We clearly have a serious dichotomy within the analyst world regarding the value of “fundamentals” and the value of “technical analysis” regarding predictive value, through which we may choose to invest. Historically, the great majority of investors have believed in the predictive value of fundamental analysis, while they completely ignore or seriously discount technical analysis as having any value at all.
However, even though most economists will agree that the market is a leading indicator of economic well-being, almost all have no clear, objective way of forecasting for this leading indicator. Rather, they fall back on using fundamental analysis to attempt to predict this leading indicator.
Is the common and older belief in fundamental analysis really warranted based upon relatively recent studies and the true nature of what drives our markets?
What is Fundamental Analysis?
Fundamental analysis is generally defined as a method of evaluation that attempts to measure “value” by examining related “current” economic, financial and other qualitative and quantitative factors. Fundamental analysts will utilize “current” macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).
What are the flaws with this methodology?
Market fundamentals are the existing conditions of a market based upon historical data. In order to utilize this information for predictive purposes, economists will employ a form of trend extrapolation. This effectively presumes that the current market conditions will continue indefinitely into the future, until they do not. This is possibly the crudest form of linear extrapolation. If we wait for the underlying “fundamentals” to change, are we not already within a different trend within the market that is now changing underlying fundamentals?
Therefore, in order to have valuable predictive value, is this the appropriate methodology to utilize to be able to identify a change in the “current market conditions” before they occur? Doesn’t the information, upon which fundamental analysis relies, have to change before one is able to identify a change in the in the trend using this analysis method? But, doesn’t this also mean that the trend has already changed well before fundamental analysis is able to identify that change? Therefore, what real predictive value does fundamental analysis offer, as it is a seriously lagging methodology?
Fundamental Analysis Based In “Random Walk” Theory
The Random Walk, or Efficient Market, theory is partly based upon the fact that ALL investors (1) make informed and (2) rational decisions, however, (3) exogenous events affect markets and cause changes to investment values. Based upon this theory, since no one can predict exogenous events, then the market must be unpredictable and will move randomly.
However, there are numerous issues with each of the three foundations which support this theory.
First, do you truly believe that ALL investors make “informed” decisions? Do all investors have access to the same information so that all investors within the market all make “informed” decisions? I think not.
Second, do you truly believe that ALL investors make rational decisions? This presupposes that there is no emotion involved in decision making, as all decisions by investors are made “rationally.” In fact, this notion has been dispelled by former Fed Chairman Alan Greenspan. In his testimony before the Joint Economic Committee, Mr. Greenspan noted that the stock market is driven by “human psychology” and “waves of optimism and pessimism.”
Lastly, we really have to begin to question whether exogenous events actually move markets. Don’t you ever question why markets go up after seemingly bad news or go down after seemingly good news?
Social experiments have actually been conducted which resulted in price patterns that mirror those found in the stock market. In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”
One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy,“ wherein the price distributions were based on Phi (.618).
Their ultimate conclusion would surprise the most avid trader today:
“In spite of the simplicity of our model and of the strategies of the single participants, and the outright exclusion of economic external factors, we find a market which behaves surprisingly realistically. These results suggest that a stock market can be considered as a self-organized critical system: The system reaches dynamically an equilibrium state characterized by fluctuations of any size, without the need of any parameter fine tuning or external driving.”
Marsili was quoted as saying that “the understanding that we got is that the statistics of price histories in financial markets can be understood as the result of internal interaction and not the fundamental interaction with the external world.”
In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news.
Based upon Walkers study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.
Robert Prechter Jr., in his book The Wave Principle of Human Social Behavior, in which he cites many of these instances, concludes “once you realize that even if you got [the news] in advance, you could not forecast the stock market. Though these facts are counter-intuitive, it does not take a dedicated market student long to observe the acausality of news to the stock market.”
R.N. Elliott, in his 1946 publication of Nature’s Law, probably puts it best when he said “At best, news is the tardy recognition of forces that have already been at work for some time and is startling only to those unaware of the trend.”
Experts Denouncing the Foundational Support for “Random Walk” and Fundamental Analysis
The Random Walk Theory has been around for quite some time now. In fact, the October 10, 2008 publication of Fortune Magazine noted that “for two decades, finance professors have taught EMH as if it were as indisputable as the laws of gravity.” However, since that time, many experts have come out criticizing the basis behind the EMH.
In the Fall 1993 publication of the Review of Financial Economics, Stephen R. Cunningham - Professor in the Department of Economics at UCON, published his research, and I quote:
"Neither the Samuelson-Fama tests for efficient markets nor the popularly used augmented Dickey-Fuller 1979 test for unit roots can successfully discriminate between a fully deterministic time series, generated from a non-linear process, and a random walk. A researcher applying these methods to a simply nonlinear price process would be misled into believing that such a series is a random walk."
In the 1998 July/August issue of Bloomberg’s Personal Finance, James Rogers - Professor of Security Analysis at Columbia Business School, was quoted as saying: "The random walk theory is absurd."
Another example is registered in the October 23, 1987 issue of The Wall Street Journal, wherein Robert Schiller - Professor of Economics at Yale, was quoted as saying: "The efficient market hypothesis is the most remarkable error in the history of economic theory."
Finally, in a paper written by Profession Hernan Cortes Douglas, former Luksic Scholar at Harvard University, former Deputy Research Administrator at the World Bank, and former Senior Economist at the IMF, he noted the following regarding those engaged in “fundamental” analysis for predictive purposes:
“The historical data say that they cannot succeed; financial markets never collapse when things look bad. In fact, quite the contrary is true. Before contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons. Despite these failures, indeed despite repeating almost precisely those failures, economists have continued to pore over the same macroeconomic fundamentals for clues to the future. If the conventional macroeconomic approach is useless even in retrospect, if it cannot explain or understand an outcome when we know what it is, has it a prayer of doing so when the goal is assessing the future?”
However, when you ask any economist about the stock market as an indicator of economic health, it is almost unanimous in the claim that the stock market is a leading indicator. Yet, their focus remains lagging fundamental information!?!?
Although fundamental analysis is clearly widely used by economists and investors alike, we have to start taking an honest look at whether there is truly any predictive value in being able identify a change in circumstances within current economic conditions by reviewing current economic data.
Simply, from a logical perspective, it would seem that all these “analysts” are doing are making “predictions” of the current economic condition, which will work as long as the economy moves along in a straight line.
However, we know that the real world does not work in this way. In fact, as Professor Douglas so aptly put it, this methodology cannot succeed in in being able to assess the future.