The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew

Figure 1.4 Price Forecasting Based on Intrinsic Value of a Stock.

      There are various ways to determine the degree of over- or undervaluation in a stock, some of which include comparing P/E and earnings per share (EPS) ratios or investigating to what extent a stock is trading at a premium or discount in relation to its net current asset value, debt, and other fundamentals. Fundamental analysis helps provide indications as to which stocks to buy based on prior company performance, that is, over the last accounting period. Some investors resort to more active asset-allocation methods to try to time the market for a suitable stock to buy into or get out of, rather than just relying on the traditional buy-and-hold strategy. They resort to studying broad market factors and sector-rotation models in order to buy into the best fundamentally performing stocks within a strengthening industry or sector. This method is popularly termed the top-down approach to investing. A bottom-up approach relies more on a specific company’s fundamental performance. A buy-and-hold strategy in today’s volatile markets may not represent the most effective way of maximizing returns while minimizing potential risks. As a result, many fundamentalists frequently look to various asset pricing and modern portfolio models like the Capital Asset Pricing Model (CAPM) to try to achieve the best balance between risk and expected returns over a risk-free rate (along what is called the efficient frontier).

      One of the problems with fundamental analysis is the credibility, reliability, and accuracy of the accounting practices and financial reporting, which is susceptible to manipulation and false or fraudulent reporting. There are various unscrupulous ways to dress up a poorly performing company or financial institution. A simple Internet search will reveal numerous past and ongoing investigations related to such practices. The other problem is the delay in the financial reporting of a company’s current financial state in the market. By the time the next audited report is completed and published, the information is already outdated. It does not furnish timely information to act upon, especially in volatile market environments, and, as a result, does not directly account or adjust for current or sudden developments in the market environment. Nevertheless, fundamental analysis does give valuable information about specific securities and their performances. Its main weakness is its inability to provide clear and specific short-term price levels for traders to act on. Therefore, fundamental information is better suited to longer-term investment decisions, as opposed to short-term market participation, where short-term price fluctuations and precise market timing may be of lesser importance.

Fundamental data, on a broader scale, accounts for the overall underlying economic performance of the markets. Supply and demand reacts to the economic data released at regular intervals, which include interest rate announcements and central bank monetary policy and intervention. One example of how supply and demand in the markets are affected by such factors is the Swiss National Bank’s (SNB) decision to maintain a 1.2000 ceiling on the foreign exchanges rate of the EURCHF, with respect to the Swiss Franc. This creates a technical demand for the Euro (and a corresponding supply in the CHF) around the 1.2000 exchange-rate level. Many traders have acted and are still acting on this policy decision to their advantage, buying every time the rate approaches 1.2000, with stops placed at a reasonable distance below this threshold. The integrity of this artificial ceiling remains intact as long as the SNB stands steadfast by their policy decision to uphold the ceiling at all costs. See Figure 1.5.

Figure 1.5 SNB Policy Impacting on the Value of the CHF.

      Source: MetaTrader 4

      It behooves the analyst and investor to examine the actual decision-making process involved with investing in a stock based on intrinsic value. While it does provide an indication, with all else being equal, of the integrity of a certain stock relative to the universe of stocks available, there is a disruptive behavioral component that affects this process. It is not just the calculated or estimated intrinsic value that is an important element but also the general perception or future expectation of this value that plays an arguably greater and more significant role in determining the actual share price of a stock. This may explain why shares prices do not always reflect the actual value of a stock. This disagreement between price and value is the result of divergence between the actual intrinsic value and perceived or projected value.

       Forecasting Stock Prices Using Information

      Generally, information may be gleaned from various public sources such as newspaper reports, magazines, online bulletins, and so on, upon which market participants may then formulate an opinion about the market, making their own predictions about potential market action. Unfortunately, such publicly available information usually has little merit when used for forecasting purposes, as those more privy to non-public material information would have already moved the markets substantially, leaving only an inconsequential amount of action for latecomers to profit from, at the very most. This is where technical analysts have the unfair advantage of observing the markets moving on the charts and immediately taking action, regardless of the cause or reasons why such action exists. They are only interested in the effects such activity has on price. Technical analysts typically do not wait for news to be public knowledge prior to taking action or making a forecast based on a significant price breakout.

      The use of non-public material information potentially affords insiders substantial financial gain from such knowledge, as the release of critical or highly sensitive company information may cause a substantial change in the company’s stock price. Hence it is no great feat to be able to forecast potential market direction based on such prior knowledge, especially if the non-public material information is highly significant or headline worthy. Needless to say, insider trading is illegal in the equity markets. But the possibility will always exist that it can occur and in fact has on many occasions. Unfortunately, in unregulated over-the-counter (OTC) markets, nothing stops brokers from front running large client orders, which is just another form of insider trading.

       Forecasting Stock Prices Using Technical Analysis

      Technical analysis is essentially the identification and forecasting of potential market behavior based largely on the action and dynamics of the market itself. The action and dynamics of the market is best captured via price, volume, and open interest action. The charts provide a visual description of what has transpired in the markets and technical analysts use this past information to infer potential future price action, based on the assumption that price patterns tend to repeat or behave in a reasonably reliable and predictable manner. Let us turn our attention to some popular definitions of technical analysis.

      The following definition of technical analysis tells us that charting is the main tool used to forecast potential future price action.

      Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.

John Murphy, Technical Analysis of the Financial Markets (NYIF, 1999)

      The next definition of technical analysis tells us that the charting of past information is used to forecast future price action.

      Technical analysis is the science of recording, usually in graphic form, the actual history of trading.. then deducing from that pictured history the probable future trend.

Edwards and Magee, Technical Analysis of Stock Trends (AMACOM, 2007)

      Notice that the last two definitions specifically refer to the forecasting of trend action.

      It is interesting at this point to draw a parallel here with information used in fundamental analysis. Technical analysis is often criticized for the use of past information as a basis for forecasting future price action, relying on the notion that certain price behaviors tend to repeat. Unfortunately virtually all forms of forecasting are based on the use of prior or past information, which certainly includes statistical-, fundamental-, and behavior-based forecasting. Companies employ accounting data from the most recent and even past quarters as a basis for gauging the current value of a stock. In statistics, regression-line analysis requires the sampling of past data in order to predict probable future values. Even in behavioral finance, the quantitative