Stockcoach's Corner

Richard from Move the Markets posted the following comment about my earlier post:

I guess, in short, I understand trading based on news, and I (sort-of) understand value investing, but I don't understand how one would go about doing short-term trading on fundamentals.

The markets are pricing in everyone's best guess about what the fundamentals will look like in the future, right? So, whether you trade fundamentals or technicals, you've still got that nagging problem of being unable to predict the future. Isn't there still a bit of black magic in figuring out what multiple you'd be willing to pay (especially if the company is actually losing money)? More of an art than a science, still, right?

I used the little search bar on your blog to search for "fundamental analysis" and got no hits other than this post. Do you have an entry that describes the way you trade fundamentals?

Let me respond to Richard by saying this:

I guess I am not saying that technical analysis is wrong by definition, but rather, those who practise technical analysis tend to rely on patterns they learned from books and blogs, the efficacy of which are based on folklore and not rigorous testing.

Short term trading based on fundamentals is largely news based. Long-term trading based on fundamentals requires screening for various criteria that tend to work well. This post mentions some.

I guess there is also the issue of what distinguishes a trader from an investor. I tend to distinguish trading and investing in the following way: The value of a stock in an efficient market should equal the present value of cash flows that shareholders will receive, typically in the form of dividends. If you are buying a stock for those cash flows, you are an investor. If you are buying the stock for capital gains, you are a trader. In practise, this means that anyone who holds a stock for less than 5 years is largely a trader. So obviously my definition of trading encompasses a much longer time frame than what others would regard as trading.

Is trading based on fundamentals more of an art than a science? Yes, in many ways it is, but I would argue that it is more of a science than technical analysis simply because there is a lot of good empirical work that demonstrates the efficacy of various trading rules based on fundamentals (buying value stocks, stocks with insider buying, stocks that recently beat earnings estimates, etc.). My own reading of the literature on technical analysis is that almost all patterns tested are unprofitable after realistic assumptions are made about slippage and commissions. It's not a hard and fast rule, however. Andrew Lo at MIT has done lots of good research on TA. Some of the patterns he tested are marginally profitable, but again, it would be difficult for a person to make a living by trading them.

The only possible big exception is momentum (buying past 12 month winners and holding them for 3 to 6 months). The momentum effect, from about the mid 1930's until 2000, was absolutely huge, much much bigger than the boost one got from buying value stocks or small caps. The numbers simply are staggering by how much past winners outperformed past losers. However, the momentum effect is long term in nature. You can't daytrade off it since it requires a holding period of about 6 months. Futhermore, more than half of momentum profits are from the short side, so in practise it may be difficult to fully realize them. Moreover, momentum profits tend to last longer for low volume stocks, contrary to what most traders believe. However, this illiquidity also makes it more difficult to trade them.

Let me also say that I don't think trading on fundamentals is the only way to go for short-term trading. Much of the trading done on Wall Street is basically liquidity provision. That's what market making is all about. Market makers tend not to take directional bets; they just sell when others are desperate to buy and buy when others are desperate to sell. But in general they are keen to balance their books as quickly as possible. There is a parallel here between what they do and the sort of value investing I do with illiquid stocks.

There is also a fair bit of money to be had from scalping off institutional money flows. People will argue about the benefits of TA if you're a scalper. My own sense is that it is of limited help, but I am sure others will disagree.