Monday, March 7, 2011

Why technical trading vs. value investing

ahhhh yes... the big question.... why trade based on moving averages, support & resistance levels, and patterns versus good old stock picking based on good balance sheets and strong cashflows??  This is an age old question and battle of the two camps.

I can't answer for everyone, but I can share my point of view.

Value investing is based on using financial metrics of a company, like cashflow ratios, leverage ratios, and stuff like quality of management.  Plug numbers into a stock growth and valuation model and you should get the "value" of the company.  If the value is higher than what the stock is trading for, then buy it, you are now a value investor.  So if based on your model AAPL is "valued" at $400/share and trading at $350/share, you should buy it.  And eventually the market will realize its value and it will trade up to where you thought its value should be!

But what about in between?  What if it goes to $300 in the meanwhile?  And how long will it take for the market to realize that maybe AAPL is a greater "value" than $350 and start trading it up?  This is the reason why value investors give themselves such a long investment time - Warren Buffers' is Forever!

Value investing is based on trusting the company's numbers and trusting that they are not using any kind of financial manipulation to artificially show income or growth, but this happens more often than you think.... and legally too.  And when they take this financial trickery too far they may get caught by the SEC, but this is too late.... by the time you hear about it, the stock has already plunged.  The most notorious case is the famous trickeries of ENRON!  

My last post was recommending the book [Swindlers] Cons & Cheats and How to Protect Your Investment From Them which talks more about this.

So companies' numbers are hard to trust, and I've already discussed in my previous posts how equity analysts are actually working against the public interest..... add to this the manipulation going on by other big market participants and high frequency trading algorithms and you have a market unfit for INVESTING.

Now trading based on technicals is meant to be shorter term, and actually based on signals from the market, based on demand and supply at each price level.  I can give you a simple example for how I see the difference between them:

A person with a major migraine goes to the doctor to be cured, the doctor asks questions like: what are your other symptoms?  What did you have to eat?  Did you take drugs?  Now the patient may tell the truth about the first two, but hide the fact that he just done enough coke to put down an elephant.  The doctor has incomplete information, or even wrong information to treat the person.  But then the doctor takes some blood and measures the heart rate.  Now the heart rate is high and the blood test shows possible drugs in the system.  The doctor can make a decision based on facts, not statements.

In this example, the patient lies, but the facts state with a high probability (notice I didn't say definitely), what may be wrong with the person.  Similarly, when traders go in and out of the market, they leave footprints revealed in technical analysis.  (More on this later)

Technical trading is based on reading these different clues as to what may be going on with a stock or the market in general..... learn to read technicals even if you are a value investor.