This Stock-Picking Strategy Won a Nobel Prize
- A company’s financial statements can be sliced and diced in 2,090,365 unique ways.
- With technical analysis, we let analysts do the math, and then we follow their models.
- Technicals show us the exact moment prices will stop falling. That’s the time to buy.
My first job paid $0.75 an hour. That was in 1976.
It was a restaurant job. But back then, job duties weren’t well defined.
Bosses yelled things like: “If there’s time to lean, there’s time to sweep” and “Do something, even if it’s wrong.”
They expected us to work to receive that princely sum of $3.35 an hour in today’s dollars.
I learned making money is hard. I also noticed some jobs were easier than others.
Bosses made more money in two ways. They did work. They also told us to work.
I saw it was possible to make money from the hard work of others.
I never forgot that lesson. That’s why I use technical analysis when looking at stocks.
How to Let Wall Street Analysts Work for You
Technical analysis focuses on price action. All I need to trade is my indicators and a stock symbol.
I don’t worry about the company’s name. I don’t know what the company does.
When my indicators say buy, I buy. I hold until the indicators say sell.
I guess I think about stocks differently than many investors.
It seems fair to say most investors think of sales, earnings and other information when evaluating stocks. This information is the domain of fundamental analysis.
Thousands of investors analyze a company’s income statement. They scour balance sheets and statements of cash flows.
Financial statements provide 156 different pieces of data. Investors do a lot with that data.
Consider sales. You can find the price-to-sales ratio by combining data from the income statement with the stock’s price.
You could compare sales to earnings or any other data series. You can calculate the change in the sales over the past year or the past quarter.
There are thousands of ways to evaluate the company’s sales.
This process can be extended to earnings, cash flow or any information in the financials. By one estimate, numbers in financial statements can be sliced and diced in 2,090,365 unique ways.
Smart people around the world are doing many of those calculations. Then they decide whether to buy or sell the stock based on their math. As they buy and sell, they move the price of the stock.
By following the price action, we let analysts do the math, and then we follow their models.
Why It Pays to Follow Rather Than Lead
Research shows the current stock price is the result of all those models.
Eugene Fama won the 2013 Nobel Prize in Economics for showing “new information affects prices almost immediately, which means that the market is efficient.” In other words, the market price reflects the analysis of every investor analyzing the stock.
His work says if a stock is worth $430, the market price of the stock is $430. When the market price is $370, the stock is worth exactly $370.
That’s because the current price is based on all the information available to investors around the world.
I could certainly build a model and create my own price target. But other investors do that.
I don’t need to duplicate their work. I see their work in the price action.
If their models say a stock is undervalued, they buy. With a little more economic theory, we see what happens next.
The Price Is Right
Each company trades a fixed number of shares. When there are more buyers than sellers for those shares, the law of supply and demand says the price will rise.
When the models say a stock is overvalued, sellers push the price down. It’s also the law of supply and demand at work.
The up-and-down moves of stock prices simply reflect the fundamental models. By tracking price action, I can ignore the fundamentals.
That’s important because fundamentals change slowly. Fundamentals can also diverge from the price for extended periods of time.
Following fundamentals often means missing big price moves.
The chart of Bed Bath & Beyond shows how investors using fundamentals were led astray.
(Source: Standard & Poor’s)
In the chart, sales change just once every three months. Sales rose for three years until late 2018, while the stock price declined.
With falling prices and rising sales, the price-to-sales ratio declined. Value investors saw a bargain. Their indicators said buy, even as prices fell.
But remember, the price was falling. It still is.
Technical analysts focused on prices. They ignored the sales data. They avoided the stock.
In the end, the price was right.
This is one of those times it’s safe to ignore fundamentals.
This sounds obvious, but when prices are falling, investors lose money.
For some reason, falling prices attract fundamental investors. They often lose money waiting for the turnaround.
Eventually, if the company survives, the price will stop falling. That’s the time to buy.
Fundamentals will never highlight that moment. Only technicals will.
Michael Carr, CMT, CFTe
Editor, Peak Velocity Trader – options trading with momentum
P.S. For more information on technical analysis, check out my YouTube channel. I have an educational series there that covers how professional traders read stock charts, and much more.