Tactical Execution

Hello and welcome to Financial Audio, an information series providing listeners with detailed and tactical guidance on today’s complicated financial world. My name is Patrick and I’m your host. You can find written versions of these podcasts at FinancialAudio.com and I encourage your candid feedback at the same location. Today, we’ll be comparing fundamental and technical analysis so let’s get started.

Why would you buy one stock over another? What industry would you focus on? When would you buy and when would you sell? These are questions all investors ask themselves. Individual investors and professional money managers alike are always looking for ways to analyze the market in a way that will yield superior returns. And the analysis they do generally falls into one of two categories: fundamental analysis and technical analysis. So I think it makes sense to start off today with some definitions of those two categories. And in order to do that, let’s take a step backwards and look at what’s really happening with publicly traded companies.

Well, on the one hand, you have their actual performance out in the real world. These companies sell products and provide services to consumers or other businesses in the economy, and around the world for that matter. So you can look at various aspects of that economic activity. Are their sales growing? Is their product or service better than the competition? Is the company financial solid and well managed? Is their industry growing or shrinking? Is there legislation that might benefit the company? Are there any global trends that might benefit the company or the industry? These are all things that should reasonably shed some light on the future performance of any particular company. And, logically, if the company is doing well, the stock should do well also.

On the other hand, you have the company’s performance on the STOCK MARKET. The stock market is a fascinating vantage point because it’s like a sociology experiment where the sample size is the ENTIRE population. In other words, the movement of a stock’s price over time displays the opinions of EVERYONE watching that company. Think about it this way: for every company, there are people who already own the stock and are looking for a time to sell their shares and there are other people who DON’T yet own the stock and are looking for a time to buy. The prevailing price at any one point represents the equilibrium between those two forces. It’s like a battle going on all the time between buyers and sellers and the price in the middle shows the consensus opinion of the stock’s value at that moment and with all the information that’s available at that time.

So having said that, let’s get back to our definitions. Fundamental analysis deals with the real world. It evaluates a company’s actual performance in terms of their products, financial strength, management, the industry and the economy as a whole. Technical analysis only looks at the company’s performance on the stock market, relying on the assumption that all the other information is represented in the daily price fluctuations anyway. So fundamental analysis only looks at the real world while technical analysis only looks at the stock market. So which is better? Let’s take a look.

Consider four possible situations. First, consider a pharmaceutical company that just received FDA approval for a drug they’ve been working on for years. The drug benefits a common diagnosis and the revenue potential is huge. Obviously, this is great news. And as a result, the price of the company’s stock shoots up 10% on heavy volume. Incidentally, volume refers to the number of shares traded. In other words, a LOT of people jump in and purchase the stock and all this new demand pushes the price higher. Now, keep in mind that the total number of buyers is EXACTLY the same as the total number of sellers. By definition, a share traded represents one buyer and one seller. The reason the price went up is because the buyers overwhelmed the sellers at the opening price, 1% higher, 2% higher, 4% higher, 7% higher and finally reached a new equilibrium at a price 10% higher than the opening price that day. That’s when the sellers finally balanced the buyers again.

Whenever you see a stock’s price, you should be aware that there are a cluster of buy orders below the current trading price and a cluster of sell orders above the price. So assume a stock is trading at $20. Well, there are a bunch of potential buyers who have a number in mind where they would be willing to purchase the stock; a number LOWER than the current trading price (if the number was ABOVE the trading price, they would’ve already purchased the stock). Someone might have a buy order at $19 and someone else might have an order at $18. In many cases, these buy orders are automated and already programmed into a trading platform somewhere. So the orders already exist and are just waiting to be executed. If new sellers enter the market pushing the price down, those buy orders systematically get executed along the way.

Likewise, there are a bunch of sellers who also have a number in mind; a number where they’d be willing to sell; a number ABOVE the current trading price (again, if their number was below the trading price, they would’ve already sold their shares). So perhaps one investor has an order to sell at $21 and someone else has an order at $22. When new buyers enter the market pushing the price up, those sell orders get ticked off along the way. Well, that’s exactly what happened with our pharmaceutical company. They got some very good news that motivated a bunch of new buyers to come in and purchase the stock. With more buyers than sellers, the price gets pushed up and various sell orders get executed along the way, satisfying some of the buy orders at the same time. This continues until all the new buy orders have been satisfied AND/OR until the price has gone up beyond what new buyers are willing to pay. Either way, the price hits a new equilibrium where buyers and sellers are again in balance. In our example, the price shot up from $20 all the way to $22 (that’s a 10% gain) on heavy volume as a result of the good news.

Let’s consider a second example. A consulting company’s primary competitor unexpectedly declares bankruptcy after an accounting scandal is reported in the news. With its primary competitor unexpectedly crippled with financial and legal troubles, the consulting company’s stock jumps up on heavy volume while the competitor’s stock drops dramatically. The bad news brought new sellers to the competitor’s stock while new buyers jumped on to the consulting company’s stock, anticipating favorable future market conditions. In fact, many of the sellers of the competitor’s stock probably executed their sell orders and quickly became buyers for the consulting company’s stock. Regardless, the good news brought new buyers and the stock price moved up on heavy volume.

Here’s a third example. An internet search engine company has been performing poorly relative to its competitors and many people believe the CEO is unwilling to make the necessary changes to improve the situation. Finally, the Board of Directors gets fed up and fires the CEO, promoting a young progressive up-and-comer to take his place. The stock jumps up on heavy volume. Here again, the announcement brought new buyers and the price moved up on heavy volume because profit-seeking investors are expecting future performance to improve under the new leadership.

Let’s look at one last example. The President delivers the State of the Union speech and identifies a new initiative to that will dramatically improve the sales prospects for a bio-fuel producer. The next day, the stock jumps up on heavy volume as an army of new buyers jump in to ride the wave this new initiative will create.

In all four examples, companies had good news that became public. And in all four examples, the stock price shot up on heavy volume because a bunch of new buyers entered the market and drove the price higher as they clamored to buy the stock; all of them expecting the stock price to go up further in the future. Now, someone who makes their investment decisions based on fundamental analysis would want to know these particular news items and evaluate how they would affect the company, both now and over the coming weeks, months or even years. On the other hand, someone who makes their decisions based on technical analysis would see the price increase and the heavy volume and know that some piece of good news was presented. They wouldn’t know WHAT was announced. They would only know it was good.

Fact is; the actual news item is largely irrelevant. It doesn’t really matter. What matters is that the investment community SAW it as good news and showed their approval by driving the stock price higher on heavy volume. The proof is in the pudding. The stock market performance demonstrated that something happened; something good. So the technical analyst would know something was happening and could either jump in right away or watch for other market indicators to select an appropriate time to buy in.

Now, some of you might be thinking that the real winners are those who bought the stock BEFORE the news was released. Good point. And you’re right. The real winners already owned the stock. But let me tell you right now that the effort to hear news before it’s released is a dangerous game and often results in fruitless “stock tips” that go nowhere. In fact, there was a study done once that suggested a stock’s trading price reflects news releases within 12 seconds from the time of announcement. I don’t know how accurate that is but I assure you it’s a waste of time trying to select stocks hoping for future good news.

Essentially, for the purposes of your investment decisions, the company’s actual economic performance is two steps removed. The actual news items are two steps removed. The INTERPRETATION of that economic performance and those news items on the stock market is just ONE step removed. These are two different versions of reality but the one dealing with the stock’s value on the stock market is a lot closer than the one dealing with actual economic performance.

My opinion is that your decisions should be based on the information closest to your objectives. As an investor, your objectives are to understand the stock’s value and gain insight as to its future value. At the end of the day, you probably don’t really care if the company does well or now. What you want is for the stock to go up. Your primary concern is the INTERPRETATION of the company’s performance on the stock market. It’s that interpretation that either helps achieve your objectives by delivering profits or does the opposite, leaving you with a loss.

How many times have you watched TV in the morning and heard some good news about the economy but the stock market was trading lower? How many times has a company delivered strong earnings but the stock price was down because the investor community was apparently expecting something even better so the news was interpreted as a disappointment? This stuff happens all the time. How would it be possible for you as an individual investor to keep up on all this data as well as the market’s EXPECTATIONS, just to know whether or not to buy or sell a particular stock? It’s far easier and, in my opinion, more accurate to evaluate a company based on its stock market performance and nothing else.

Now, does fundamental analysis have benefits? Yes, of course it does. But I believe its primary benefits exist at the macro level. In other words, I think the fundamental analysis of the economy as a whole and even within one industry or another can shed light on the prospects of companies within that group. And that can help narrow the focus when selecting stocks in the early going. But after that, I think the technical analysis of stock market performance is far more reliable than any particular news item or financial statement.

This was made painfully clear to me by a friend of mine called Ray back in 2002 that did a ton of fundamental analysis and determined the next big wave was going to come from fuel cell companies – not a bad determination, I thought. In fact, I still think fuel cell companies will one day have their day in the sun. But back in early 2002, Ray read a series of expensive reports and identified 5 or 6 fuel cell companies and invested heavily in each. Everything looked great, especially with the new “risk factors” in the Middle East. We had already invaded Afghanistan and it looked like Iraq was next on Cheney’s list. Oil prices were rising. Public awareness of global warming was growing. Fuel cell technology was being hyped on TV. Partnerships with large companies like General Motors were being announced. Fundamentally, it looked like a pot of gold, just waiting to be discovered.

Well, Ray waited and waited. Prices went modestly up and then came right back down again. For quite a while, prices went significantly below where he bought them at. At one point, his portfolio was worth less than half what it was a year earlier. Eventually prices sauntered back up and he eventually sold out of his positions, STILL at a small loss. Bottom line; the investment community wasn’t ready to value those stocks any higher. The fundamental picture was beautiful but the technical indicators never materialized. Now, will those same stocks one day soar in value? Probably. And will the fundamental analysts claim victory when they do? Probably. Truth be told, I have absolutely no doubt those stocks will go up at some point. But when? Until the technical indicators materialize, there’s absolutely no reason to invest in those stocks.

We’re talking about price-volume action. The price-volume action reflects all the information available on a particular stock. The number of buyers, the number of sellers and the price change tell you everything you need to know. Academics would describe my beliefs as an “efficient” stock market model. That means that all relevant information is public and known by everyone who cares. That’s not quite true but the fact is; there are armies of people who spend all day every day doing research and analyzing data to determine which stocks are good buys and which are over-priced. I have no interest trying to compete with their knowledge. I just don’t have the time. I only want to invest my money at a profit and the price-volume action tells me everything I need to know.

Over the next year or so, this information series will present an enormous amount of great information – and it’s FREE – about today’s stock markets and a variety of different investing strategies but it’s pretty obvious I’m a strong believer in the value of technical analysis. I think a technical understanding of the market is the biggest advantage an investor can have when allocating his or her money between different opportunities. In fact, it can lead to a market intuition that overflows into a wide range of other finance and economy-related topics. Listening to the news is a very different experience when you have a technical understanding of the market. I hope you’ll stay curious long enough to experience that for yourself.

The next two chapters will deal with technical analysis in more detail. There’s no way to do the topic justice in just two chapters so we’ll focus on the underlying logic behind the technical approach. The first these two chapters will lay the psychological foundation and then look at some basic territory markers on technical charts. The second will introduce some swing indicators and discuss the basic pillars behind specific trading strategies. And whether you agree with my approach so far or not, I hope you’ll commit to listening to these next two chapters so you can make an informed final judgment on what this series presents. At the end of the day, the numbers speak for themselves and if I can show you how to get real returns, you may become a believer the same way I did.

If you’d like to see what I’M doing in the market, just create a FREE account and login at FinancialAudio.com and then click on Market Position. Now, it’s important I tell you that I’m NOT a licensed Financial Advisor. This is FREE information and I do NOT accept money to give investment advice. I’m just giving you a little glimpse into my own trading activity, that’s all.

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Again, you can find written versions of these podcasts at FinancialAudio.com and I do offer workshops, seminars and keynote speeches as well as a variety of more advanced information products so please email me at Patrick@FinancialAudio.com for more information. I’m also doing a series on innovative marketing and strategic business positioning. That series is called Tactical Execution and you can find it on iTunes.

Stay tuned. There’s a lot more to come. In the meantime, think big, take action and invest strategically. Bye for now.