Thursday, March 09, 2006

The Great Debate

For those of you who read this blog regularly - - and there are a lot of you - - you should know that the comments section is just about as interesting as the original content. There are a lot of intelligent, insightful readers on this blog, and I personally enjoy reading what they have to say. Part of the reason for this rather lengthy entry today is some comments a few people have made.

Before I get into "The Great Debate" - that is, technical analysis versus fundamental - I want to review some very recent history (like the past 14 hours or so).

I mentioned early this morning before the market opened how the $UTIL (Dow Jones Utility Index) was vulnerable to a fall, which would mean higher interest rates. Sure enough, both MarketWatch and TheStreet declared (at the end of the day) that interest rates were the principal cause behind the market getting smacked around. (Oh, by the way, one fellow asked what security would be used to trade this market - I'd suggest symbol UTH).

In the same post, I apologized for my not-so-hot recommendations to short Hansen Natural (HANS). When I originally recommended this as a short, the stock was about $101. They posted great earnings after the close yesterday, and it opened this morning at $107, blowing out the position.

What's interesting, though, is that the stock actually ended up down for the day, as shown in the graph below. Indeed, this is a big, fat bearish engulfing pattern on gigantic volume.

So perhaps I was too hasty with my apology! But the fact is that when the stock opened at $107 this morning, that was the time to get out. There was no way to tell the stock would end up down or end up at $130. Once a stop is violated, you get out, and you get out at once. It's heartening to see I didn't screw up this analysis as badly as I feared, but I stick by my "always have a stop" rule.

I'm going to go out on a limb here (even moreso than normal) and state that I believe the bear market has finally started. This isn't a "maybe" or a "someday." This is: it's finally here. I think we finally topped out in the final week of February and the pieces are finally in place for this market to start disintegrating. MarketWatch finally got it right by declaring on its home page today:

I'll add one more thing to this assertion - the QQQQ is closer than ever to breaking below its head and shoulders pattern, as you can see below. If the QQQQ breaks below 40.16, I predict a rapid 9% decline in the NASDAQ 100. This prediction is invalidated if the QQQQ crosses above 42.01.

Now, let's turn our attention to that debate I mentioned!

As you know, I have stopped the submission of comments by Anonymous users. Because everyone - bulls and bears - are required to show themselves, my pledge is to be respectful of all opinions. As long as people aren't hiding behind the shield of anonymity, all opinions are welcome.

One bullish fellow wrote in shortly after my mea culpa post this morning with the following thoughts:

No, Trader Tim. Your mistake is not that you read the chart wrong. It is that stocks are moved by fundamentals and not technicals. All these double tops, fibonacci, trendline, and moving averages formations are pretty silly. It is the high of hubris to think that you can use chart reading to predict something as complex as the economy system. Sometimes the fundamentals and technicals happen to match so that gives you the illusion that you can use technical charting to predict the fundamentals. But it is just that, an illusion.

Let me address the core points of this comment:

  • Stocks are moved by fundamentals and not technicals - I agree! Absolutely! Great earnings power stocks. No question about it. I simply believe, however, that the fundamentals are already built into the chart, as are everything else that can be known. The chart, after all, is the perfect representation of the balance between supply and demand for a given instrument. Don't you think the fundamental analysis is already built into that balance? I certainly hope you do.

  • Chart patterns, Fibonacci studies, trendlines, and other studies are silly - I've been charting for many years, and experience has taught me that all of these 'silly' methods are invaluable in predicting future price movements. Different techniques work for different people - for instance, I really don't use any technical studies, but rely far more on patterns - but that's just personal preference. And I don't find Fibonacci silly; instead, I find it almost eerily predictive of the future.

  • It's hubris to think you can predict the future based on technical analysis - On this point I disagree the strongest. In fact, I believe just the opposite - that fundamental analysis is the height of hubris. And that isn't just a "nyah" on my part. To my way of thinking, everything that can be known about a security is already built into a chart. Why on earth would anyone think they have some kind of special insight based on fundamentals? Don't you think all the million-buck-a-year analysts running around do a good job with this kind of thing? Do you think they actually missed something somehow? The chart has everything you need. Don't bother with fundamentals.
Another person wrote in with the following:

I too look forward to the TA fundamental dicussion, I think you should always use both. On The Hans trade I would not of entered the trade because of the major event (earnings) that was upcoming. In fact as the comments on your prior post point out it was a hard to borrow this issue in the first place I was thinking there would be a short squeeze situatuion because of this but it did not turn out to be one at least during trading hours. It looks like many holders took this as an opportunity to dispose of stock particularly in the last half hour of trading. Maybe the long time holders are happy with thier multi-thousand percent gains or they believe hans has reached its growth limits. I think the later is true and will be watching for a good short entry. I think most analysts would love to make an apology for a trade that turned out to be in the money at the end of the day.

And, finally:

The mistake was not in your technical analysis. I think that the stock was setting up as a potential double top and still is by the way, and the entry was right, to short right below overhead resistance with a tight stop over it. The problem was that the earnings were coming out this morning and usually and when one enters a trade before the day of earnings one leaves themselves vulnerable to all the upside and downside volatility that comes with the earnings report. I still think that the stock sets up the double top up here, since the break out attempt on strong earnings failed this morning and a lot of bulls included "superbull" were trapped at the top. I think it is still a short now and a much safer short than it was yesterday.

Also no analysis is bullet proof if you get 60% right you are doing great as long as you control your losses to a minimum. I use 3-5% stop loss rule. Risk management is the key to any investment.

Anyway to close on a funny note our mutual friend "superbull" who makes his decision based on strict fundamental analysis decided he wants to buy hans today. "Superbull" confident in his views that technical patterns such as double tops are silly and illusionary, he analyzed and decided to buy the stock after he saw that earnings were stellar. The company he thought was growing sales and earnings expotentially and it would go much higher than is was this morning. After all the analysts were putting buys today and they are using the same fundamental analysis he is using so he must be right. Needless to say he bought hans at $109.85 this morning. He is down $11.60 on the stock but he says it doesn't matter. His flawless analysis points out that by summer the stock will be at 500 dolars since everyone will be drinking hans drinks to cool off from the summer heat. He says he doesnt care even if the stock goes down to 50 he will average down even more down there.

So I appreciate hearing both sides. If Friday's market isn't down, I'll be very surprised.

But it all boils down to this - eventually a trend ends. Eventually even the best of stocks go from a general uptrend to a general downtrend. And it's finding that change of direction which can make you a fortune. Look no farther than BMHC, shown below. The stock seemed it could do no wrong. But it did break its trend - look where the price went to the other side of its ascending trendline - and that spelled the end of the uptrend. After bobbling up and down for a while, it had carved out a head and shoulders pattern. And now it's broken below that, which in my view spells out even more massive losses for this stock.

So I'm sure the fundmental analysis when the stock was $100 told a great story. But the trend ended, and the chart would have told you that. Buying puts on this sucker would have netted you hundreds of percent in gains. Such is the power of technical analysis.

Good luck, everyone. Keep those comments coming!


Erik_W said...

Sure looks like the Nasdaq (QQQQ) is almost done with a head and shoulders top.

Also, looking at the Wilder DMI, ADX is starting to rise from a period of decline and channeling.

Things are looking like it's time to short... Thoughts?


Erik_W said...

I do agree that fundamentals are built into the chart and price action reflects that.

A good argument for technical analysis, in my opinion, is DIA and QQQQ. As most of you know, these are a group of stocks that track an index.

I suppose one could perform a fundamental analysis on every stock in these ETF's. I have never met anyone that does this.

I personally do not rely heavily on fundamentals, but I do check Zacks ratings,news, and sometimes certain ratios. I also track when earnings are to be released, because as one poster suggested this is a big influence.

The main thing I remember is that I am not the one who moves the market. I want to do what "big money" is doing. No matter what they do, they are right, period. They make and break trends.

I am not biased on how I make money. If I feel the market/stock is bullish, I am long. If it is bearish, I am short.

Best of trading to all,


thenoz said...

Please don't try to convince the fundamentalists about the power of technical analysis. We need two sides for a trade.

Suffice it to say that "technical analysis shows you when the fundamentalists put their money where their mouths are". I am

Jean-François said...

I think it's only counterproductive to religiously believe in one single method. Worst, being biased is a sure way to loose money.

I mean TA will give you signals you can act upon. FA will confirm a trend. The difference between the two is that FA always reveals past information whereas prices are damned real.

Of course being short on a weak stock of a weak industry in a bear is best. and vice versa.

But if you're willing to take more risk you can be long in a bear. That's where FA is useful. A strong balance sheet, a competitive advantage, a strong management vision and growing earnings in an economically interesting industry tells me I have a growing co. I just make sure of the strength of my buy signal and lower my expectations.

In a continuing trend, FA will comfort me with a decision to buy in an oversold situation or sell short in an overbought situation. Provided it's not a turnaround pattern, it's a good trading entry because fundamentals converge.

The turnaround pattern is the more difficult situation. You typically have a strong signal with contradictory fundamental information - just like for hans. Provided you opened up your position and wasn't stopped, you may expect a fundamental confirmation down the road. Being early increases profit !

Will hans show a deteriorating situation next quarter ? If it does, stay short !

Ain’t trading fun?

Jean-François, Montréal

PB said...

Arguing about Fundamental vs. Technical is quite silly. It's kinda like arguing about what drives an engine, is it air or fuel? You need both! They keep each other in check. So stick with whatever works for you and stop belittling the other guy all you ego-maniac suber-bulls!!

Super Bull said...

"To my way of thinking, everything that can be known about a security is already built into a chart. Why on earth would anyone think they have some kind of special insight based on fundamentals? Don't you think all the million-buck-a-year analysts running around do a good job with this kind of thing? Do you think they actually missed something somehow? The chart has everything you need. Don't bother with fundamentals."

I strongly disagree with the above statements. American workers are very dynamic and innovative. For example, supposed a drug company is currently doing poorly and the stock chart reflects that, but what if the workers came up with a drug that can cure a major disease, then the stock price will surge higher. There is no way that reading a chart can predict that. I guess we just have to agree to disagree.

Tim Knight said...

I don't disagree American workers are very dynamic and innovative (hey, I'd like to think I'm one of 'em!) But you are asserting that fundamental traders would have some kind of insight - in your example - of a breakthrough drug (what stock screening tool would you use to find that?) and someone those who actually BUY the stock (that is, those who drive the prices.....which makes the chart.......which we technicians analyze) would somehow be in the dark.

This is totally illogical, truly.

Again - - all that can be known is reflected in the chart. No matter what kind of trader you are, your "input" (if you participate in the stock) is already there. So if some company came out with a cure for AIDS, obviously their stock would surge........but fundamental analysts would have NO advantage in terms of getting onto the trade early. A surprise is just that - a surprise - and it would take everyone by storm.

I would go on to say that the chart would probably give you tips to even a "surprise", however, which no fundamental data can support.

Super Bull said...

"What's interesting, though, is that the stock (HANS) actually ended up down for the day, as shown in the graph below. Indeed, this is a big, fat bearish engulfing pattern on gigantic volume."

Trader Tim, take this as an example of the futility of the technical analysis. All these bearish engulfing patterns won't predict that the stock is up $7.8 today at a closing all time high. But fundamentally, all you need to do is to look at the earning report which states that they made the most money ever in their history last quarter. So it is up up and up away for HANS. I am sure short term if you time it right, your puts can make hundreds of percent in gains. But it is extremely difficult and risky to time the puts correctly. If you don't do it correctly and a majority of the option holders don't do it well, you can lose ALL your money in a short time. On the hand, if you just buy and hold a fundamentally strong stock like HANS at the beginning of 04, you would have made over 23 times your money. Just imagine that! You don't need to do any tricky timing maneuver and just buy and hold and you will make a fortune in a little over two years!

Tim Knight said...

Well, I will concede that point - - that you can make unlimited gains on the bull side, whereas with a short position, the most you can possible make is 100% (Obviously I'm ignoring options here). So, yes, the big money is made on the long side, I agree.

TechTrader said...

I think these discussions are great. I am a relatively new option trader. I do believe that the temperament of the mob is revealed in the daily, weekly, and monthly price action, which ultimately rolls up into technical patterns.

Geoff Gannon said...

I'm enoying the debate. Some time ago, I wrote a post on my blog about technical analysis in response to a comment from a blogger who favors using both technical analysis and fundamental analysis:

On Technical Analysis

Here's the gist of it:

"Let me first say that I do not now engage in technical analysis; nor, have I ever engaged in technical analysis. I do not believe doing so would be a productive use of my time."

"Having said that, I do not claim technical analysis has no predictive value. In fact, I suspect it does have some predictive value. The Efficient Market Hypothesis is flawed..."