In these turbulent times, investors need to use all of the tools at their disposal to protect their capital and find profit table trading opportunities.
Investment banks and research houses around the world employ thousands of ‘fundamental analysts’. These highly sought after roles involve the rigorous and detailed dissection of company financial statements. Once the analyst has determined the value of the company as a whole, it is a relatively simple process to divide this figure by the number of shares on issue to determine the ‘fair value’ for each share. However, just as most investors are not interested in buying whole companies, they also don’t rely solely on cold, hard facts and figures when making investment decisions.
Beyond the analysis of financial statements and company forecasts, there are many elements that influence share prices. Among the most recognised of these are the powerful emotions of greed and fear. These emotions tend to be contagious and often result in prices moving a considerable distance from their theoretical ‘fair value’. The future expectations of investors will also have a significant influence on price. While these additional elements can be difficult to quantify from a fundamental perspective, they can be seen clearly on the charts.
One of the basic tenets of technical analysis (charting) is that in a free market where prices are determined by the forces of supply and demand, price discounts everything. In other words, the chart of any particular security will reflect everything that anybody knows about that security – because anything that can influence the price will influence the price. This will include everything from widely available fundamental valuations through to specialist knowledge of the relevant industry, inside information and even the ‘gut feel’ of certain investors. More than simply reflecting the price of a security, charts are also a reflection of crowd behaviour.
Using the example of ABC Learning Centres
Consider the above chart of ABC Learning Centres. Since reaching an all-time high of $8.80 in December 2006, the share price has been in decline. Even the most basic application of technical analysis indicates that it would not have been wise to be buying this stock following the November break below the August low of $6.07. This move, indicated by the red arrow, clearly confirmed that the bear trend was gathering momentum with lower prices likely to ensue.
Although some fundamental analysts did indeed downgrade their ratings on this stock, others did not. In fact, on 14 February (as marked by the blue arrow) after prices had virtually halved, one analyst saw fit to reiterate a ‘strong buy’ recommendation. A couple of weeks later, the stock lost nearly 70% in a single day, before rebounding to end down ‘just’ 42.8% for the day.
Of course, it is easy in hindsight to say that the ‘strong buy’ recommendation was flawed. However, if investors receiving that advice had cross checked the recommendation against a chart of the share price, they should have realised that more than the fundamental valuation of the company was driving prices. Given the high level of debt held by the company, it was fear (fuelled by the sub-prime crisis) that was influencing investors.
In addition to fear, future expectations were influencing prices. While some inputs that affect these expectations relate directly to the company, many have no direct connection at all. The beauty of the charts is that they will reflect this change in expectation as soon as it arises. By comparison, changes in future earnings expectations and other parameters contained within financial statements, generally take considerably longer to be updated. This effectively negates the suggestion that taking guidance from the charts is like trying to drive a car by looking in the rear-view mirror, or base trading decisions on past prices. If anything, it is the charts that are quickest to reflect changes in market assumptions about the future.
In the current environment of high volatility and uncertainty, it is advisable to check the chart of all investments to see whether or not the fundamental valuations and "the crowd" are in sync. If not, tread carefully.
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