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Getting Technical

Frank Minssieux

When it comes to stock market investing, there are two main schools of thought on how you decide which apples you want to buy and sell. They are known -- in not very colorful terms -- as fundamental analysis and technical analysis.

Fundamental analysts study everything from the financial performance and management reputation of individual companies to the overall economy and industry conditions.

Analyzing company fundamentals has been the bread and butter for generations of stock-pickers. They use this approach to select companies that represent the best value and probability of increasing shareholder equity.

Day and night, they shuffle through reams of company data, such as earnings per share, price/earnings ratios, debt-to-capitalization ratios and business models, comparing them with those of peers, competitors and industry averages to identify the elusive undervalued jewel.

Analysts, market strategists and economists apply this same kind of study to an industry or economic level to forecast future trends.

At the economic level, broad measures such as employment figures, inventories, the money supply, interest rates, currency fluctuations and many other indicators are analyzed for their potential impact on stock markets. At the industry level, they dissect industry conditions, competitive factors and product supply and demand.

Is your head spinning yet?

There are several reasons why I am not a proponent of fundamental analysis. First of all, it is just too much information to process if investing is not your full-time job. It requires an enormous amount of research, time, effort and energy. And just when you think you know everything there is to know, you find out there is more to learn.

What's more, the data used in fundamental analysis -- such as earnings announcements and economic reports -- are often old news by the time they're made public. In fact, the primary weakness of fundamental analysis is the lack of clear timing indicators.

Secondly, it's well known that about 80% of stocks move with the broad markets -- regardless of whether they are great values or not. So having a strong grasp of a company's fundamentals does not necessarily translate into great investment results.

In the Know

But perhaps the biggest drawback of all with fundamental analysis is that the markets are influenced by many unknown -- and unknowable -- factors, including world news, natural and man-made disasters and investor psychology. As the saying goes, "What you don't know can hurt you."

Technical analysis, on the other hand, involves a completely different paradigm.

Technicians -- also known as technical analysts -- hold that there's safety in numbers. As such, they primarily focus on two questions: What is the current price, and what is the history of the price?

Over the past several years, technical analysis has become an increasingly popular method of evaluating securities and markets, fueled perhaps by the bursting of the dot-com bubble.

Many fundamentalists predicted a safe future in technology, and people bought in. The problem was that they never had a plan for getting out. And when the bottom collapsed, people watched six figures drop to four and four to three. Fundamentalists were left trying to figure out what happened.

In the Numbers

In my opinion, it doesn't matter what happened. The only thing that mattered is that it did happen, and that you could see it in the numbers. This is the unemotional heart of technical analysis.

Instead of attempting to measure a market or a security's intrinsic value, technical analysis strictly looks at past and present market data, such as price and volume movement, and attempts to identify trends and patterns. The primary tools of the trade are various types of charts, trend lines, moving averages, relative strength indices and support/resistance zones.

While some technicians favor complex statistical analysis tools and the recognition of patterns such as head-and-shoulder, cup-and-handle or double-bottom formations, my philosophy is to keep it simple.

As a trend-follower, I'm a strong believer in listening to what the market is telling me, recognizing the predominant trend and following it. This is not rocket science (unlike fundamental analysis). No, this is surprisingly simple.

Let me explain: While trend-following does look at various indicators, such as moving averages and volume activity, it leans most heavily on price performance.

The most basic tool in technical analysis is the trend line. By constructing a price trend line over a specified time frame, you can see beyond the short-term ups and downs and spot the trend in the chart.

Technical analysis also provides the ability to look at charts across the broad market -- rather than just examining one company or a single industry. This makes it a perfect fit for the growing trend of investing in index funds and exchange-traded funds. Because these investment vehicles cover a broad range of companies and industries, fundamental analysis becomes virtually impossible.

But the real beauty of technical analysis is that you don't have to be an expert at it. You don't have to completely understand the tools to use them. If you can apply points to a graph and draw a line between them, you can do it. Or you can choose from a variety of professional technical-analysis products widely available online.

A word of warning: If you do decide to use a service, be sure to find one that has both a back-tested model and a live track record. Hulbert Financial Digest and TimerTrac are good resources, as they both offer independent evaluations of various systems.

Ultimately, the goal of technical analysis is to eliminate all human interpretation and second-guessing. You can simply close your eyes, believe in the system and follow it -- even though intuitively it may look like the wrong time to buy or sell.

As playwright Oscar Wilde wrote, "The advantage of the emotions is that they lead us astray." So while emotions may be good for actors, they are no good for investors.

At the end of the day, it comes down to this simple distinction: Fundamentalists focus on why the price is what it is, while technicians focus on what the price is. Which homework assignment would you rather have?