For a long time, people who write about stock investing have maintained that there are two approaches to examining the market. One is fundamental analysis. That is looking at the economic realities. For stocks to produce gains, the underlying companies need to generate profits. The other is technical analysis. Investors can through emotional behavior cause stock gains greater than what the economic realities justify. Understand the direction of investor emotion and you can predict where prices are headed.
Preference for fundamental analysis over technical analysis
I am not comfortable with technical analysis. I certainly believe that investor emotion plays a role in the determination of stock prices. But I do not believe that our understanding of investor emotion is sophisticated enough for investors to be able to profit from their attempts to predict price shifts. If there are some who possess the skills needed, my sense is that they are few and far between and that the typical investor would have a very hard time pulling it off. So, if I had to choose between the two schools of thought, I would place myself in the fundamental analysis camp.
That should make me a Buy-and-Holder. The Buy-and-Holders disdain market timing, which is the speciality of those who believe in technical analysis. The Buy-and-Holders believe that market timing is just not necessary. Stocks have always produced a long-term average return of 6.5 percent real. That’s a good return. Be satisfied with that, focus on the long term and you should end up fine.
All of that makes a good bit of sense to me. However, I am certainly not a Buy-and-Holder. I think the Buy-and-Holders take the idea of disdaining market timing too far.
I completely agree with them that the guessing-game approach to market timing is a foolish endeavor. However, I am a strong proponent of valuation-based market timing. It drives me nuts that Buy-and-Holders act as if the two approaches to market timing are the same thing. They are not even a tiny bit the same thing. They are very, very different things.
Ask a Buy-and-Holder why market timing is a bad idea and he will point out how hard it is to be successful in predicting both when stock prices will fall and when they will rise again. That’s a strong argument against the guessing-game approach to market timing. But it is irrelevant to a consideration of valuation-based market timing.
Investors who engage in valuation-based market timing are not seeking to identify when price shifts will take place. They are seeking to keep their risk profile constant. When stocks become significantly overpriced, stocks are more risky than they are when prices are reasonable. So the investor who wants to keep his risk profile constant is required to lower his stock allocation to do so. It doesn’t matter when the inevitable price shift takes place. For so long as stocks remain overpriced, the investor is doing the right thing to go with a lower stock allocation. The only thing that would justify him returning to his higher allocation would be a price drop. He won’t have to predict when the price drop will take place to make the allocation change. He can wait until the price change has taken place to change his allocation.
It’s a safe prediction that that will happen sooner or later. Stock prices have been returning to fair-value levels for as long as there has been a stock market to invest in. A prediction that that will not happen this time would be a long-shot prediction.
The driver of the stock investing story
The Buy-and-Holders are right to be skeptical of market timing. But they take their skepticism too far. Technical analysis really is part of the stock investing story. Fundamental analysis is the driver. It’s economic realities that ultimately cause stock price changes. But to entirely ignore the effect of investor emotion on stock prices is to ignore an important part of the story. Investor emotion can push prices far higher than they should be for a significant amount of time and far lower than they should be for a significant amount of time. Investors who ignore valuations (Buy-and-Holders!) thereby blind themselves to much of what is going on. They find themselves accepting as credible prices that are far off the mark because they cannot bear to accept the influence of investor emotion.
Investor emotion matters! A lot. Stocks are today priced at two times their fair value. People who have a good bit of their wealth invested in stocks need to know that. They need to know the true and lasting value of their portfolio. To be able to make the necessary adjustment to the official price, they need to feel comfortable enough with very limited forms of technical analysis to gain a sense of the full realities.
It’s fine to discount the value of technical analysis. But it is important to understand why that is appropriate and not to overdo it. Technical analysis can be largely discounted because we lack the tools needed to make precise calculations. But we simply cannot ignore the psychological side of the story altogether. It’s too big a factor. The proper way to go (in my assessment) is to make adjustments only at the macro level, where it is entirely possible to make them effectively.
A smart investor is not going to try to identify the day or week or month or even the year that a price shift is going to take place. But he is going to acknowledge that, once stocks have become wildly overpriced, there is going to be a big price drop at some point in the future and he is going to adjust his stock allocation accordingly. An investor who refuses to do that much is engaging in wilful blindness (again, in my assessment).
Technical analysis has its limitations. But it exists because it relates to something important to the stock investing story – investor emotion. Ignoring it altogether, as the Buy-and-Holders do, is an extreme approach.
Rob’s bio is here.
