Caterpillar, Aluminum Corp. Offer Perspective on Technical vs. Fundamental Investing

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Includes: ACH, CAT
by: Ricard

I recently emailed one of my relatives some investment advice, and noticed that my reply was actually something I’d post on a blog. So, with some editing, here’s a perspective on technical vs. fundamental investing for your perusal. First, it may help you to understand my philosophy on 'trend investing' before I explain my position on the market.

Trend - this to me is a contrarian indicator (if you even bother with it). One popular metric is the 200 day moving average, which turns the choppiness of an index (say, the S&P 500) into a smooth 'average' curve. If that curve ever is passed by the underlying index, then it is said to have 'broken resistance'. What does this really mean? In order for the index to pass the curve, the index would have to have already made a very large move in one direction (let's say, up) contrary to the direction of the 200 day moving average (which, let's say, is moving down).

What I just described is exactly what's happened since March. This popular 'trend line' has just informed the general public that a rally may have started. In my opinion, it has really just indicated that a rally that began in March has gotten a little long in the tooth because whatever movement in the index that caused the trend line to 'break resistance' was probably already significant, and has probably already priced in whatever fundamental factors caused the move in the first place. I've read a lot of technical analysis recently that has essentially said that despite breaking resistance, they are strangely enough advising caution, and they can't explain why through their models.

What is interesting about the trend line is that in March, the trend line was down, way down. In April of 2000, it was up, the sky's the limit. Right now, the trend line is again up, and it has just broken resistance (meaning that the underlying index has surpassed the trend line in upward movement). As you can see from my first two examples, the right move to make was to do exactly the opposite of the trend. That alone is enough to make me cautious going forward. Of course, you could argue that the index broke resistance sometime in 1998, and didn't look back until 2000, so if you started buying in 1999 you would have had a good year of stellar gains. No one really knows what the market is going to do in the short term.

Stocks were dirt cheap in October-March based on fundamental factors. How couldn't they be? They had just plummeted anywhere from 50-90% from a year earlier, and the real fundamental problems were confined to the housing and financial sectors. Aluminum Corp. of China (ACH) below 20 was a steal to me, and indeed that was when I started buying. Had I succumbed to the trend, I probably would have sold when it fell below 10, but I knew the underlying fundamentals for that company (China is essentially guaranteeing that domestic natural resource producers will succeed, hell or high water, among other factors) were too good to ignore, so I continued buying. Now, in hindsight, even though I was kicking myself when ACH dropped below 10, it's now priced at 30. Even my initial purchases at 20 have proven profitable, to say nothing about my purchases below 10. Of course, now I am kicking myself again for not betting the farm when ACH was at 10. Jeremy Grantham's 'Curse of the Value Investor' immediately comes to mind.

In this sense, getting a handle of the fundamentals of a company will prove much more advantageous than simply measuring trend. This is Warren Buffett's mantra, which he tries to convey through folksy fairy tales. Fundamentals would also prevent you from buying, say, AIG or Bear Stearns as they were plummeting.

So what about the fundamentals now? Well, Caterpillar’s (NYSE:CAT) recent story certainly points towards a trend upward. But, fundamentally speaking, all other things being the same, as a stock moves upward, it actually becomes a less desirable investment - basically, you are paying more for the same amount of earning power. The key is to see why it is moving upward, and for CAT, the reason was that the company was approaching a nadir in earnings. That's right, the company had reported a massive drop in earnings, and because they thought that earnings would get even worse next quarter before they get better after 2009, the company promptly went up 60%. Such is Wall Street logic. Call this forward thinking if you will.

So, before I get lost in macro-babble, my bottom line on trend investing is 'there is no spoon'. You can follow trend if you want, or not. You can do just as well with it as without. But, you cannot lose sight of the fundamentals. If you do, you'll buy in April 2000, or sell in March 2009. If you can prevent mistakes like these and just eat ice cream and drink beer for the rest of the time, you'll do all right in the end.

My bottom line on fundamentals is that they generally looked a lot better in March than they do now. Invest with caution.

Disclosure: I still own the vast majority of my initial investment in ACH, but have hedged nearly my entire position through options going into the winter. I am still kicking myself for spotting CAT's 5% yield the day before their earnings announcement - too late for me to do my due diligence before it shot up 60%.