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Analysis can tell you where to invest, but what about the right timing?

Markets-men party! If headlines such as these have you wringing your hands in frustration, because you’ve been on the sidelines of this stock-market rally, take heart. If you have the long-term in mind, it may not be too late yet to start with equity investing.

Having made the decision to take the plunge, which route can you take to select stocks? If you are a whiz at finance, you may be able to spot winners by trawling through company balance-sheets, crunching numbers and reading up every morsel of news about a company and its business plans. That’s fundamental analysis, the time-tested way popularized by gurus such as Peter Lynch and Warren Buffet, to pick stocks that can multiply your money over several years. But there is another way, for investors who aren’t trained in finance. Technical analysis — or the art of gauging where a stock is headed by looking at charts of its historical trends — tends to work equally well. Technical analysts study trends in stock prices and traded volumes to predict how a stock may behave in future.

How it works

But isn’t equity investing all about understanding the business, visiting the company and holding on to a stock for dear life? It is, but there could be problems too for those looking to buy and sell stocks based on fundamentals alone. Fundamental analysis can tell you whether a company’s business holds promise and is on the right track, but how do you know whether this is the right time to buy the stock?

Companies with perfectly good businesses may languish if they fail to attract ephemeral “market fancy.” What is more, with a potent cocktail of domestic as well as global factors holding sway over Indian stocks, timing has been a crucial factor in how well your equity investments perform. It has become quite usual, over the past year, to see stocks surging or falling by 5-10 per cent in a single day. Such moves can make or break your returns. Yet, cues about how a company’s financials or business has changed are available no more frequently than once a quarter!

When to buy

That’s where technicals come in. Chart patterns can be a useful tool in identifying the inflexion points in stock. For example Sushil , an investor and trader, bought Kirloskar Electric in March 2006 based on fundamental analysis. Though the company’s business was sound, the stock subsequently went into a prolonged correction. Had he applied technical analysis, he could have exited it with profits and re-entered upon completion of consolidation. But he remained invested.

That experience has made him supplement traditional investment tools with technical analysis. Inherently he is a long-term investor and, therefore, always rely more on fundamental analysis. He was attracted towards technical analysis to identify trends and decide on suitable entry and exit points.

The value dilemma

Another dilemma for a common investor is that, having identified a superb business, you also need to know the price you should pay for its stock. Ratios such as the price-earnings (PE) ratio or price to book-value ratio, used by fundamental analysts, may help set a value to a business, but there is a large dollop of subjective judgment involved in deciding what PE ratio you should pay for a particular company.

An investor who has made a successful transition to technical analysis says, “I was a fundamental analyst for almost six years before I picked up technical analysis. Fundamental analysts focus on forecasting a company’s earnings (EPS) for future years. But they have little idea about what the right PE multiple (price-earnings multiple) should be. A stock with an EPS of Re 1 will trade at 30 PE in a bull market, but slump to 6 PE in a bear market, with no real change in the fundamentals of the company. People attribute that to factors like re-rating and sentiment. Fundamental analysts could get their EPS forecast 100 per cent right and still go completely wrong on price move. That’s why I picked up technical analysis”.

After the relentless run-up in stock prices over the past four years, there are not that many good businesses that are trading at rock-bottom prices which would have the fundamental investor rubbing his hands in glee.

“Buy on rumour”

Another dimension to technical analysis is that it captures news flow that may not yet be available to the public at large. The old adage “Buy on the rumour and sell on the news” is often the best way to make a quick gain on a stock. Yet, balance sheets and published financials are hardly the best place to look for “rumours”. By capturing the behaviour of a large section of traders in a stock, technicals can often tip you off about a key event that is yet to become public knowledge.

Why they go hand-in-hand

But if all this suggests that you can throw a company’s business and its financials to the winds and rake in the money purely by chart-gazing, you would be quite wrong. In fact, the most successful investors (especially those who invest for the long term) are those who have married both these sciences, when it comes to their investment decisions.

For one, while technical analysis can provide cues about timing, this does not detract from the fact that a stock should be underpinned by a sound business and good management for long-term gains. Betting on stocks or companies with poor credentials based purely on technicals can leave you saddled with lemons, especially if the markets turn turtle, leaving you with very little time to exit. So the best practice would be to use fundamentals to decide which ones to buy and use technicals to know when to buy them.

Second, while technical tools can help you gauge stock price movements based on historic trends, these trends can reverse pretty quickly on dramatic shifts in the big picture (such as a US sub-prime crisis, or a spike in rupee). This is why most successful technical analysts often keep an eye on global and domestic developments on the macro front, along with the charts of specific companies they track, while deciding on their calls.

No money for jam

Finally, contrary to popular perception, whatever the method you use, there is no easy money to be made in the stock markets. Adopting technical tools may not require you to be a finance whiz, but reading charts is no cakewalk either! Just as fundamental analysis requires you to invest time in researching a company’s business, technical analysis requires considerable training in watching and interpreting chart patterns. It is interpretation, ultimately, that holds the key to what you make of the commonly available technical tools.

You also have to invest funds in acquiring the relevant charting software and live data that can support your foray into technical analysis.

Stocks-Fundamental Analysis and Technical Analysis

There are two methods regarding security analysis - fundamental and technical analysis. Fundamental analysis utilizes a much wider range of information than does technical analysis and relies on traditional financial statement analysis. Technical analysis, on the other hand, concerns itself with attempting to identify patterns in past price movements. Both consider macro economic trends to differing degrees, but emphasize the use of firm specific micro economic data.

Fundamental Analysis

Fundamental analysis generally refers to the study of the economic factors underlying the price movement of securities or commodities, not the price movements themselves. For the most part, this form of analysis usually results in longer-term investments and is considered to be a more conservative approach. At a high level, fundamentalists attempt to quantify the current value of a stock by gathering data relating to general industry outlook, overall market conditions, corporate financial strength, historical patterns of sales, earnings, market share, dividends, etc. Using this data they then try to assign a future value to the stock by interpretation and projection. The difference between the current and future values reflects the fundamentalist's assessment of the stock's potential as an investment opportunity. Investment decisions are made based on this fundamental information relative to other opportunities.

Much of the work of the fundamentalist involves accurately projecting earnings going forward and the factors affecting earnings. In theory, the fundamentalist who can make accurate projections and who chooses quality securities when they are under-valued and sells them when they are over-valued can reap substantial profits. Of course, when these assessments are faulty the result is a tendency to maintain a losing position longer than necessary.

Technical Analysis

Technical analysis is based on the following three principles:

1. Everything relevant to the value of a company's stock is discounted and reflected in share price.
2. Trends sometimes appear in share price moves and when once started, these trends tend to persist.
3. Activity in the market repeats.

The purpose of technical analysis is to detect the trend or momentum of a stock early so that a good entry or exit point can be selected. Traditionally, charting is the main approach for technical analysis. However, interpreting a chart or an indicator is, at least in part, a subjective issue. Even if you have the knowledge and experience to understand what a chart is telling you, the accuracy is still limited since many trading patterns and some correlative information are not visible or not perceptible directly. The technical analysis generally concentrates on the study of historical price and volume data to detect future trends.

Within the ranks of technical analysis there are two factions - chartists and technicians. While the chartist embraces a more visual approach to the analysis, the technician uses a more quantitative approach and often employs sophisticated statistical methods. Chartists refer to line studies such as trendlines, triangles, speed resistance lines, Gann angles, and the like. Technicians employ technical indicators which usually are variations of common statistical methods such as ordinary least-square regression, exponential moving averages, etc. Whereas fundamental analysis allows you to make an informed determination of a company's current share valuation, technical analysis aims to improve the timing of your investments.