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- Navigating Stock Bubbles: Fundamental Analysis vs Technical Analysis - May 8, 2017
“Fundamental analysis vs technical analysis” is a topic that people have been arguing about for decades, since the start of stock market trading.
As the saying goes, there are many ways to skin a cat. There are investors who made money using pure fundamental analysis and there are traders who profited by using pure technical analysis.
However, not all methodologies are created equal, especially not so during certain parts of the market cycle or during special market situations.
An example of such circumstances is during a stock market bubble.
Coming from a background where I had passionately learned the art of both fundamental and technical analysis, I can understand how differently a fundamentalist and technician will behave and trade in a stock market bubble.
And as such, the outcome would have been vastly different as well.
In order to help you better understand the key differences between fundamental analysis vs technical analysis in such situations, I will use the internet bubble (around the year 2000) as a case study to explain to you why,
1) Fundamental analysis would have made you miss the boat of a lifetime or even got you drowned, while
2) Technical analysis would have been your best friend and could have helped you make a killing both on the way up and on the way down.
A fundamentalist’s behavior in a stock bubble
When NASDAQ index was at 1250 level
It was the year 1996 and the date was 5th of December to be precise. The NASDAQ index was hovering around 1250 at that point in time.
During a televised speech, Alan Greenspan, who was then the Federal Reserve Chairman of the United States, made a speech that became famous because of his use of the word “irrational exuberance”.
Many interpreted that as a warning from him that the stock market at that point in time had somewhat became over-valued and the market participants were becoming irrational enough to continue pushing stock prices higher.
Alan Greenspan was an economist by profession. He probably had an army of fundamental analysts working for him, helping him to analyze the massive amount of economic fundamental data at his disposal.
If someone of Alan Greenspan’s background and resources comes out to the public to warn everyone about the market’s irrational exuberance, would you have question his reading of the market?
Of course not, and I believe many pure fundamental investors/traders were thinking similarly to him as well.
NASDAQ index headed from 1250 to 2000
Despite Alan Greenspan’s comments, the NASDAQ index continued to head higher thereafter to around 2000 in early 1999 with a 60% gain.
If the market was already irrational at 1250 by Alan Greenspan’s standards, let’s imagine how a typical fundamental investor/trader who have said and behaved when the index reached 2000:
“Valuation is expensive, we should start selling now. 2000 level will not hold.”
So naturally, it would not have been a surprise to see him starting to liquidate his stocks then, in anticipation of a major market correction or crash.
Heading further to 2700
Despite the typical fundamental investor’s pessimism, by mid-1999, the NASDAQ index has climbed to 2700.
By this time, that typical fundamental investor/trader would have been gotten very bearish about the market,
“This is crazy! Everything is over-valued. It just don’t make sense. SELL!!!”
And he was absolutely right to say that. If you invest or trade the market using pure fundamental analysis, you must be crazy if you are still holding on to any stocks at that point in time.
This typical fundamental investor/trader would probably have sold off all his shares by now.
The index climbed to 3500
Despite all the negative views about the market from a fundamental perspective, the market continued to climb towards the 3500.
By this time, that typical fundamental investor/trader who has already liquidated most of his stocks would probably be thinking,
“You must be crazy if you are still holding on to any stocks!! You should short the market!!”
And I’m sure that’s what many pure fundamental fund managers did as well at that point in time.
The NASDAQ index soared to 4500
By the time the NASDAQ index reached 4500, the market was already in euphoria and this was probably what that typical fundamental investor/trader would have said at this point in time,
“I can’t believe this is happening. Has everyone gone bonkers??”
And I have no doubt that it was definitely the case. By then, I’m sure every Tom, Dick and Harry were making tons of money trading the market.
Everyone was using all the cash they had and even borrowed money to trade the market. Even hair barbers and restaurant waiters were talking about how much money they were making from the stock market.
The index finally topped out at around 5100
It was only until early year 2000 that the stock market finally reached a peak before starting to crash.
From the point that Alan Greenspan made the “irrational exuberance” comment at the 1250 level, to the point where the market peak was reached at around 5100, that was more than a 300% rally in just 3 years!
How to be right, and still get killed
Now let’s take a look at what happened to that typical fundamental investor/trader.
Do you think he was right to say that the market was over-valued and that everyone was crazy during the stock market bubble?
Sure, he was absolutely spot on with all his fundamental analysis about the market but my question to you is,
Did he make a lot of money with the way he analyzed and traded the market?
Clearly, the answer is no.
By getting out so early at the start of the market bubble because of fundamental reasons, he had missed the entire ride.
How many times do you think in his lifetime, will he get the opportunity to ride a 300% broad market rally (within 3 short years) again?
And did you remember he probably started shorting the market way at around 3500, way before the market topped out?
If he did not have the margins to hold out to his short position until the market peaked out much later, do you think he could have gone bankrupted as a result?
This is a classic example of how you can be absolutely spot on with your fundamental analysis and still get killed.
Let me ask you a very honest question:
Are you participating in the stock market to be right? Or are you in the market to make money?
When I asked this question during my seminars, everyone says they are in the market to make money, yet you will be surprised how many people keep trying to prove their fundamental view is right rather than focusing on using the best tools to maximize their return.
What many people forget is that, the market rewards you based on when you get in and when you get out, not how right you are in analyzing the fundamentals of the market.
As such, you should be using tools that helps you get in and get out at the right time and make money, rather than simply depending on tools that feeds your ego that you are right and the market is wrong.
So how should you get in and get out at the most optimal time to maximize your returns during a stock market bubble?
This is where technical analysis and technical trend trading comes into the picture.
A technician’s perspective in a stock bubble
From a technical analysis perspective, especially in the field of technical trend trading, the most important rule is that you should go with the trend.
Ride the trend as long as there is no indication that the trend has changed.
The basic tools of technical analysis includes things like trend lines, trend channels, horizontal support/resistance lines and trading volume.
With just the above simple charting tools, let’s take a look at how a technician will analyze and trade the dot-com bubble.
When index was hovering just above 1400
Between 1997 – 1998, the NASDAQ index bounced off the 1400 level 5 times over the 1-year period (now tell me that’s pure coincidence?).
From a technical analysis perspective, this is what it means,
“Key horizontal support holding firm, no reason to sell.”
Clearly, the market is supportive of the index at the 1400 level, regardless whether the market is over-valued or not. As long as everyone deem the market a worthy buy at 1400, there is no reason for us to get out of the market.
Subsequently, over the next one year, the index continued to trend higher towards the 2900 level.
Resistance at 2900 level
Initially, when the index reaches the 2900, there seems to be some difficulties pushing forward.
Over a period of about 6 months, the index touched the 2900 level a total of 3 times but just could not conquer it.
However, the pull-back from the 2900 level was fairly shallow. The key uptrend support remains well supported despite the numerous retracement from the 2900 resistance.
By the virtue of that, this is what it means to a technical analyst,
“Uptrend support still holding firm. Continue to ride the trend.”
This is a very important aspect of technical trend trading.
As long as the uptrend support that you have identified remains intact, there is no reason for you to get out of the trade even if you notice a resistance forming.
2900 resistance finally taken out
Fortunately, on the fourth try, the index finally punched through the 2900 resistance.
From a technician’s perspective, this means that,
“Key resistance conquered. Load up some more!”
One of technical analysis’s key phenomenon to watch out for is support/resistance reversal point.
Essentially, this means that when a key resistance has been conquered, the market will likely continue to trend higher in the direction of the break of the resistance. That original resistance will now become a support level.
As such, it makes sense to buy even more when occasions like this happens.
Uptrend got steeper
After overcoming the 2900 horizontal resistance, the index started to climb very steeply.
Between end-1999 to early-2000, the index trended higher very steadily, supported by a very clear uptrend support.
And this is what will occur to a technician,
“Uptrend starting to get steeper. Still no reason to sell out yet but time to be wary.”
“This steep uptrend can’t run indefinitely. Let’s ride the trend as far as possible but monitor market closely.”
As a technician, we have seen charts of market bubbles before. We know that a steep climb like this is not sustainable.
It is not that we do not know that the market is over-valued. It is not that we do not know the market is getting irrational.
But as I shared earlier on, if our purpose of being in the market is to maximize our returns, then it makes perfect sense to continue to ride with the positive sentiments as long as the trend is well supported, regardless whether the market is over-valued or irrational.
In this case, the clear and well-supported uptrend support line gave us the courage to hold on to our positions.
Another key resistance forming at 5100
Like the previous case at the 2900 level, the index started to face headwinds at the 5100 level.
On two occasions, the index rallied strongly to the 5100 level but pull-backed rather strongly as well.
And this is what a technician would have noticed,
“A dual peak has been formed here, but continue to hold as uptrend is still intact. Be alert now.”
While the index faced difficulties overcoming the 5100 level, the pull-backs were also fairly short-lived as the index bounced off the 4600 level on numerous occasions.
This clearly illustrates that the index is undecided between the 4600 and 5100 levels. That is the reason why we need to be alert and wary.
Should the index overcome the 5100 resistance in time to come, it means that the market is ready to push the index higher.
And if the index breaks the 4600 key support, this means that the bubble game could be over.
Key uptrend support and key horizontal support were violated at the same time!
This was the defining moment that all serious technicians were looking out for.
Firstly, the 5100 resistance was ultimately not conquered. Instead, the 4600 key horizontal support was convincingly violated.
At the same time, the index’s key uptrend support that held firm over the past six months was also violated!
From a technical analysis perspective, this means that,
“Key uptrend support and key horizontal support both broken! Start getting out now!”
Compared to a pure fundamental investor who got out of the market much earlier because of pure fundamental reasons and as such missed the ride of a lifetime, technical trend traders like us do not attempt to predict when the market bubble will pop.
We measure the probability of directional moves or changes based on how the market participants vote with their cold hard cash.
Every stock or index or asset class, has a certain tipping point. When this tipping point is violated, it will start to cause a domino effect on overall market sentiments.
Technical analysis is one of those very few tools that can help identify those tipping points.
Conclusion: Fundamental analysis vs technical analysis in a stock bubble
I’m sure by now, you are rather clear about why I am advocating the use of technical analysis so strongly versus fundamental analysis.
In a situation like a stock market bubble, fundamental analysis will tell you the fundamental state of the economy or any company, but it will not tell you when is the best time to get in and get out in order to maximize your returns or minimize your losses.
A Fundamental Analyst is concerned about how much he personally thinks the stock is worth, while
A Technical Analyst is concerned about how much the participants think the stock is worth
As what I have shared before in another of my article, the fastest way to take a bath in the stock market or go broke is to try to prove that you are right and the market is wrong.
Now, I am not advocating that you dump whatever strategies you have been using all the while.
You could be using fundamentals, astrology or crystal ball for all you like, but the point that I wish to bring across is that ultimately, technical analysis is still your best friend especially during a stock market bubble.
From a technical trend trader’s perspective,
“The stock is worth as much as the price that market is willing to pay for”
The earlier you can internalize this reality, the earlier you can start to learn how to maximize your returns with the help of technical analysis.
I hope that the case study above has helped you understand better, the values of applying fundamental analysis vs technical analysis in a market bubble.
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