February 11th, 2007

Fundamental vs. Technical Stock Analysis – I

It’s been quite some time since I last wrote so, you’ll have to bear with me while I get the rhythm and style back. Mike Santoli’s column this week’s in Barron’s, along with all the other commentary you hear, see and read, was the direct impetus to get me writing again. In short, he considers the market “strong, but stretched” offering the following facts in support of a forthcoming correction:

  • stocks have gone up for 8 straight months
  • the market hasn’t had a 2% down day in 144 trading days
  • corporate earnings have risen by double-digits for 17 consecutive quarters.

He quotes this additional supporting fact: “more than have of all S&P500 stocks are within 5% of their 52-week highs, near the kind of overbought condition that has preceded corrections in recent years.” He concludes that “any crack shouldn’t be terribly nasty-pending the arrival of some devil we don’t yet know.” All this talk of an impending correction led me to revisit the relative merits of fundamental and technical (specifically, stock charts) analysis.

All this talk of an impending correction led me to revisit and the relative merits of fundamental and technical (specifically, stock charts) analysis. Now, I should tell you, I received an MBA in Finance from a prestigious Midwestern university where I studied complicated theoretical valuation fomulas and models (just look at this Wikipedia page on the term “stock valuation formula“. And yet, for most of my life, I have been defending stock charting against a barrage of ridicule and disparagement from friends and family.

Regardless of whether one uses fundamental or technical analysis, all investors search for situations where the current stock price is below what is considered a “fair current or future value”, according to their analysis. What that “fair value” is, however, represents the true challenge and the core difference between the two approaches.

Investors who employ fundamental analysis need to be clairvoyant about future earnings, future growth rates, future interest rates for risk-free government bonds (the discount rate) and the distant future value of the stock. You plug those assumptions into the model and then compare the resulting value against the stock’s current price to decide whether to buy (if the value is less than or equal to the current price) or sell (if the value is higher than the current price).

It’s a long process involving many assumptions about the company’s future prospects, the prospects for its industry and the state of the economy and the country’s position in international trade and financial markets. Most don’t have the necessary experience to formulate these assumptions with a great degree of certainty or authority. And, even if they could, this sort of analysis couldn’t be performed on very many stocks.

That’s why true fundamental analysis is best performed for very long-term, buy-and-hold investments. I’m not a climatologist but I can predict with some confidence that it will be in the 80’s sometime this coming July or August but I can’t tell you with any certainty what the temperature will be tomorrow …. unless I refer to a professional weatherman. And that’s why so many fundamental investors actually defer their judgements to the opinions of investment houses and experts in various media.

But there’s a rub here. These experts often don’t know any more than the average investor (although they have more time and are paid for doing so). And if it were that adept, why would two sophisticated investment houses upgrade and downgrade their ratings on the same stock within weeks of eachother or change direction in their ratings in a matter of months?

Don’t believe me? Just look at the ratings for IBM over the past 36 months!

Research Firm

Date

To

AG Edwards

18-Jun-04

Buy

10-Jan-07

Hold

Banc of America Sec

29-Apr-05

Buy

Bear Stearns

28-Jan-05

Outperform

Bernstein

13-Jul-05

Outperform

Caris & Company

24-Feb-04

Buy

15-Apr-05

Above Average

13-Jun-05

Buy

CIBC Wrld Mkts

29-Jul-04

Sector Outperform

Citigroup

10-Oct-05

Buy

Cowen & Co

6-Nov-06

Neutral

CSFB

29-Jul-04

Outperform

15-Apr-05

Neutral

11-Oct-05

Outperform

Deutsche Securities

8-Feb-05

Buy

First Albany

29-Jan-04

Buy

15-Apr-05

Neutral

19-Jul-05

Buy

Goldman Sachs

20-Jul-06

Neutral

18-Oct-06

Buy

JP Morgan

5-Oct-04

Overweight

9-Jan-06

Neutral

Moors & Cabot

21-Dec-05

Buy

Morgan Stanley

13-Jul-04

Overweight

Prudential

18-Dec-06

Neutral

UBS

9-Dec-05

Neutral

8-Jan-07

Buy

to be continued …..

Subscribe below or click here to learn more about help for navigating turbulent markets.