Paradigm shift: FromFundamental Analysisto Technical Analysis

Tom BoppGolden Gate University

0B /12 /201,6FI 340: Investments

With Professor Lenzi

Introduction

From fundamental analysis to technical analysis markets can be better explained

through the simplicity of technical analysis with innovators outside the realm of finance.

Experts in the fields of sociology, and psychology are adding credibility to technical

analysis. A few conclusions will be expanded upon to support this analysis. There has been

a major shift in the finance world away from fundamental analysis and growing popularity

in behavioral finance. We can see supporting evidence that behavioral finance yields a

positive and predictable analysis on three examples. First we can look at the global

economics, secondly we can view the mainstream media, and thirdly a brief assessment of

the financial markets. In conducting a survey from the big picture of current global

economic events we can zoom in on current mainstream media, and magnify our analysis

on the current financial markets to view the ease and simplicity that one can draw

predictable conclusions from why markets go up, down, and sideways.

Technical analysis has been gaining creditability from innovators outside the realm

of finance. Experts in the fields of sociology, and psychology are adding credibility to

technical analysis. They can diagnose why a particular security or a market may suddenly

spike or fall and can more aptly illustrate market moves with psychology, consumer

sentiment, actions off of good and bad news as well as, greed, hope and fear. Hence, we

arrive at a major shift in the finance world away from fundamental analysis and growing

popularity in behavioral finance. We could think of the large deep pocket institutional

traders as both purchasing and selling their positions in the markets. If the market is going

sideways, it may merely mean that large market makers are building a position via

accumulating a large line of stock at bargain prices while absorbing all of the available

supply, It is later now that strong demand by the entire market bids up the price of the

scarce supply. Further, w€ can imagine the composite operators distributing a long line of

stock on the campaign upwards, slowly releasing their supply.

In the process, the composite operator begins his campaign and slowly sells little by

little some stock to the general public allowing the crowd to thereby bid up the price. This

early process has been related towards greed, and the general public keeps speculating and

purchasing more and more of the stock in hopes that the price will continue to rise. Near

the bullish peak the composite operator has relinquished most of his position and will sell

off the rest of the security ideally at market peaks to the general public, whom of which

hope the price will keep going up. In this fashion the composite operator has made a

handsome return on his trade. All the while the late comers to the market buy as the price

now drops. They perceive these drops in prices as bargain deals. However, the general

public and the laggards are the weak hands and wer. noi aware of the large and strong

composite operators that created this bull market campaign. Now in the fear stage, a

panicky sell off commences at continuously dropping prices by the general public in the

fear stage all the way down to through the bear market bottoms. Finally, reaching

capitulation where the small ill-informed speculators take huge losses and may not return

to the markets for some time if at all.

I. Global Economics

Behavioral finance yields a positive and predictable analysis on three examples.

First we can look at the global economics and see principles in practice. Take for example

the most recent global economic crisis in the real estate bubble of 2007 -2008, and even a

bit further back with the tech bubble of 2000. These booms and busts are attributable to

three basic premises: greed, hope and fear. Take for instance the collateralized debt

obligations (CD0'S) where real estate mortgages were split off into tranches and

repackaged and sold in the financial markets worldwide. We can observe the innovators

who first created the CDO's whom of which were the banks that offered the mortgages to

subpar clients, the underwriters at the investment banks that in turn repackages the debt

as securities as well as the credit rating agencies. They all realized how much money they

could make. The investment banks shortly realized how toxic the CD0's were and

immediately relinquished any holdings and sold them to whomever would take the

securities off the investment banks books. After all, the investment banks had paid the

credit agencies a handsome fee for triple AAA ratings on the CDO's.

People flocked to these investments and entire countries invested heavily in CDO's

later going into bankruptcy, and many people's retirement accounts were wiped out by this

contagion effect. Further, challenges arose with a high possibility of default. Then, we can

link the underwriters at the investment banks who in turn worked with the credit rating

agencies to repackage the mortgages and pass on the risk of default to anyone who wanted

to invest. Investing started with the institutions, pension f,unds, hedge funds, and

governments early on, then the general public and finally the laggards. In this analysis we

see the mortgage crisis as something like an international domino effect.

II. The Mainstream Media

Secondly, we can view the mainstream media as a financial markets barometer. We

can often draw reference to magazines like The Economist, Forbes, Newsweek, and Time

Magazine. In technical analysis these simple magazine covers can be viewed by a brief walk

through your local Barnes and Noble Book Store. Back in 2000 and200B many of these

magazines served as contrarian indicators just by looking at the covers. We would have

seen some magazines with a picture of a bull on the front cover often trying to show

optimism and belief that the markets are ready to rally higher. Other magazines may have

big pictures of houses on the cover, stating that now is the time to invest, or another real

estate boom is just around the corner.

In technical analysis we know that there are large composite operators at work with

deep pockets and strong hands, also known as market makers, like large institutional

investors, pension funds, and insurance companies. These players are in control of the

markets and also generally are the owners of the mainstream media like Fox News, CNBC

Business Channel and the Wall Street Journal. They want both you and I to believe that

things are getting better and the market will go higher so that they can get every last dime

from investors of the crowd,

IIL Assessment of Financial Markets

Thirdly, we can take a brief assessment of the financial markets. In Daniel

Kahneman's book titled, "Thinking, Fast And Slow" he discusses a similar analysis from a

doctor's perspective. "To be a good diagnostician, a physician needs to acquire a large set of

labels for diseases, each of which binds an idea of the illness and its symptoms, possible

antecedents and causes, possible developments and consequences, and possible

interventions to cure or mitigate the illness" (p.7). |ust as the good doctor conducts his

analysis on a patient; so to the technical analyst or rather market technician requires a

prognosis and diagnosis of the financial markets.

The financial markets always seem to have a place for opportunity as we rise up and

into a growing bull market as well as sharp fall into a spiraling bear market. Take for

example the recent British exit out from the Euro currency. Financial markets globally

panicked off of the perceived bad news and went into turmoil temporarily over a few days

only to recover. The large scale investors know all too well that markets are prey to general

psychology and will take every opportunity to place their trades betting that the market

will turn south via short orders and placing long positions in times of perceived positive

events.

In technical analysis we would disregard all of the fundamental information such as

price to earnings, dividends, earnings per share, beta, return on investment and return on

equity. In technical analysis of the financial markets we would solely follow the price action

and volume on simple candle stick charts. It is well known that candle stick charts were

effectively employed to forecast rice futures in Japan for thousands of years. Further, one

could employ the use of a point and figure chart as a companion piece to get cold hard

calculated trade positions on the long side as well as going short in a particular financial

market and trade stocks, bonds, commodities and futures. The point and figure (Pnf) chart

is comprised of X's and O's on a grid.

Generally, if the price moves up for three consecutive days we would observe an X. If

the next day, if the price went up by at least another three points on the exchange it is listed

on we would observe another X in the same column in the next box above the previous

day's high. Likewise, in a similar fashion, for a reversal to the downside an explanation

follows. If the price declines for three consecutive days we would observe an 0 in the

adjacent column, one box below the previous day's high, hence the price reversal. Three

point's for a reversal in either direction with the Pnf is the most widely used, but five and

ten points may work better for longer time frames of a decade or more. One point reversals

are effective for analysis on a short time frame, such as one month, or even one week.

We would arrive at price projections to the upside by counting what looks like a

congestion area at market bottoms, counting from right to left O's for lows and X's for

congestion zones at market tops. Further we would multiply the count by the box reversal

of three, times the point per box of one, add it to the price at the count line thereby arriving

at the bullish price objective. Bearish price objectives would require one to subtract the

count from the price at the congestion zone. Identifying congestions zones or rather trading

ranges is something of more detailed analysis and is more of an art form.

In Dr. Hank Pruden's book, "The Three Skills of Top Trading: Behavioral Systems

Building, pattern Recognition, and Mental State Management" he discusses the major

components of technical analysis [price, volume, time, and sentiment) very succinctly.

Referring to exhibit A.) his adoption/diffusion life cycle model largely utilized in the fields

of social science, psychology, and marketing serves as reinforcing significance of financial

markets as a very much social and psychological phenomenon.

Crowd behavior is explained in the S-shaped curve of the life cycle model beginning

with phase I fAccumulationJ, phase II (Markup), phase III fDistribution), and finally phase

IV fMarkdown). We can also visualize price beginning from the bottom of the curves at

zero, to the top of the curves at price highs. The overlay, which you could visualize as a bell

shaped curve illustrates the market participants, "...ranging from the early smart money to

the 'odd-lotters,' those who enter the market last" (p. 5B). The bell shaped overlay proceeds

in the following fashion: Innovators/lnsiders, Early Adoptors, Early Majority, Late Majority,

and finally the Laggards/Odd-Lotters. We can also label in a time horizon fear at the

beginning of the curves, while contrary opinion sits about in the middle and towards the

end of the curves we arrive at greed.

Work Cited

Kahneman, Daniel. Thinking, Fast And Slow. Farrar, Straus and Giroux,2011. Print.

Pruden, Hank. The Three Skills of Top Trading: Behavioral Systems Building, Pattern

Recognition, and Mental State Management. Hoboken, NJ: John Wiley & Sons, 2007.

.Print.

Exhibit A.)

Appendix

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