The Basics

Is technical analysis useful in the stock market?


A while back zigfred at The Polymath Investors wrote a 2-part piece (Part 1, Part 2) sharing his views on why technical analysis is of no use in stock market trading – at least by itself. His reasons are three:

  1. Its nature
  2. Its tools are flawed
  3. A lot of credible long term studies reveal that it does not work

OK, I have to address the last one first as being a non-argument.

Basically, he’s saying that technical analysis doesn’t work because studies have shown it doesn’t work. That’s not a causal statement at all. It’s like saying, “I can’t run a 100m dash in under 10 seconds because I’ve never been able to run it in under 10 seconds.” It’s providing evidence of the fact, not a reason why it’s true. As such, you can basically toss that out, but I won’t quite do that because the evidence needs to be addressed, which I do later.

Tackling things in their proper order, though, let’s start with #1.

The flawed nature of technical analysis
As zigfred rightly points out, the basis of technical analysis is market psychology. Taking that as given, he then presents the argument that on this basis, using technical analysis to trade the markets is a kind of recursive effort in that it turns back on itself because the act of using market psychology to trade influences that market psychology.

While it is certainly true that a definite issue with technical analysis is that it can create a kind of self-fulfilling market dynamic, zigfred presents things as if everyone is trading on technical analysis. Obviously, that’s not the case.

He also seems to be implying that trading on technical analysis is the cause for markets being more volatile than fundamental valuations would seem to suggest. In a truly efficient market – which zigfred seems to think one driven only on fundamentals would be – price would change relatively infrequently, only when new information arrives. Reality is far, far different. Even in the absence of technical analysis there are market mispricings. It’s the under/over-reactive nature of markets driven by individuals who are not perfect in their analysis of information and forecasting of future events. This isn’t even mentioning well-known psychological biases and other factors.

One need only look as far as the housing bubble for a major example. You can’t tell me that technical analysis was the main driver of that!

From a more market-specific perspective, what about the way prices react to data and news with sometimes extreme volatility? You cannot attribute that to technical analysis.

So while I agree that a market overly populated by technical analysis will tend to see TA losing its effectiveness, where fundamentals are still a major factor it remains a useful way to view prices.

Flawed technical analysis tools
The second argument against technicals zigfred makes is that the methods of analysis are basically no better than throwing a dart at a board. His major point is that even technicians don’t agree on which techniques are best or how to interpret charts and indicators.

Hard to disagree. There are a great many indicators out there that are derived from the fields of math and statistics and such which are either poorly understood or incorrectly interpreted. The same can be said of chart patterns and what the underlying causality of their development means. To my mind, this is largely a function of people failing to do the work and the study to really know what it is they are using to analyze the markets.

As flawed as the technical tools may be, let’s not suggest there aren’t major issues with the way fundamental analysis is applied.

Studies show that it doesn’t work
In zigfred’s post he specifically mentions a couple of studies which suggest that technical analysis methods don’t work. I’m not really surprised because I personally believe that rote application of the techniques aren’t really effective in the long run. The markets are too dynamic and changing for things to hold their usefulness consistently.

That said, however, academic research has consistently pointed out a momentum effect in the markets. I don’t have a reference at hand, but it came up a lot in the readings I did while developing my PhD thesis. Momentum in the academic usage of the term is basically trending. If there are trends that can be measured and anticipated, then at least one element of technical analysis has firm grounding in the research.

Now, this post is not me saying that technical analysis is the best thing. As you’ve seen, I’m quite willing to admit it’s problems. I just want to make sure the discussion is done on balanced terms. In my own stock trading I combine it with fundamental analysis. In other markets, and especially in shorter time frames, though, I rely on technicals more heavily.

Trading Book Reviews

Book Review: The Secrets of Economic Indicators by Bernard Baumohl

[easyazon-link asin=”B008O7V05U”][/easyazon-link]It’s taken me about a year, but I’ve finally gotten around to having a look through the 3rd edition of Bernard Baumohl’s book [easyazon-link asin=”B008O7V05U”]The Secrets of Economic Indicators[/easyazon-link]. Now that I’ve done so, I really which I’d dug in sooner.

This book answers the question a lot of new and developing traders have in terms of what economic indicators are important and where to go to get information about them. It comprises only 6 chapters, despite being over 400 pages long in print format. They are as follows:

Chapter 1 – The Lock-Up, which looks at how indicators are released and lays the groundwork for what’s to come.

Chapter 2 – A Beginner’s Guide: Understanding the Lingo, which is a brief look at what does into economic data and the interpretation of releases.

Chapter 3 – The Most Influential US Economic Indicators is the bulk of the book (over 300 pages). It goes through each of the major releases (and not so major) with a quite thorough discussion. That starts with a quick reference on

  • Market Sensitivity
  • What Is It?
  • Most Current News Release on the Internet
  • Home Web Address
  • Release Time
  • Frequency
  • Source
  • Revisions

That is then followed by discussion sections

  • Why Is it Important?
  • How Is It Computed?
  • The Tables: Clues on What’s Ahead for the Economy
  • Market Impact

Lots of information here, for sure.

Chapter 4 – International Economic Indicators: Why Are They So Important? follows a similar pattern to Chapter 3 in looking at the major non-US data releases.

Chapter 5 – Best Websites for U.S. Economic Indicators is several pages worth of useful websites to find fundamental information and news.

Chapter 6 – Best Websites for International Economic Indicators is the same as with Chapter 5 for international data.

I can’t imagine a better, more complete resource on the subject of economic indicators. If you’re looking at using fundamentals in your trading, you’ll definitely want to give [easyazon-link asin=”B008O7V05U”]The Secrets of Economic Indicators[/easyazon-link] a look.

Make sure to check out all my trading book reviews.

Trading Tips

Bernanke’s view on inflation, I think

Fed Chief Ben Bernanke did his first post-FOMC press conference yesterday. Predictably, he got a question about the impact of energy and food prices on the public and the whole issue of the impact of QE on inflation and the value of the dollar. There’s a lot of screaming and yelling about this subject in the press and among market participants. Bernanke held to his line, though, about inflation being low and these food and energy things being transitory, which annoyed a bunch of folks.

Here’s what I think Big Ben is reading the inflation situation. I’ll try to explain by way of example.

Imagine that you have $100 in your budget. Your housing (rent or mortgage) is $35. Food runs $25. Utilities and other expenses are another $25. Gasoline costs $15. Now let’s say gasoline prices double, so your cost goes to $30. What happens? If you cannot increase your income or borrow money you’ll have to cut $15 from among the other categories. That means your demand for other goods and services will go down.

Extend this example to the whole US economy. If income isn’t rising, then rising food and energy prices means money not available to spend on other things. That means less demand, and by extension lower prices in those sectors. What that tallies up to is no net change in overall prices. Even if income is rising, as long as it’s rising less rapidly than the increase in food and energy prices there will still be the dampening impact on prices elsewhere in the economy.

Below is a chart from the St. Louis Fed showing disposable income over the last 10 years. It show’s a year-over-year growth rate between 3% and 4% in the most recent figures. How does that compare to the change in food and energy prices? Just a fraction, right?

Of course, folks can borrow to make up the shortfall. Are they? To find out we need to look to the money supply figures.

Here’s the chart for the Monetary Base, which is the lowest level of money supply that is directly influenced by what the Fed does.

Again, we’re looking at year-over-year changes here. Notice the big spike up in 2008 when the Fed got aggressive about dealing with the financial crisis. In late 2009 and early 2010 we can see a spike up in the growth rate from QE1. The growth rate actually went negative in the latter part of 2010, though, before QE2, after which it has bounced back again.

The monetary base, however, does not reflect borrowed money. That’s in the bigger aggregates, especially M3. The Fed stopped publishing M3 a few years back, but we can see a continuation version created by the folks at ShadowStats.

Notice in the chart how the y/y change in M3 has been negative since late 2009 or early 2010. That basically means the amount of debt outstanding has been falling. In other words, folks in the US have not been borrowing to finance purchases beyond their income. Quite the opposite. They’ve been reducing debt (though write-offs are a factor here).

So what we have is income not rising at the same pace as increases in food and energy prices and debt shrinking, not expanding. That means there’s less money available to be spent on other goods and services. That is helping to depress prices in those sectors, which is why Bernanke is not worried about general inflation yet, but does have concerns about economic growth. At least that’s how I think he’s viewing things.

Trading Tips

Non-Arguments Against Fundamental Analysis

I’m going to join Adam from Forex Blog in taking on a post at Counting Pips titled The Problem with Forex Fundamental Analysis. Obviously, the focus of these pieces is on forex, but really the ideas apply to pretty much all markets.

The author of the latter has defined fundamental analysis in this way:

Fundamental analysis mainly focuses on the overall state of the economy, interest rates, monetary policies which are basically the economic conditions of a country.

These are three arguments made why having a fundamental analysis focus “will be disastrous”.

By the time you receive economic news it will have already been reflected in the charts.
This will tend to be true if the data is largely anticipated. If everyone expects the Fed to hike rates by 25bp at the next meeting then that is bound to get factored into market prices in advance of it happening. A recent example of this is the rise in the euro following hints from the head of the ECB that there could be a rate hike in April.

This, however, doesn’t not account for surprises where an event or data item is nowhere near market expectations. Those sorts of developments are the ones that produce high volatility reactions.

But it doesn’t take a big variance from expectations to cause a market reaction. Unless the market is 100% sure of something there will remain room for reaction. Think of it this way. If the market is only 75% sure the Fed is going to raise rates at its next meeting, it’s probably only going to price about 75% of the hike into current prices. This is why trades pay such close attention to all the Fed speak so they can gauge the probabilities and factor them in.

Economic data is skewed and biased by those reporting it
This may be true, but I’m not inclined to think it matters. Traders and market analysts tear apart every piece of data they get their hands on to see what’s what. They also have secondary sources of information beyond just that reported by the government. They know when things look dicey and react accordingly.

Everyone reacts the same way to news, producing a herd mentality
This would seem to tie in closely with the question from my Trading FAQs book “Why doesn’t everyone trade in the same direction?” The fact of the matter is, they don’t. Anyone who’s been in the markets long enough has seen plenty of times when the market reacts very strongly in one direction only to eventually reverse. That seems pretty good evidence to me that not everyone is included in the initial herd.

But We Miss the Point Entirely
All of the arguments against fundamental analysis listed above are strongly slanted toward trading off immediate term developments – the data and news that’s just hit the wires. This, though, isn’t fundamental trading. It’s news trading. It’s trying to figure out what the market is expecting and how it’s positioned ahead of time and knowing how best to react to the headlines when they hit. Fundamental analysis is taking the bigger picture view with macro trends and valuations in mind. That’s the complete opposite to news trading.

If you want a reason not to use fundamental analysis in your trading, there’s really one one major one. Because of it’s longer timeframe focus, fundamental analysis is of little use for short-term traders beyond providing of the underlying macro scenario.

Trading Book Reviews

Book Review: The Great Deleveraging

[easyazon-link asin=”0132358107″][/easyazon-link]”Capital preservation should be goal number one” is the final line in [easyazon-link asin=”0132358107″]The Great Deleveraging[/easyazon-link] by Chip Dickson and Oded Shenkar. That’s the conclusion provided to finish off about 300 pages worth of discussion, data, and analysis related to economic and stock market patterns of the last century or so. The authors take the reader through extensive historical study of how the US and global economies have changed and evolved and how stock markets have reacted to those changes in their bull and bear market cycles. They do so in a very easy to read fashion, however, with loads of charts and graphs to make their points. It is, in many ways, a quick read for all its length and content.

My one gripe about this book is that the subject matter noted in the title doesn’t really get all that much coverage in a direct fashion. The first chapter is titled “The Great Leveraging”, which makes sense since you have to lever up before you can delever. The chapter with the same name as the book’s title doesn’t come until the tenth (of twelve), though. In between there are chapters reviewing the history of real asset returns, global growth, and stock market patterns. Chapters on emerging markets and developments in the private sector are tossed in as well, some of the content of which only seems loosely related to the main discussion.

After all that, I’d like to have seen a more of a forward projection as to what The Great Deleveraging could look like, especially since the book seems to intended to give the reader something practical to apply. That stuff comes through in the final two chapters. The penultimate provides ways to gauge the economy and markets. The final chapter could be reasonably described as laying out a high level, fairly conservative plan for your financial future.

As much as I’m a bit disappointed that there isn’t as much meat to the deleveraging discussion as I’d have liked, I still give the book a solid overall score. There’s loads of very interesting information and suggestions of the sorts of things you can use to develop expectations for how the financial markets will perform given likely economic developments. Definitely something traders and investors whole like to take a fundamental view on things will find worthwhile.

Make sure to check out all my trading book reviews.

The Basics

Influences on Price/Earnings Ratios

The Price/Earnings ratio (P/E) is a metric commonly used in fundamental analysis of stocks – both individually and in terms of indices. It can be a useful gauge of relative over- or under-valuation both in terms of looking at a stock or index singularly, or in comparison with others. For example, one could evaluate where the current P/E of JPM is in terms of it’s historical levels and/or in terms of how it compares to BAC, C, WFC, and others in the banking sector.

It’s not recommended that P/E be used in isolation – meaning low P/E = cheap stock, or vice versa. There are reasons why a P/E can be low or high, including changing expectations for growth rates which have not necessarily started showing up in the earning data. For that reason, you should only use the P/E in conjunction with other forms of analysis.

Looking at Stock Valuation Math
In thinking about doing so, it’s worth noting the two mathematical influences on the P/E ratio when looking at the valuation of a stock. They are the earnings growth rate and the interest rate. Stock valuations are done by determining what future earnings are expected to be, then discounting them back to the present by doing a Present Value (PV) calculation.

Earnings growth rate assumptions obviously factor into the expectations for future annual earnings per share figures. The table below shows the impact of different levels of growth rate expectations for earnings on valuation, and thus P/E.

The above calculations only go out to 5 years. Valuations are often done with an additional perpetual growth rate for the years beyond #5. For the purposes here, however, five years is enough to make the point.

Notice in the yellow Value row how the valuation of the stock in question (based on adding the PVs of the earnings forecasts for Years 1 through 5) rises as the assumed annual growth rate (left column) goes from 0% up to 20%. Using the Year 0 earnings (current year achieved result) as the E in the P/E, and the valuation as the P, we get the P/E listed in the right-most column. Notice how it rises in line with rising growth rates.

Now, this probably won’t come as a big surprise. It’s commonly understood that higher earnings growth rates translate to higher P/Es. That’s why the P/E of a perceived growth stock will generally be higher than the P/E of a more mature stock, like a utility. It also should be noted, however, that P/Es also vary because of interest rates. The discounting of future earning’s done in the valuation process employs an interest rate to calculate the PVs. Thus, interest rates impact P/Es.

The chart below provides an example.

The chart above shows the P/E value of a stock with a 5% annualized earnings growth rate with valuations determined using discount rates from 1% to 10th. Notice the steady decline as interest rates rise. It’s not a big change, of course. Changes in earnings growth rates are more impactful. This may be something very important for the stock market moving forward, however. If we think interest rates are going to be rising in the years ahead, then we have to factor in slightly lower P/E ratios.

The Basics

Top Factors Influencing Exchange Rates

During my usual roaming around the web I came across an entry from Oanda titled Top 5 Factors Affecting Exchange Rates. Those five factors are:

1. Interest Rates
2. Employment Outlook
3. Economic Growth Expectations
4. Trade Balance
5. Central Bank Actions

I think whoever authored this item actually made things a lot more complicated than need be and has things here are a couple of different levels in the discussion. There are only two things which impact the exchange rate of a currency – items which speak directly to the supply/demand equation. One is capital flow. The other is trade flow. Everything else speaks to one or both of those primary movers.

A swirl of overlapping influences
Let’s take the first entry above, interest rates, as an example. What impact does the level of interest rates, or the change in that level, have on a currency’s exchange rates? The most direct impact is on the capital flow side in terms of making a currency more or less attractive to investors (either for investing or for borrowing, as we’ve seen from the carry trade). Interest rates also factor into the trade flow side in as much as they have an impact on the domestic economy and the ability of domestic consumers to purchase and/or produce trade goods.

The second item on the list is Employment Outlook, which to my mind either feeds up into or spins off out of #3, Economic Growth Expectations. That then speaks to the trade flow side of equation (#4) and prospectively to interest rates as well. As noted above, that latter element feeds through into the capital flow side of the equation.

And keep in mind that where exchange rates are concerned everything must be taken in comparison to something else. You cannot look at one economy in a vacuum because the exchange rates are determined by looking at two matched against each other.

The one “external” force in all this is government or central bank intervention. Some are quite active in attempting to influence exchange rates directly. For example, at this writing Brazil is buying dollars twice a day to keep the real from appreciating. Not all countries do this, though, and most of the time it’s only done in perceived extreme circumstances to keep the markets getting out of order.

Another kind of intervention is government regulation and fiscal policy. These things, however, flow through into the capital flow and trade flow considerations. They do not directly act on exchange rates.

Now, some will say that inflation directly impacts the value of a currency. In purchasing power terms that is most definitely true. Inflation only has an indirect impact on exchange rates, however, as a contributing factor in the determination of capital and trade attractiveness. After all, if every economy is experiencing 10% inflation, there is no relative impact for exchange rates.