This article is a temporary respite from innovative ways to invest. It deals with traditional approaches to stock market analysis, specifically fundamental and technical analysis.

The treatment is brief and likely should have come earlier in this series.

One of these methods is rejected as having value for the average investor. The other may be of some value.

Fundamental Analysis

Fundamental analysis focuses on economic variables to ascertain the value of a company. Financial statements, future earnings prospects, new product development, changes in management and a host of other company-centric issues are looked at. So too are more global issues (macroeconomic expectations, industry trends, political events, legal threats, competitor actions, and geopolitical events for example).

The approach is conceptually sound. It’s is based on the notion that all value/prices should reflect the present value of expected future cash flows. This approach to stock analysis was popularized by Benjamin Graham, considered the Father of Value Investing. It has many other supporters, including Warren Buffett.

Conceptually the approach is unassailable. But theoretical perfection does not necessarily lead to practical value. In this case, it does not, at least for the average investor.

To benefit from fundamental analysis you must:

1. Have early access to information.
2. Be able to interpret that information properly.
3. Be able to act on the information before others do

The average investor is unable to do these things as well as the seasoned pro who devotes 40 – 60 hrs. per week to the task. It is not a matter of intelligence. It is an issue of resources and timing. The pro has better access to information. He has more computer power to process it. And his job requires him to do so.

The average investor must focus on a job not directed at markets. He comes home at 6 PM, tired from the workday. By the time he gets around to looking at markets, the pro is on his second martini or perhaps has retired for the evening.

In my opinion, it is a fool’s errand to try to compete on this basis. Fundamental analysis should be left to the pros, not because they do it better but because they do it full time.

Unless you receive information early or have some unique ability to see the future clearly, you have no chance to capitalize via this approach. “Inside information” is the type of knowledge required to benefit. It can provide you an advantage but its illegality can also provide you with jail time.

Fundamental analysis is theoretically correct but practically useless for most investors. Don’t waste your time trying to compete with the pros in this manner.

Technical Analysis

The other form of stock market analysis is technical analysis. It ignores fundamentals and focuses primarily on price and volume action. Many believe this analysis is worthwhile, although there is a large body of research known as The Efficient Market Theory (EMT) that disagrees. (It should be noted that EMT also argues that fundamental analysis is futile.)

Whether you accept or reject technical analysis, it is less harmful than fundamental analysis in that it is nearly free to perform, taking little time and using resources that are free and readily available.

Much of technical analysis deals with patterns (think “head and shoulders,” candlestick patterns, etc.). Many investors swear by pattern analysis as a means of making money. Usually, these are short-term traders, often day-traders. Day-trading, in my opinion, is another black hole in which to pour (or lose) money. Some people claim to make money this way, but the evidence is sketchy and the majority do not

Eugene Fama

Efficient Market Theory (EMT) advocates claim there is no mechanical trading strategy that outperforms markets on a consistent basis. Research into the theory began almost sixty years ago as a joint project between Merrill Lynch and the University of Chicago. Eugene Fama, considered the strongest advocate of EMT, was awarded a Nobel Prize for his work in this area. (To learn more about efficient markets, try this article.)

The one anomaly that EMT adherents have difficulty explaining is the positive bias of momentum trading. Momentum trading has been shown to be a thorn in the side of EMT. AQR  describes this tendency as follows:

Momentum is the phenomenon that securities which have performed well relative to peers (winners) on average continue to outperform, and securities that have performed relatively poorly (losers) tend to continue to underperform.

“Momentum, in my view, is the biggest embarrassment for efficient markets,” Fama said, admitting that he was “hoping it goes away” [Source].

The momentum anomaly is strange. It provides a means for earning excess returns for investors and it is known. As such, more investors should take advantage of this apparent aberration, causing it to disappear. Yet that has not been the case.

An example of momentum was demonstrated in this series, even though it is not usually classed as such. That example was presented in Market Returns — Simple Improvement. It used a moving average as a screen to enter/leave markets. A moving average is always late in sending a signal, yet the trend it signaled went on much longer than EMT would suggest.

There is no explanation as to why momentum is an exception to EMT. However, so long as it lasts, it provides one of the few ways to excess market returns.

The next article in this series will explore momentum in detail and show testing results that do indeed outperform markets.

Summary Comments

Fundamental analysis, in my opinion, is a fool’s errand.

Technical analysis provides a practical means to outperform markets, at least for the present. However, any simple means to outperform markets should not be expected to last forever.