm where I was employed. A colleague who was part of the CFA program taught fundamental analysis. I once spent a day monitoring his crash course on fundamental analysis. His explanation of using financial ratios to assess the value of companies made sense. Despite my early concerns about fundamental analysis, formed from past unproductive experiences and my preconceived beliefs regarding the efficiencies of the markets' discounting mechanism, I was intrigued.
Like many fundamental analysts, the presenter had his favorite stock. He provided seemingly convincing reasons for why this stock was overlooked and undervalued in relation to earnings, the industry, and other comparative valuations. According to his analysis, the stock was intrinsically worth $6, although it traded slightly below $3. At $3, it was a cheap stock, so I inserted the symbol into my quote machine just to keep an occasional eye on it. Several days and weeks that turned into several months went by, and the stock did nothing but trade in a tight sideways channel despite the broader market being strongly bullish. One day, however, the stock broke through its long-standing resistance at a little over $3. I pulled it up. It had developed a huge base and was breaking out on strong volume. I bought it. In a short time, the stock ran up close to $6 and then began to wane. I sold part of my position and put a limit order in just below the round number of $6 to sell the rest based on some technical considerations. The $6 was the same price level the fundamentalist had estimated as fair value. I watched the stock closely and prepared to change the limit order to market if it showed further weakness. However, my order filled as the stock moved a bit over $6. It was at this time that I first realized that the fundamentals were indeed most likely wagging the dog, suggesting that the fundamentals were driving the technical aspects.
Believing I was bearing an olive branch, I sought out my new fundamental ally to point out that he was right and thank him for helping me make a buck. I even made a point to mention that he had bought the stock at a lower price than I had while I intentionally neglected that he had been sitting on dead money for over a year. Meanwhile, I had enjoyed participating in numerous stock issues throughout the bull market. However, I was floored when he told me he had not sold the stock. Based on revised data, he now saw the stock fairly valued at $9. I tried to inform him that the stock appeared to be weakening technically and perhaps he should sell part of it while he had a double in hand. No, he was far too excited. He proceeded to list many more reasons why the stock was still undervalued. As a staunch technician, those details were just not important to me. As he went on, I listened politely while deliberately blocking out his arguments for fear that it might influence my own objectivity. The stock went back down to its former base at $3 faster than it rose. I felt really bad for the guy. He had finally gotten it right, and yet he had missed it! How could I face him again? I thought I might repurchase some shares with my profits as the stock met support at $3, just so misery might have some company. But, nah, I would just be wasting my good capital on bad assets. What kind of example would that be for my stockbroker students?
This anecdote shows that my colleague and I each had our own perspectives of the market. The fundamentalist viewed stocks as companies in which he could become part owner. He believed his favored company was worth significantly more than the market price, so he bought it. This perspective of the market springs from what is called fundamental analysis. My view of the market is that stocks are shares of companies. These shares go up because eager buyers push them up, and they go down because fervent sellers sell, forcing them down. When I saw a stock that had previously gone nowhere suddenly pop up, I concluded the force of buying pressure could propel the stock further, and I bought it. Our different investment approaches did not reflect a difference in intelligence, but they did reflect a difference in our perspectives. Fundamental analysis is primarily about the "what," whereas technical analysis is much about the "when." Rather than being pitted against each other, technical and fundamental analysis can be used to complement each other. With that clearly stated, Investing with Volume Analysis introduces you to a perspective of market analysis based on the principles of supply and demand. In security analysis, this perspective is technical analysis.
The Fundamental Approach
Fundamental analysis presumes security prices are based on the intrinsic value of the underlying company. Price is formed based on these values and facts surrounding the company. Seemingly, this is a highly logical approach, one that many assume is correct in most markets most of the time. The fundamentalist believes that with time, stocks will move up to minimize the disparity between their present value and their perceived intrinsic value. Thus, fundamental analysis presumes the future prospects of a security are best analyzed through a proper assessment of the intrinsic value of the underlying company.
Fundamental analysis is not concerned with the behavior of investors as measured through the stock price or trading volume. Rather, the pure fundamental analyst's focus is on finding the true worth of the underlying company. In pursuit of value, the fundamentalist collects, analyzes, and models company information, including earnings, assets, liabilities, sales, revenue, and other information required to evaluate the company. Assumptions of the fundamentalist include a belief that markets are not completely efficient and that all necessary information is available to the public, but the company may not always be efficiently priced. Overall, fundamentalists are concerned with what the price should be according to their valuation models. The determination of value from the collective action of these fundamentalist investors is the primary force moving today's markets.
The Technical Approach
While fundamental analysis focuses on the investment's intrinsic value, technical analysis is the study of the market through its creators, the investors. Therefore, the focus of technical analysis is the behavior and motivations of investors observed primarily through their own actions. It is imperfect people who determine market prices, not highly perfected valuation models. However, the technician does not deny that the pursuit of value is a primary source of market movement. Yet, the technical perspective deems that market price is formed by the collective opinions of market participants pursuing value. Thus, in the mind of a technician, price is less about company facts and more about investors' feelings and perceptions concerning those facts.
In the exchange markets, prices are determined by what one party is willing to pay and another is willing to accept. Therefore, price is ultimately the end result of a battle between the forces of supply and demand, manifested through the actions and behaviors of investors. Price represents all that is known, feared, and hoped for by the market. It is through the diagnostics of price, volume, and other technical metrics formed by the actions and sentiments of market participants that the technician gauges stock performance.
Technical analysis assumes that market participants are efficient in price formation, thus avoiding any judgments about the intrinsic value of the underlying company. Therefore, the technician is not concerned with what the ideal price should be; rather, he is concerned just with what it is. Consequently, the company or any dataset used to determine the company's value is not the pure technician's direct concern. The technician's objective is to develop an understanding of the behavioral forces producing price (such as supply and demand). The core aspects of the technician include believing that the markets are efficient at discounting even future developments, price moves through trends, investors are both logical and emotional creatures, and past behaviors tend to repeat themselves more so when enough time has elapsed that the behaviors have been forgotten.
Driving a Comparison Between Fundamental and Technical Analysis
The movie Vantage Point begins by playing out the same scene over and over again, each time from a different vantage point as experienced by each major character. From such a portrayal or depiction, the viewer can easily see that one's vantage point largely influences one's perspective. Likewise, the fundamentalist and the technician have similar objectives in analyzing securities. Their views are, however, developed from different vantage points. An analogy can be drawn between a fundamentalist and a technician who both examine a high-performance automobile. The fundamentalist looks under the hood, kicks the tires, and inspects the frame—the physical aspects of the car. The technician does not look under the hood. Rather, he evaluates how the car performs under a set of conditions, such as turning, accelerating, and shifting. The fundamentalist examining the engine notices a potential flaw in the engine design. Similarly, when the gauges exceed the threshold of the expected parameters, the technician is led to the same conclusion as the fundamentalist, but without a physical inspection of the engine.
A fundamentalist might identify a good valuation point of a stock based on his analysis of the company. The technician observing the actions of market participants through the stock's movements might identify the same price level as a potential support level. What is support? Support is demand (buyers). So where does this demand come from? Often, it originates from the fundamentalist's determination of value. In this way, the two perspectives often yield the same conclusion using different methodologies. One opinion is based on the search for intrinsic value, whereas the other is shaped by extrinsic behavior.
Whatever one's vantage point, price goes up for only one reason: Demand has surpassed available supply. When the available supply outweighs demand, the price must go back down. Volume is the scale weighing these forces of supply and demand that produce price. In this way, volume ultimately reflects the ebb and flow of money into and out of the market or the security. Therefore, my belief is that volume analysis provides a superior view of the market's internal structure that other forms of analysis do not offer. This book explores the market from this underemployed perspective of volume analysis, providing an investor with the tools and concepts to advance his or her own abilities in evaluating the market.