Why the Chart Often Moves Before the Fundamentals
"The market eventually trades to the fundamentals, but the technicals lead the fundamentals." - Bob Farrell
Hey Mindful Investor,
Back in my days in the Fidelity Chart Room, we had this quote from legendary technical analyst Bob Farrell hanging on the wall. Farrell had a remarkable career running the technical research team at Merrill Lynch, where he influenced generations of institutional investors and market technicians. I never had the opportunity to work directly with Bob, but I've worked with, managed, and learned from many analysts who were part of that legendary Merrill Lynch genealogy. His influence on the field of technical analysis is difficult to overstate.
But even today, there are plenty of investors who don't pay much attention to charts. They consider themselves fundamental investors, focusing on a company's ability to grow earnings and cash flows over time. If they can determine what a business should be worth based on those fundamentals, the thinking goes, there isn't much reason to worry about things like price action, supply and demand, sentiment, or investor psychology. And to be clear, fundamental analysis can be incredibly valuable. The problem comes when we assume that fundamentals tell us everything we need to know.
Fundamentals tell you what a company may be worth. Technicals tell you what investors think about it right now.
Some of the best investors I've encountered have recognized the benefits of combining the two disciplines. William O'Neil did a fantastic job illustrating the importance of blending fundamental and technical analysis, while John Palicka used the term "fusion analysis" to describe intentionally bringing those approaches together. The advantage of that combination is that fundamental analysis can help us understand what a company may ultimately be worth, while technical analysis can tell us how investors are actually responding to that company's prospects right now.
Investors often sense something has changed well before the reasons become clear.
That's important because investors often begin sensing that something has changed before the reasons become obvious. I always tell people that the reasons why things happen are usually crystal clear in the rearview mirror. A company can report consistently strong earnings and maintain a compelling fundamental story, yet the stock may begin weakening well before Wall Street recognizes that the underlying picture has changed. Investors closest to the situation may begin adjusting their expectations, selling shares and reducing exposure. By the time those problems appear clearly in an earnings report or 10-Q, the stock may have already rolled over and surrendered a significant portion of its previous gains.
Price and volume contain information the fundamentals haven't caught up to yet.
This is where technical analysis can provide tremendous value. Price and volume contain information. When a stock stops making higher highs, breaks important support levels, or experiences a meaningful change in volume characteristics, the market may be telling us something before we fully understand why. A period of accumulation can gradually transition into a period of distribution as investors become less enthusiastic about the company's future prospects. We may not immediately know what has changed, but the chart can alert us that something deserves our attention.
None of this means we should ignore fundamentals. Over the long run, stocks generally do trade toward their fundamental valuations. But they rarely travel toward those valuations in a straight line. Markets constantly move between optimism and pessimism as investors process new information and adjust their expectations. The difference between where a stock trades today and where fundamental analysis suggests it should eventually trade creates an important gap, and that's precisely where technical analysis can add so much value.
We don't have to choose between understanding the company and understanding the chart.
Bob Farrell's quote reminds us that we don't need to choose between understanding the company and understanding the chart. Fundamental analysis can help us appreciate the long term prospects of a business, while technical analysis can help us recognize when the market's assessment of those prospects is beginning to change. By combining the two, we can develop a much more complete picture of both value and investor behavior.
Mindless investors focus exclusively on the fundamental story and ignore changes in price and volume until the reasons for weakness become obvious.
Mindful investors combine fundamental insight with technical evidence, recognizing that the chart can signal an important shift long before the fundamental story catches up.
RR#6,
Dave
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Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. The author does not have a position in mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity. For full disclaimer, please see our website: marketmisbehavior.com/disclaimer.
