100 100 90 Portfolio KEY POINTS 80 80 70 70 PERFORMANCE 60 • Technical analysis is based on the 50 50 40 40 belief that the market is not efficient. 30 30 • Technical analysts use indicators that are independent of the company’s financial condition. Fundamental vs. Technical Analysis • Fundamental analysts focus on the Controversy between the two schools is still alive and well financial health of companies. BY CYNTHIA HARRINGTON, CFA momentum and reversal factors in all • Fundamental analysis chooses stocks of our own equity and bond models.” to buy; technical analysis chooses ometimes the truth of a matter Christopher Orndorff, CFA, man- when to buy for analysts who use both. isn’t so obvious. A South Ameri- aging principal, head of equity strategy, • Proponents of strong form efficient can historian once remarked Payden & Rygel, Los Angeles, Calif., market theory and technical analysts are that despite the rapid spread of USA, is also an unabashed member. S at opposite ends of the philosophical Catholicism among indigenous peoples “We use both technical and fundamen- spectrum. in the New World, people continued to tal analysis for both fixed income and celebrate the rituals that brought good equity,” he says. “Fundamental analysis weather, plentiful crops, and healthy really drives the decision of which lives. As the writer said, “Under every securities we want to own. But the tim- find the inefficiencies that technical Catholic altar in South America lurk ing of purchase and sale decisions is analysts look to find.” the pagan gods of the ages.” According split pretty evenly between technical “Sure, we bump into the contro- to some, technical analysis tools are and fundamental.” versy between the two schools,” says similarly hidden under stacks of finan- Like Sauer, Orndorff’s group at the Orndorff. “There are investors who cial statements in the desk drawers of US$40 billion asset and mutual fund adhere to the strong form of the efficient fundamental analysts. manager employs a couple of technical market and believe that all information “It’s an old Wall Street tale,” says indicators. “We try not to outsmart our- is reflected in the current price, and John Bollinger, CFA, CMT. “Fundamen- selves,” says Orndorff. “We use moving it’s impossible to make any above-aver- tal analysts would get their list of top averages, moving average crosses, and age returns. PROFESSIONAL PRACTICE stocks and, when no one was looking, oscillators. We believe that with just “We don’t think that’s entirely accu- would pull out their charts to decide these three factors we get 80 percent of rate. We think all markets are sometimes when to buy or sell. Yet most fundamen- the usefulness of technical analysis.” inefficient. People miss things. The tal analysts tend to think of technical Bollinger coined the term for the last couple of years are a great example, analysis as chicanery and charlatanism.” juncture of technical and fundamental both the up and down movements.” Bollinger runs the Manhattan Beach analysis almost 20 years ago. He calls it Technicians are also faced with a research and asset management firm “rational analysis.” “If you’ve got two new opponent — that of quantitative that bears his name. He is one of the toolboxes, one labeled ‘tools for red cars’ analysis. “The technical analysis com- 380 investment professionals who have and the other ‘tools for blue cars,’ what munity has split in the last 20 years straddled the subjects of fundamental would you do if you wanted to work with a great big piece cleaving off and and technical analysis and achieved both on a white car? The rational approach calling themselves quants,” says the designation of chartered financial would be to use the best tools from Bollinger. “If you go down the halls in analyst as well as chartered market tech- each box,” he says. “Rational analysis is big institutions today, you will find lots nician. The Market Technicians Associ- made up of the finest fundamental tools of doors labeled ‘quantitative analyst.’ ation administers the CMT designation. and the finest technical tools.” They’re getting highly paid, unlike “In general, I believe that funda- Not all professionals stand in the technical analysts. mental analysis has more value than middle where technical and fundamen- “They took a large body of knowl- technical analysis because it provides a tal analyses coexist, however. Adher- edge from the technical approach, made much deeper framework for valuing ents to one school of thought assume a it rigorous, fired it up with higher math stocks or bonds than just looking at much more warlike stance toward the and statistical power, and incorporated patterns in past price movements,” says other. “There are forces polarizing fun- parts of fundamental analysis. Some use Andreas Sauer, Ph.D., CFA, managing damental and technical analysts,” relative strength with ideas like alpha, director & CIO of UNION PanAgora in explains Bollinger. “The whole idea of earnings growth, and cash flow.” Frankfurt, Germany. the efficient market hypothesis is most Edward Best, CFA, managing direc- Sauer belongs to the community of often what fundamentals use to attack tor and senior analyst for Trusco Capi- fundamental analysts who readily admit technicals. If the market is efficient tal Management, Atlanta, Ga., USA, is the use of both sets of tools. “We employ after all, then there is no opportunity to one of those in the new camp. “We 36 CFA MAGAZINE JAN-FEB 2003 don’t use technical analysis, we use I believe that relying on one kind of technician is nothing more than a psy- quantitative,” says Best of the decision- information to find superior stocks or chologist looking to determine and making process for the US$47 billion bonds carries too much risk.” describe the mood of the market,” he under management for institutions and Researchers are looking for con- says. “In many cases, the behavioral the STI Classic Family of Mutual Funds. nections between the statistical rigor of finance practitioners cleaved off tech- “Technical analysis is related to stock the quantitative world and the potential nical analysis and renamed the work price and volume, things like charting of technical indicators. One study pub- they do. They just wrap the old in dif- price momentum. Quantitative is statis- lished in the Journal of Finance in August ferent wrapping paper.” tically based. We use excess return 2000 by Andrew Lo, Harry Mamaysky, While the controversy continues forecasting and fundamental indicators and Jiang Wang concluded that a bridge to grow, at least one person believes such as earnings, earnings trends esti- over the gulf between technical analysis that more fundamental analysts are mates, and growth rates.” and quantitative finance could be built checking their charts these days. “Lots Sauer admits to using technical on the smoothing technique of “non- of analysts are more cynical today. indicators but sets his work in the parametric kernel regression.” The sta- More are agreeing with the technical broader context of quantitative model- tistical method “identifies regularities analysts who say that financial num- ing. “In general, quantitative analysis is in time series of prices by extracting bers don’t mean a thing and the books based upon the idea that an investment nonlinear patterns from noisy data,” have always been cooked,” admits philosophy can be expressed as a statis- which expands on the otherwise linear Orndorff. tical model. A quant model may be data series in technical analysis. The “But to say that all they need to built on a variety of different sources of authors concluded that “traditional pick stocks and bonds is to see price information or factors to find underval- technical analysis can be improved by movements doesn’t seem to be enough ued securities,” he explains. using automated algorithms, and theirs either. That method is no different than “A pure ‘technical analyst’ is look- is one of many possible techniques.” trading wheat, corn, or cattle futures,” ing for specific price patterns in the (Joseph D.V. Vu, CFA, The CFA Digest, he says. “Most CFA charterholders past to predict the future and builds his February 2001) differ with that approach, or we did analysis solely on these factors. A quant Nor are the quants the only defec- all that studying for nothing.” usually relies on a more diversified set tors. Bollinger says the new field of Cynthia Harrington, CFA, is a financial of information. I’m a strong proponent behavioral finance broke away from the journalist with 20 years’ experience in of quantitative analysis based on a technical analysis fold as well. “Right at the investment business. diversified set of information because the heart of the matter is that a market TOOLS OF THE TRADE Technical Analysis Trading Rules and Indicators Fundamental Analysis Valuation Models and Factors Trend channels Dividend discount models Support and resistance levels Free cash flow models Moving average lines Residual income models Relative strength Price to earnings ratio Charting of prices and volume Price to book ratio Contrary opinion indicators Price to sales ratio Mutual fund cash positions Price to cash flow ratio Credit balance brokerage accounts Enterprise value to EBITDA Investment advisory opinions Dividend yield OTC versus NYSE volume Return on equity CBOE put/call ratio Operating and profit margins Traders bullish on stock index futures Asset turnover ratios Follow the smart money Leverage ratios Barron’s confidence index Earnings growth rates T-bill/euro spread Free cash flow growth rates Short sales by specialists Growth rates of dividends, cash flow, and earnings Breadth of market Risk free rate and risk premium Short interest Stocks above 200-day moving average Sources: Investment Analysis and Portfolio Management, Block uptick-downtick ratio 6th edition Analysis of Equity Investment: Valuation CFA MAGAZINE JAN-FEB 2003 37.