The fundamentals of fundamental analysis...

For many analysts (not all), fundamental analysis is just limited to the financial numbers and the inferences derived from historical (financial) data.

However many Management Gurus think otherwise; and many have gone on record to the extent of saying that judging the future performance of an organization by looking at historical financial performance is like driving a car by looking at the rear view mirror. This statement has merit, even though all the conclusions from financial analysis should not be entirely written off.

Some comments on circumstances where the numbers cannot tell a story:

• Sudden change in management structure & philosophy.
• External economic conditions and major events.
  
• Technology disruptions.
• Unexpected competition.
• Change in government regulations.
• ...
  

The list may not be comprehensive, but is sufficient to illustrate that a subjective analysis of an organization is an equally good mechanism. The real difficulty lies in modeling such scenarios to determine the value of the stock...

Technical Analysis : sorting out the useful...

Investors and investment advisers tend to have strong opinions about this subject. There are virtual camps of believers in technical analysis and fundamental analysis and they have infinite arguments against the other side. My viewpoint is that there are useful pieces in both and neither should be written off entirely. I will ponder over the TA side in this post.

Technical analysis was my starting point in finance, when I was searching for a parallel computing problem. Without any background in economics and finance, I accepted things at the face value. However things started to change, when we started to observe the recommendations generated by these techniques. Over a period of time, I learned to differentiate between the useful and not so useful stuff.

Certain pieces / techniques lack any convincing logic. Many arguments have been given (by scholars) subsequently, but they still look unconvincing to me. I would like to enumerate a few...

• Elliott Waves and Fibonacci Relationships.
  
• Trend lines.
• Support and resistance.
  

I hope the life was so simple. It also contradicts commonsense. Any easily recognizable pattern will be exploited by the masses, immediately resulting into trend reversal.

However there are few which do give meaningful information, even though none of them will be useful in a market crash situation (the unexpected event):

• Bollinger Bands is a reasonably good indicator to visualize volatility.
  
• Upside / Downside Ratios and many similar indicators do indicate the market sentiment, fairly well.
  
• Stochastic Oscillator and Willams%R seem to work fairly well when the market makes a sideways movement and specially if it has periodic characteristics.
  

However, if you are planning to use any of these, my recommendation is to test your hypothesis over a reasonably large historical data which includes major rises and market crash situations...

Quotable Quotes...

I decided to take a break and look at Financial Markets in a lighter mood. Here are some interesting quotes...

• Stock market is fundamentally driven by fear and greed. An Analyst is one who tries to predict the extent of these.
  
• If all the predictors were as good, they should be making money by investing in stock market and not by advising others to invest.
  
• At a macro level, there are only two major entities in the market, the retail investor and the institutional investors and institutional investors are the ones making most of the money. It is obvious, who is loosing!
  
• Stock market is where you gamble and futures market is where you gamble on gamble.

Coming back to the ground, right information at the right time in a comprehensible manner will make a lot of difference in improving your odds in the market. But even with the right insights, fundamentally a financial market remains just that, a gamble...

What really determines prices ???

Here is a very fundamental (and interesting) question to ponder upon, starting with the following graph...


Consider the fluctuation of US$ and JPY in the year 1998, coinciding with the exposition of the burst of real estate market in Japan. The accompanying chart shows the extent of swing. What is can see here is an unprecedented 35% swing in the exchange rate in a duration of just 5 months. This leads to the following major observations :

• As the world’s two largest economies with an emphasis on stringent norms for disclosures, the range of swing (35 % in about 5 months) is of an unbelievable order.
• The exchange rate fluctuations cannot be on the basis of economic performance, since we have seen quick devaluation followed by a sharp recovery.
• This also points to the fact that the markets are not efficient.

Using this as an analogy for the stock market, is it reasonable to assume that :

• There are definite instances of inefficiencies in the market for every stock, irrespective of the size of the float.
• Large investors can still move the market.
• There is a large possibility of market manipulation, in cases of abnormal movement of stocks.
• The sentiment plays a major role in specifying the “perceived real value” in the market.

Gaining an insight into what happened here can possibly give us some insights into the markets...

Markets : From efficiency to inefficiency and back...

Market efficiency has been a hot topic since ages. So I decided to jump in with a perspective and I will publish another post with an example around this thought...

Market has a particular degree of efficiency at a particular point of time and it tends to fluctuate between efficient and inefficient levels. Inefficient levels are considered to be moneymaking zones where profits can be booked by exploiting the anomalies that led to inefficiency. As more and more operators discover and exploit the profit making, market tends to move into efficient zone leading to reduction of its profitability. As market becomes non-profitable, people stop exploiting it. This opens up scope for reappearance of anomalies in market, making it inefficient.













This psychology should reflect in cyclical patterns; though the periodicity and volatility may vary over a period of time. This may look like a random time series but we expect embedded patterns in this time series. Moreover, these patterns may be less prominent in efficient markets, as compared to the inefficient markets. During these cyclical patterns, we may observe the following :

• The newer anomalies will be discovered and exploited by various entities participating in the market.
• The older anomalies may vanish, if large number of operators start exploiting them.
• However, as some of the market participants stop exploiting the known anomalies, they are likely to reappear in the market.

Random walk may not be as random...

In an efficient market, the price of security at any point of time will reflect it’s intrinsic value. However, since the price cannot be precisely pinned down, the actual price movement will wander randomly around the intrinsic value. The prices will also adjust to new information about the stock. However there are couple of observations here, from the perspective of the theory of random walks.

• Given a large sample size, the market will over-react as frequently as it will under-react.
• The price changes before the news will be as frequent as the changes after the news.

So the theory of random walks states that, even the market reaction cannot be utilized for profit making, since it’s behaviour is also random.

Norman G. Fosback (Author of Stock Market Logic) puts a powerful argument in favour of predictability. As per his view, the random walk theory solely focuses on the short term movements of stocks. The long term trends definitely display recognizable patterns.

I think this is a strong argument and deserves a more thorough analysis. From my viewpoint; in long term, a strong company will show more resilience to (specially poor) economic conditions.

This may OR may not reflect in the price movement in stock market (I have not investigated this, so it would be premature to say anything with confidence).

The static nature of Technical Analysis...

In my view, the most fundamental flaw in technical analysis is the static nature of indicators, specially when they are critically dependent on the time period (or the number of samples).

For example a specific indicator may be based on the cyclic characteristics using past 10 samples. This is tuned to that duration; but the stock to which this is applied may have cyclic characteristics of around 5 days. Or the stock may be following a long term trend with no visible cyclic characteristics. In either of the two cases the indicator will become ineffective.

So, what is required is to have dynamic indicators, which can tune themselves, according to the stock characteristics. From a design perspective, the life starts to become difficult from this point onwards...

Information overload and need for simplification...

Today is an information age; but information can turn out to be an asset as well as a liability. Whereas precise information aids in quick and correct decision making; one overloaded with a mix of poor quality information may lead to just the opposite. The key issue is the limited human capability to store and process information at one point of time.

For an average investor, information overload is precisely the problem in stock market investing. There are scores of sources, which claim to give the ultimate recommendation for investment and their number is only growing.

What an individual really needs, is a single unbiased source of recommendations, which gives unbiased view and more correct pointers than the wrong ones, and with a substantial margin. One also needs a Google (simplified) perspective of the market; since the complex models of today are beyond the comprehension level of an average investor.

Why following the stock investment recommendations on television and print media is a bad idea ?

This is a simple truth, not recognized by 90% of investors. I will take the risk of oversimplification to explain this logic; but the logic remains valid in more complex scenarios as well...

Let's assume we have a (hypothetical!) great analyst who can predict with 100% accuracy and has a large following. The moment a prediction comes out, there would be large number of buyers and few sellers, immediately leading to overpricing.

The reverse is also true. A sell recommendation will lead to large number of sellers in the market immediately leading to price crash.

So in this situation an average investor will always buy high and sell low, leading to losses. The only solution is to be able to make the recommendation ahead of others which means not following the analyst.

So in this market, the only way to win is to play with few elite / informed players (I wouldn't call them investors), who can outguess the public opinion...

Today's Market's : Investment or Speculation

Most of us do not have the time to stop over and think on this issue. Everything goes under the head of investment; but there is a difference and let's explore the true character of today's markets...

While investing one puts his/her money to use, resulting into a tangible output in form of a product OR service which generates returns proportional to the value of service OR product.

Speculation is only about putting in money and using some technique (luck, gut feel, technicals) to make a prediction and take an exit at an appropriate time resulting into a profit OR loss.

Today's financial markets and players display the second characteristic which is a zero sum game. Largely somebody's gain is somebody else's loss...

The changing face of financial markets in the past century...

Many experts have already commented on this subject, so the topic does not deserve elaboration. However, since this is just the starting point of my blog, I think it is important to capture the gist.

In 1900's, people invested to build companies and had the patience to wait till the enterprises scaled up, generated and eventually shared wealth...

The financial markets (at least in India) have assumed a totally different characteristic today. I think more than 90% of trades do not result into deliveries, probably a pointer to heavy speculation. It is a time, when smart players try to quickly multiply their money without going through the grind...

Somebody made a very appropriate statement; stock trading is gambling and F&O is gambling on gambling.

It is a system where the least informed (typically the retail investor), is always the loser. Maybe it's time for introspection (for each one of us) on how slippery the ground is !!!

So this is where I would start our journey. To set the right expectation for our readers, I would just want to say that in this world of Complex Non Linear System (the financial market) each one of us can see only a piece of the puzzle. So I just want to share my own pieces with a hope that an unbiased view from someone disassociated with this industry may be interesting and useful to some of you...