Essentials of Equity Valuation: Technical Analysis and Fundamental Analysis

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Topic III. Essentials of Equity Valuation: Technical Analysis and Fundamental Analysis

The attempt to predict accurately the future course of stock prices and thus the appropriate time to buy or sell a stock must rank as one of the mankind's most persistent endeavors. This search for the golden egg has spawned a variety of methods ranging from the scientific to the occult. The core of the issue is related to how we measure the value of stocks. If we know the true value of the stock, we can predict whether the price of some stocks are too high or too low relative to the true value, and then make the correct decision on when to enter or exit the market, which is essential to trading profits or losses.

The two most basic methods of analyzing stock price are the technical analysis and fundamental analysis.

Part I. Technical Analysis

Technical analysis is the method of predicting the appropriate time to buy or sell a stock based on the historical experience of stock prices. The basic assumption of technical analysis is that history repeats itself, implying that past patterns of price behavior in individual stocks will tend to recur. Consequently, technical analysts seek to forecast stock prices by studying past trading activity, primarily price movements. Technical analysis is essentially conducted by making and interpreting stock charts. Technical analysts try to identify trends and major turning points. A trend develops as information is disseminated and more and more people recognize an opportunity. This is crowd behavior which, in extreme form, leads to euphoric bull markets and panic crashes. These patterns tend to recur in different markets at different times. The context and detail of this kind of behavioral pattern will vary from episode to episode, but the process is the same, and it can usually be recognized in some form.

Price charts tell us two things. Firstly, they tell us objectively what investors (especially big institutions) have been doing with their money on balance: buying, selling or holding. Secondly, they tell us something about what investors believe about the future, their hopes or fears about what they expect but cannot know for certain. This is the realm of technical analysis.

Some Funny Technical Analysis Cases

If we push the technical analysis to the extreme, sometimes we can get some ridiculous theories of price prediction.

Hemline Indicator -- "Bull markets and bare knees" theory

Check the hemlines of women's dresses in any given year and you will have an idea of the level of stock prices. There does seem to be a loose tendency for bull markets to be associated with bare knees, and depressed markets to be associated with bear markets