Fundamental and Technical Analysis of Financial Markets
There are two general approaches to analyze and understand financial markets: Fundamental and technical analysis. Prices on financial market are moving up and down, day by day. It is very hard to predict the next movement.
After reading this article you should understand the core concepts of fundamental and technical analysis and appreciate their mutual relationship.
Fundamental Analysis
Let us start with fundamental analysis of a financial market. It is quite simple: a fundamental analyst observes the development of supply and demand in the market he follows and the factors that determine both. If you take as an example the oil market, a fundamental analyst would consider events like:
- New oil field explorations
- Problems like the current deepwater horizon oil spill.
- Movements of oil and gasoline stock levels.
- Usage level of refinery capacity
- Development of alternative energies
- Overall economic activity
The fundamental analyst combines all these factors into a single picture, and will end up with an opinion whether supply and demand are in an equilibrium, and remain in an equilibrium, or whether there will be an excess supply the foreseeable future or excess demand.
As a last step he evaluates the current market price level, asking whether in this example oil is priced fairly.
Technical Analysis
The fundamental approach sounds fair enough. But I have seen more than one big company going belly up just a few weeks before the market did, what they had forecast. But by then it was already too late. This is where the other mode of analysis comes into play: technical or chart analysis. Technical analysts use information about recent market behavior, like price movements, tends, trading volumes, volatility etc. to get an idea what the market might do next. The idea is that it is almost always possible to see the picture generated by fundamental analysis as a glass half full or a glass half empty. A technical analyst tries to figure out, how the market participants in sum react on the fundamental market information. They might ignore bad news for a long time, and then suddenly panic. Or they might become excited about good news, only to discard it a few days later. Policy makers and spin doctors may want to influence the market perception of the fundamentals. Technical analysts do not try to forecast the actions of spin doctors, but the charts may very well give a hint, whether a PR stunt may have a real impact at a given point of time. The main thing to understand: Technical analysts use mathematics and statistics. But in truth they try to measure and forecast market perception of fact on the ground. Fundamental analysts on the other hand try to establish and understand the facts of supply and demand itself.
Use Fundamental and Technical Analysis as a Pair
Considering it all, fundamental and technical analysis relate to each other like a brother and a sister. They are quite different, and the fundamental analyst does not understand or even respect the technical analysts all the time – and vice versa. But to really understand a market and to make money with trading, you need both: a firm grasp of supply and demand conditions, and a thorough understanding of the current market perception of these facts, as evidenced by market behavior and measured by technical analysts.
Financial Assets and Risks
Financial assets and risks are closely related. Every asset carries a value and a risk. The value of an asset is the price the owner can get by selling it. In liquid markets, e.g. for shares of big corporations, government bonds or commodities, where many standardized units are traded, the price of an asset is clearly defined at any time.
For other asset classes, like real estate or shares of small companies the only way to determine the real value of an asset is to sell. In such cases models and recent prices of similar assets are used to determine the asset value. The resulting valuations are more or less educated guesses.
For this discussion of the relationship between financial assets and risks I want to stick with liquid assets with a known market price.
The Risk
After defining the value of an asset, the next question is: What is the meaning of the term “risk” in the context of financial assets? Modern trading platforms allow us to know the current price of any liquid asset with precision. But do we know tomorrow’s price of the same asset? We do not know. The price can change, most probably will change. But we do not know in which direction. This insecurity about the future price of an asset is called the asset’s financial risk. Risk is a complicated concept having at least three dimensions:
- The magnitude of the price change
- The probability that this change will actually happen
- The timing
Risks have also a value and price. But the price of a risk can be negative. In our day-to-day thinking, we associate the term “risk” with an undesired possibility. If we would profit from the same possible event, we would use the term “hope” instead of “risk.” This distinction between “hope” and “risk” relates solely to our position relating to the possible event. It is possible and in the financial world standard, that one party’s “risk” is for the counterpart “hope”. A high price for wheat may be the farmer’s hope, but the baker’s risk.
For this discussion, we use the term risk for the probability and magnitude of a possible change regardless of the question whether we desire or fear that specific outcome. We do not differentiate between “hope” and “risk”.
Trading Risk
As the same event can be good for one person and at the same time very bad for another person, it makes sense to trade risks. Both could share the pain and the gain and improve their ability to plan their businesses.
Financial institutions developed tools to separate financial assets and risks form one another. One very simple example would be a contract between the farmer and the bakery spelling out that the bakery will buy a certain quantity of wheat in autumn from the farmer for a specified price. This price could be a little higher than the current price, thus giving the farmer an extra profit. But it would protect the bakery from the danger of a huge price rise making the bread too expensive for the bakery`s customers. This generic future contract would be a good deal for both sides.
Futures and Options
The contracts used to separate financial assets and risks are called derivate contracts. The example between the farmer and the bakery is a future contract, in which they agree to a sale of a certain quantity of a certain asset for a predetermined price at a specified time in the future. This future contract is binding for both sides, the farmer must sell and the bakery must buy.
Another generic form of a derivate contract is an option. The option comes in two forms:
The Call
The farmer could sell a call to the bakery. In this case the bakery would pay the farmer for the right to buy a certain quantity of wheat in autumn for a specified price, the “strike price”.
This contract is legally binding for the seller of the option, the farmer. The buyer of the option, the bakery, exercises its right if he chooses. Otherwise the contract will expire.
The Put
The bakery could sell a put option to the farmer. In this case the farmer would pay the bakery for the right to sell a certain quantity of wheat in autumn for a specified price, the “strike price”.
This contract is legally binding for the seller of the option, the bakery. The buyer of the option, the farmer, exercises its right if he chooses. Otherwise the contract will expire. Please note, that in this case the buyer of the option is the seller of the underlying asset.
Hedges
If you combine two risks, the sum of the two original risks may be bigger than the combined risk. Think about an area with frequent hurricanes: It could make sense to bet on a profit of insurance companies and to bet at the same time on a profit of building companies. In a strong hurricane season, the insurance would suffer and the builder would profit. In a weak hurricane season, the insurance company would profit and the builder would lose. If you buy insurance company shares and shares of the home builder, you can smooth out the difference between years with strong hurricanes and years with weak hurricanes. If you use options or futures on the shares of both companies, you may even be able to profit financially from the hurricane threat.
Warning
Be careful. Derivate contracts are very powerful tools with a high leverage. Because they allow you to treat financial assets and risks separately, you can also accumulate dangerous risks, if you mishandle them. The result can be very and painful and dangerous. Never enter a contract, if you do not understand all implications completely.
What ETF Investors Can Learn from the May 6 Flash Crash
If you had any doubt that today’s markets aren’t what they used to be, it should be gone after last Thursday.
U.S. stocks were already having a bad day thanks to riots in Greece, elections in the U.K., freezing credit markets in Europe and a growing oil spill in the Gulf of Mexico. Within a matter of minutes that afternoon, even some blue-chip stocks went from bad to worse to catastrophic. Then, just as quickly, they came back!
What in the world happened? And what does it mean for you as an exchange traded fund (ETF) investor? Today I’ll try to give you some answers …
ETFs Caught in the Storm
Last week the markets hit rough weather. One of the attractions of ETFs is that they are excange-traded, which means they can be bought and sold all day long, just like stocks. Last Thursday, however, that feature proved itself to be a risk factor as well.
When circuit breakers brought NYSE trading in some key stocks to a halt, their prices plunged on various electronic systems. And ETFs that held those stocks dropped as well.
The “market makers” who are supposed to provide liquidity — didn’t. And the fear quickly spread to all corners of the equity markets. Stocks and ETFs traded — and some orders were filled — at discounts of 50 percent or even 90 percent to where they had been just minutes earlier!
For instance, the iShares Russell 1000 Growth (IWF) is a popular ETF that typically trades more than three million shares a day …
Last Thursday at 2:40 pm Eastern time, it was trading at $49.70, which at the moment like most of the market was down about 3 percent. Over the next five minutes it fell to $48.29, another 3 percent drop. A minute later, at 2:46, it was at $44.23.
Then the bottom dropped out …
At 2:47 IWF traded at $19.98. Prices continued to plunge during the next 30 seconds. Many trades went through at 15 cents and one at a penny!
When the minute was up, IWF was again trading at $47.43. A minute later it was back to 10 cents. Stability returned as it climbed from $17.69 to $36.88 to $49.65. By 3:00 IWF was back above $49, completing its round trip in about 16 minutes.
(Note: Trades below $19.88 were cancelled for IWF. But thousands of shares traded at a 40 percent to 60 percent discount to prices prevailing just minutes earlier.)
Politicians wasted no time jumping on the bully pulpit.
If your reaction is “this makes no sense,” join the club. Indeed it doesn’t make sense — but it happened. One thing we can always rely on, however, is a swift and senseless reaction from Washington …
Even before the dust settled, people on Capitol Hill were shoving each other out of the way to get their share of the headlines. Regulators sniffed and threatened investigations.
I’m totally in favor of appropriate market safeguards. But I’m against overreaction that makes the problem even worse — and I fear that’s what we are going to get.
News Flash: Markets Go Both Ways
Here is a hard truth the politicians and regulators don’t want to admit: Markets are volatile. They go up, they go down. Everyone has an even chance to profit if the playing field is level.
Look at what just happened last week …
Somebody bought all those stocks and ETFs that traded at such ridiculously low prices. They were smart to do so. They deserve to profit — but they aren’t going to. Why? Because the exchanges decided to cancel many of the “outlier” trades.
Call it whatever you want, but this does not make for a free market. Instead it’s a market in which people who make bad decisions try to pass the buck to someone else.
In today’s fast moving markets, meltdowns can occur. The best policy is usually to let prices find equilibrium on their own. This is the only way to discover the bottom. A stock (or a house or any other asset) is worth as much as someone is willing to pay for it — no more, no less. Discovering this level is why we have markets.
The knee-jerk reaction, though, when prices are falling is to stop trading. But attempts to interfere almost always backfire.
In last Thursday’s meltdown, the NYSE tried to call a brief time-out because stocks were falling. The computers refused to cooperate.
The government is probably going to respond by muzzling the computers. If they do it, it’ll be a big mistake — and we’ll all pay for it in the next crisis.
Think about it for a minute. Computers can be reprogrammed, and they will be reprogrammed to do whatever their owners think will maximize profit and minimize risk.
So the next time prices fall, for whatever reason, the computerized buyers-of-last-resort may not be there. They’ll stand aside and wait for better opportunities. And that could take a long time.
What does it mean for you? I still see many opportunities in ETF trading, so there’s no need to head for the hills. You do need to pay attention though, and learn two lessons from May 6:
Lesson 1 —
Try to always use a limit order and avoid market orders.
Lesson 2 —
Think long and hard before placing stop-loss orders on ETFs. And if you do, be sure to update them as your holdings rise in price. Otherwise you might end up selling for a whole lot less than you planned.
One way to avoid this is by using a “mental” stop-loss instead of an actual stop-loss order. With a “mental” stop-loss, your computer or broker can alert you if the price is breached and then you can place a limit order.
As always, stay informed and know what you’re doing before you buy.
Best wishes,
Ron
This letter was orgignially published by Ron Rowland in the Money and Markets Newsletter.
About Money and Markets
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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Dinesh Kalera, Roberto McGrath, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Marty Sleva, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.
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Benefits of Financial Services
Casinos and government sponsored lotteries are merely peddling hope. But financial services provide real benefits. Today I want to talk about those benefits, apart from the most obvious one, namely to facilitate payments between all members of a society.
Resource Allocation
The financial service industry allows you to move resources along a time line. Banks do this by selling investment products and by providing funds for those, who can use them productively. In one sentence: They facilitate a viable allocation of economic resources.
Human life would not be possible without moving resources through time. Every child needs to grow and learn before creating value and earning income. Thus the generic provider of financial services is the family. Parents care for their children and hope to get in return care when they are old.
Accomodation of Cycles
Financial Service companies help us to allocate resources as needed along economic cycles. One example is a life insurance company. You pay a small amount every month for a very long time. You receive in exchange monthly payments after retiring. We use financial services to smooth other types of economic cycles as well. Examples are:
- yearly seasons
- product life cycles
- economic cycles of boom and bust
Every economic cycle contains a time period to invest and another period to profit. Financial services take care of resources which you want to keep for later use and allow yuo to focus your resources where they promise best results.
How is this done? People are born and die, new projects are started and concluded every single day. Some produce currently more resources than they consume. This happens most often in the middle of a life cycle. Others need a current net input of resources. The results can be smoothed by connecting people and projects in different phases.
Speculation
Seasonal cycles and boom/bust cycles of the economy need another type of financial services, the accumulation of tangible goods. For example surplus farm products are stored in summer and autumn. We eat them in winter and spring. Almost no fresh food grows in Europe in January, but hungry mouths are still around.
The Bible describes an archetypical economic boom and bust cycle: The seven fat and the seven meager years, managed by Joseph who stored food in warehouses. The ugly word for his behaviour is “speculation.” But people do not hate the food provided by a speculator. In truth they hate their own myopia, which can be cured at times using financial services provided by speculators, although for a hefty price.
