A Fundamental Lesson For The Technically Minded by Matt Blackman
For decades, there have been two major schools of thought when it comes to stocks. First came the fundamental analysts, who believe that stock prices are a product of revenues and earnings. Then came the technicians, who believe that all they need to know is contained in stock charts. Here, we look at how the two methodologies come together.
Like many investors, I began to play the markets believing that if you found companies with strong balance sheets, a good product, and strong management team, you would make money. But one challenge quickly became evident: Earnings lagged stock prices most of the time. When the economy slowed down, earnings often gave little or no warning before stock prices fell. Relying on balance sheets to determine trade entries & exits tended to get you in well after the move was over and out too late to avoid the pain.
DO FUNDAMENTALS REALLY MATTER?
An article on the Wall Street Rant blog titled “Is This Bull Market Fundamentally Driven?” sought to help answer this question. “Fundamentally driven bull markets should rely more on cyclically adjusted earnings growth and less on investors’ willingness to pay ever-increasing multiples on those earnings,” the author posited.
But do they? To explore this question in detail, I used the cyclically adjusted price/earnings (PE) ratio data from Robert Shiller’s website. He separated out bull markets that experienced at least 100% gains without a 20% correction between 1930 and the present and then ordered these markets from the most strongly earnings-driven to the weakest using the ratio of price gains divided by the expansion in the PE multiples. Bulls showing the smallest PE expansions (that enjoyed the greatest earnings growth) were considered the most fundamentally driven. I show his results in the table in Figure 1.