Wednesday, May 13, 2009

Tug of War – The technical view vs. the fundamental view of the market

This article tries to bring out the essence of technical and fundamental views in trading through a hypothetical discussion between a fundamental analyst and a technical analyst.

Place: Fundamentalist (Fund) and Technicalist (Tech) in their office during a normal working day

Fund (Seriously doing stuff with his excel…may be a DCF valuation??)
Tech (Passing through Funds desk)

Tech – Arrey…So serious these days…What happened?

Fund – I’m trying to calculate the value of this firm which looks like a potential takeover target for us..Currently it is quoting in the market at Rs.50 per share and I’m trying to estimate the premium for the synergy!!

Tech – Don’t worry (Idhar dekho…he logs into some software and shows some charts) – As per this chart, your potential target looks like a good buy..There is a stiff resistance at Rs.55 and Dow pattern indicate there is reversal in the offing. Hence don’t pay a premium of more than 5 Rs for the S-factor (He is not able to pronounce ‘Synergy’ properly)

Fund (stares at him)—Pagal hogaya kya??… I have been collecting the inputs, discussing with the management, consulting experts , doing calculations for the last six months ,, but all of a sudden u show me some lines which are moving up and down (purposely avoids using the technical jargon price-volume relationship) and end up saying that this stock cannot be paid a premium of more than 5 Rs

Tech(stinged by Funds comments) – I agree that we work on charts and we try to understand the future from the past…Don’t you guys work for more than a year on such M and A deals…Then why does half of the Mergers fail..Even you are also not able to properly predict the value….Now come on ..Show your Excel (Seriously observes the excel sheet) ….Control Premium 3 billion…Now what is that figure?? How did you get this?

Fund (Stutters)..Con..trol..Prem..ium…..(In a characteristic style of ‘DDLJ’ Sharukh, Fund tells to himself : I hate technicalists!!)

Tech – You will not tell it ..All that you guys do is to have a acquisition price in your mind..Try to come up with complex excel models which nobody can understand..and then finally if there is a mismatch between whatever price you have in your mind vs. the model , you’ll include that in a factor called Control Premium(Tech takes pride in the fact that his 6 Lakh investment in MBA has not gone for waste and he is also able to use some technical jargon)….

The fight continues…
Technical and Fundamental view of the market are totally contrasting opinions. Both have their own strength and weakness and definitely one cannot complement another. It’s like the difference between the legendary Gavaskar and the big hitter ‘Yusuf Pathan’. You cannot ask Gavaskar to play blinder of a knock in the super over; neither can you ask Yusuf to play a patient innings of 70 in a seaming track to save a test match.

Fundamentalist look for long term value of a stock. They try to understand the business, try to predict the future cash flows, riskiness of the firm and try to value the firm. As Warren Buffet preaches “Don’t buy a stock…Buy a business”.Buffet never invests in a business which he doesn’t understand. But definitely there are draw backs associated with this approach. Predicting the cash flow and riskiness of the firm may be easy to propagate in theory..But they are the most difficult things.Who would have predicted the collapse of the financial system..All the fundamental analysts were predicting that markets has the potential to go up to 30000 as the P/E was not so high either(when the market was at 21000) ..But after the fall the markets came down to 8000.Did anything change fundamentally .Even if one goes on to say that the turnaround will happen in the next couple of years, then the valuation(according to the future cash flows) should not be affected by more than 10-15%...But why does a market fall by 60-70%. Nevertheless as my guru Damodaran puts it across “In a market fall, most of the time valuations also fail you…But at least you understand your current situation and avoids panic selling by the investors (who stick on to the fundamentalist view). Fundamentalists strongly believe that “Markets are efficient” …When stocks are mispriced no sooner than not investor will cash in on the opportunity…

Technical analysts on the other hand believe in charts and patterns..They never believe that “Markets are efficient”..They predict the movement of the stock prices based on the past movements. There are a lot of indicators, theories which aid the analyst..For example Dow Theory which is one of the age old pattern formation theory is a handy tool for technical analysts to identify a reversal pattern happening in a stock. Technical analysts don’t get into the depth of understanding the business. They don’t try to differentiate company based on their name or product , or their financial ratios…All they are bothered about are the curves which move up and down…They also take hints from some of the other factors like mutual fund ratio(whether MF’s are holding or selling stocks) , some of the momentum indicators and the likes..

PS: The above article is just through the theoretical understanding, through some of the discussion with my friends who are doing Summers in Fin profiles.So it might be prone to error..

PPS: The article is not intended to hurt either Fundamental or Technical traders…I have the greatest respect and my first inspiration towards finance: Warren Buffet is a believer in fundamental strategies (fundamentalist) and an equally good amount of respect for George Soros-Derivatives Guru.

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