Technical analysis and value investing are two of investing's most powerful strategies, yet their fundamental beliefs contradict each other.
John Murphy defines the basis of technical analysis in Technical Analysis of the Financial Markets:
"There are three premises on which the technical approach is based:
1. Market action discounts everything.
2. Prices move in trends.
3. History repeats itself."
Value investing is defined by Morningstar.com in a description of Benjamin Graham's The Intelligent Investor:
"Value investors seek to purchase assets at prices that are substantially below the assets' true, or intrinsic, value."
I thought that here, at their definitions, I would find the basic conflict. Below I will identify the source of conflict and address it.
The second tenet of technical analysis can be dismissed. Its truth is dependent upon an assessment of the Random Walk Hypothesis, which contradicts it. I will leave this question unresolved, because for everyday purposes, we can look at a price chart and see trends. Trends are an applicable tool of technical analysis, and do not conflict with value investing. This is because nothing about trends precludes prices from moving in certain ways. If anything, prices would trend towards their intrinsic values.
The third tenet is almost universally agreed upon. Human nature has not changed drastically over the centuries. This sentiment is even more recognizable as phrased by philosopher George Santayana: "Those who cannot remember the past are condemned to repeat it." Again, this universal idea is not contradictory to value investing.
The first tenet of technical analysis directly counters the definition of value investing. If the market discounts all information in its price, then value investing should be fruitless. The company's intrinsic value and its stock price should be identical. This, however, seems laughable in light of the success of Benjamin Graham and Warren Buffett. Thus we are left with a choice: value investing, or technical analysis?
By a modification of the first tenet, the two philosophies can be logically reconciled, paving the way for a new approach that combines the best of both.
If the market is made up of individual actors, then market action is the composite opinion of the investing community. When Murphy says that this action "discounts everything," we generally hold that he means the following: "market action reflects a rationally derived consensus about intrinsic value given all currently available information." The crux and the failure of this statement are in the word rationally. As evidenced by the rise of behavioral finance, market actors are not universally or consistently rational. If rationality prevailed, crises would only apply to governments and bubbles would only be found in bathtubs. The evidence that people are not rational is too voluminous to count. What, then, does market action discount?
Market action discounts everything as perceived by market actors. By adding the second clause, the confusion surrounding technical analysis is largely addressed. Proponents say that technical analysis is nothing more than applied social psychology; a view recognized by the word perceived. Detractors attack the first claim of technical analysis: that the market is rational and efficient. Although the Efficient Market Hypothesis (EMH) has lost the luster it had at the University of Chicago in the 1990s, this modified first tenet no longer implies the EMH. Instead, it allows for inefficiencies due to wavering market perceptions. Thus technical analysis and value investing can work together both logically and practically. A combined strategy gets the best of both approaches by looking for stocks priced below their intrinsic values with technical evidence that the market's perception of their fundamentals is turning.
Despite having its headquarters in Las Vegas, American Pacific Corporation (NASDAQ:APFC) is the opposite of glamorous. It has been manufacturing chemicals since 1955. In 2008, I unfortunately bought shares from another trader also standing on the edge of the precipice. Like everything else, it took a nosedive that fall. A year later I rediscovered it. In this post, I make a case for American Pacific based on the synthesis outlined above. The business was boring, but it produced solid free cash flow and the balance sheet was stable. Meanwhile, it traded at $4 per share, a support point that had been tested and had held about once every five years since 1988. The probability that it would hold a sixth time was very high, and the fundamentals did not present any reason that it would not. I bought in, and the thesis worked. I ended up selling far too soon, but that is the subject of another article.
Running a screen based on this article in Fortune Magazine, I found another company that currently fit this mold well. John Deere & Co (NYSE:DE) has all the signs of a successful long-term company: industry-beating margins and returns on equity and assets, sustained high revenue and earnings growth, and a solid balance sheet. Within the framework of these solid fundamentals, Deere is in the middle of a very bullish chart pattern.
The share price has slid into a triangular holding pattern after a solid uptrend that brought the stock back to its all-time high. As is traditionally the case, this pattern is accompanied by declining volume as shown at the bottom of the graph. It indicates an outsized chance of an upside breakout.
In the coming weeks I will publish a more detailed explanation of this strategy as well as more stocks that it recommends right now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: My portfolio is fully invested. This is the only reason I am not looking to buy shares of John Deere & Co.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.