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1.1. Why technical analysis :
the lack of fundamental analysis
Technical analysis has a quite different
approach to the estimation of buying and selling levels
compared with fundamental analysis.
Indeed, fundamental analysis, as
used by bank analysts (leading to recommendations), mainly
relies on financial ratios linked with the company’s
fundamentals.
Thus, ratios such as stock price on
expected earnings, market cap on turnover, debt level, will be
studied…. As norms are determined, they enable to
determine the risk level associated with an acquisition or a
sale of a share. For example, a quite common norm consists in
looking mainly for stocks whose stock price / expected
earnings per share ratio stands below twenty, which is
considered as a major threshold. Similarly, a major level for
the market cap / turnover ratio stands around two.
Still, this method may lack some
elements. Let us take the case of IT stocks at the beginning
of the year. Many of these stocks reached a stock price /
earnings ratio above 100 and a cap / turnover ratio above 10.
From a fundamental point of view, how can we behave? Either we
establish new ratios, specific to the “New Economy”, which can
take some time, either we stay with the former ratios, which
leads to avoiding some good opportunities.
Moreover, it often appears that the stock
price evolution does not necessarily reflect actual
fundamentals of the companies, as over-reaction effects (both
on the downside and on the upside) are quite common,
especially relatively to announcements.
1.2. Technical analysis in order to
take a greater account of psychology
For its part, technical analysis comes
from a simple financial theory: at a T period of time, a
stock price precisely reflects all information available on
this stock, all its history. This is due to the fact that
time is considered as continuous, as any variation of the
price determines a new level, which constitutes a new basis
for further variations. It is thus possible to use prices
evolution, on different levels, to try to determine further
likely evolutions.
Still, this identification of variations
directions and extents is not self-understanding. Indeed, it
becomes quickly obvious that psychological effects
(such as threshold effects or the behavior of individuals
compared to that of institutional investors) can actually be
just as important as pure technical reflections. Thus,
opposite opinions can happen on the basis of still similar
information. This is even on this very principle that stock
prices are determined, as they reproduce a market consensus
between buyers and sellers. Thus, technical analysis does not aim, by
itself, at determining precise reasons for stocks
variations but rather at measuring their evolution and,
if possible, at determining their future likely
behavior.
This approach thus enables to take a
greater account of the psychology of operators.
Indeed, up and down markets moves are
almost always following trends, in short or longer
terms. These trends are based on the investors’ approach to
the stocks, either pessimistic (bear) or optimistic
(bull). The optimism situation is characterized
by stock prices always higher even though the
fundamentals do not at all justify this rise. Ratios
are thus increasing, which can lead analysts to sell the
stocks.
Still, this is often on such up trends
that individuals slowly convince themselves that it may be
wise to buy, just as the rise potential is significantly
diminished. This observation is an example of the 'sheep like'
effect of the markets, and thus the interest of belonging to
the first beneficiaries of movements.
1.3. Dow’s
analysis and the investors psychology towards
announcements
Keynes himself asserted in its main book,
the Theory of employment, interest and money (1936)
that “most investors and professional speculators care less
about making precise previsions in the long term than
forecasting just before the public the upcoming changes on the
conventional evaluation scale”. This approach follows initial
Dow’s analysis, the creator of the eponymous index and of the
Wall Street Journal. Dow’s theory is a core aspect of
technical analysis and is worth developing.
Indeed, Dow understood among the firsts
the importance of “timing” and reactivity. Its model
lies on the idea that, when stocks are heading down, there
will always be more aggressive and better informed investors
ready to buy stocks in prevision of the recovery (“aggressive
buyers”, step "a" in the graph), while individuals are
getting rid of their shares. Following this period is the
improvement of the company’s results, having investors become
more attracted by the stock (“accumulation”, step "b").
This amelioration phase is then likely to put very high buying
pressure on individuals, willing to take part in what they
consider an everlasting movement. This period is for the first
investors an occasion to sell (“distribution”, step
"c"), forecasting the upcoming reversing…
These different analyses come from
essential points, which need to be clearly defined. Though
every investor conceives the prices up or down concepts, it
still needs to be understood how this expresses itself
graphically and in prices.
For example, an upward trend is
characterized by ever-higher lows while a downward trend is
characterized by ever-lower highs.
This approach of trends can appear
trifling but it really is essential to integrate the
principles of the technical indicators
construction.
1.4. Contrary opinion
Right in the continuation of Dow’s
theory, Neil (1954) developed the “contrary opinion”
principle.
This system lies on the idea that,
whenever all investors have the same opinion at the same
moment, it is very unlikely that this opinion will materialize
in facts… This is due to the fact that, if everybody is
bullish, who is left to buy?
This approach can appear extremely
systematic and hazardous but it still stands in the logical
continuation of Dow.
Indeed, in the theory of this latter, the
second period corresponds to a phase of growing confidence in
the stock, associated with its acquisition by a growing number
of investors. Thus, at the beginning of the third phase, all
investors, which are bullish on the stock, have already bought
it, while the first “aggressive buyers” are selling. We can
then wonder, who will be the buyers enabling the stock to go
on with its rise! The market would even have a tendency to
fall as the first investors get rid of their
shares…
So as to estimate sensitive levels,
investors use mostly opinion polls related to professionals’
confidence: a very high confidence level is likely to indicate
an overbought situation, announcing a reversing on the
downside. A symmetric situation could of course be handled on
the downside.
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