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.