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Fundamental versus Technical Approaches

The question of how to apply core earnings adjustments has to also take into account likely effects of such changes on market price of stock. Even if that effect is only short term, it may also radically change the way that we view stocks and their growth potential.

For example, if a corporation reports net earnings year after year, we may develop a sense of confidence in that stock, at least to the extent that earnings are a primary fundamental indicator that is followed each year. Of course, earnings serve as one of the primary indicators, and the Wall Street obsession on earnings is well known. The predictions made by analysts about quarterly earnings per share are followed carefully by "the street" as a most important measurement of corporate performance. In fact, the analyst's prediction (and how close actual EPS comes through) often is viewed as more important than longer term growth prospects—at least to the extent that the accuracy of those predictions is factored into stock prices.

At the point that the analyst's prediction becomes a primary indicator of "good" or "bad" results, the fundamental significance of earnings has already been lost. This crossover from fundamental to technical is dangerous. Even the most serious fundamental analyst can easily be distracted by short-term reaction to earnings predictions and may easily lose sight of more important trends.

Without making core earnings adjustments, the apparently strong EPS of a company could be far weaker than it first appears. In many instances, core earnings adjustments drastically reduce EPS and may even change a reported profit to a net loss. Of course, core earnings are the isolated earnings from operations, so one argument could be made that the corporation in question did, in fact, earn the reported profits. However, with the long term in mind, it is equally valid to recognize that nonoperational profits are not going to recur year after year and that the exclusion of items such as employee stock options makes reported profits inaccurate. So, core earnings adjustments are not merely theoretical for the fundamental investor. These adjustments can serve as the basis for realistic analysis and not merely as an alternative way to look at the numbers.

Is there a conflict between fundamental and technical? Of course. If you decide to watch price trends without also identifying what is going on in the fundamentals, then this limits your information. If a corporation is not making core earnings adjustments voluntarily, both fundamental and technical indicators are unreliable. The technician will be just as interested as the fundamental investor in seeing how core earnings adjustment affects stock prices. To the extent that reported results are less than accurate under traditional methods, the market price is going to be distorted as well. The technical analyst who tracks only price information is dealing in short-term trends only. How much faith would that investor take in the trends upon realizing that reported EPS was far off?

The reality is the same for both fundamental and technical sides: Core earnings are the most reliable and accurate format for tracking earnings and for identifying likely long-term growth. Even the technician, interested only in price trends, has to realize that price is also affected—in positive or negative ways—by inaccurate fundamental reports. Fundamental investors cannot completely ignore technical trends, and the opposite is true as well. Technical analysts who recognize the potential inflationary effects of overstated earnings will be interested in calculating the possible effects that core earnings adjustments would have on price. In fact, when price is inflated as the result of overstated earnings, the technical investor may be able to take advantage of the aberration through short selling, covered call writing, or put option speculation—as examples of how technicians and speculators may make profitable use of the situation.

Fundamental analysts who are aware of the importance of core earnings adjustments may also track technical indicators to identify the effect between earnings and market price. For example, monitoring price volatility is a smart way to monitor how EPS interacts with technical market trends. A stock with historically narrow trading range trends may enter a period in which support and resistance levels begin to expand or in which a price breakout occurs. With an awareness of core earnings in comparison to reported earnings, even the fundamental investor will be able to make short-term decisions based on growing price volatility. As one of many methods for confirmation (see Chapter 4), technical indicators may help you to verify or even contradict an apparent fundamental trend.

For example, if you are tracking a series of fundamental indicators and you see a departure from the established trend, seek confirmation of the apparent change by checking related ratios. If sales increase without explanation, you may see a corresponding increase in accounts receivable balances. Does this mean the company is booking earnings too early or too aggressively? The change requires further investigation. However, at the same time, if you also see increases in price volatility, that technical indicator could confirm your suspicion that something is not right with the reported fundamental trends. When fundamental and technical indicators are used to verify (or contradict) one another, both gain in value. The debate as to which type of indicator leads the other becomes less important; both sides may ultimately recognize that fundamental and technical trends are intertwined and directly connected.

On a practical level, it is difficult to confirm fundamentals using technical information on a day-to-day basis. The fundamentals are often months old by the time they are available to you, whereas technical information changes on a day-to-day basis. The comparison is valid, though, in evaluating a stock with historical perspective. For example, you may be trying to quantify the investment value of a stock with a review of the fundamentals for the past three years—perhaps the appropriate starting point. By including historical reviews of price trends along with the fundamental trends, you improve the scope of your review. When you recognize changes in price volatility, tests of support or resistance, and other important price trend alterations, you might also find a correlation to ongoing fundamental changes during the same period.

The problem in connecting fundamental and technical is one of timing. You cannot use fundamental trends to track stocks day to day any more than you can use technical trends to identify long-term growth. The fundamental trends are more applicable for long-term analysis. Your fundamental approach will be more accurate when it is based on post-core earnings adjustment numbers rather than on the unmodified GAAP numbers. To the extent that technical information helps to explain recent trends, it can be useful as well—not for current short-term market timing but as confirmation of what you see in the adjusted fundamentals.

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