Pure stock market technicians ignore fundamentals.
To them, the chart tells the whole story, while the fundamentals are distracting
and misleading. Pure fundamental analysts, on the other hand, ignore price
action. Here's a method that synthesizes the best of both: converting a
fundamental variable -- the interest rate-adjusted earnings yield on the
Standard & Poor's 500 index -- into a technical indicator to maximize
risk-adjusted returns.
VALUATION
Most technicians view price relative to a derivative of price, such
as a moving average. The objective is either to identify a trend or identify
periods when the market is extremely overbought or oversold. However, all
of these approaches suffer from a common problem: Viewing price in a vacuum
may completely disconnect it from any underlying reality. This happened
during the Internet stock bubble of 2000, for example, when so many momentum
players rode the trend that it took on a life of its own.
The fault of many pure fundamentalists is the opposite: in an often
vain attempt to peg an "appropriate" valuation level on stocks,
they may buy or sell prematurely. For example, until 1959, the dividend
yield on the S&P 500 was an excellent gauge of market value. Whenever
the yield on the S&P 500 dropped below that of high-grade corporate
bonds, the stock market was overvalued and tended to fall. A profitable
strategy was to sell stocks when the dividend yield dropped below the bond
yield and buy when the dividend yield rose again.
In 1959, however, the dividend yield on the S&P 500 dropped below
that of corporate bonds and has been below it ever since. If you had exited
the S&P 500 in 1959, you would have underperformed the market by a
wide margin. Similarly, those who followed the dividend yield or the earnings
yield (one divided by the more familiar price-earnings ratio) would have
exited stocks somewhere in the early 1990s, missing out on the bulk of
one of the greatest bull markets in history.
CONSTANT FLUX
This doesn't mean fundamentals are useless, but traditional valuation
measures must be put in perspective. Fundamental analysts spend a great
deal of time trying to determine the appropriate level of the market. Their
method is based on the concept that when you buy a stock, you are purchasing
a claim on the future earnings of a company. Therefore, the price of a
stock should bear some relationship to the earnings of the underlying company.
In the same way, the price level of the index should be related in some
way to the aggregate earnings of the companies making up the index.
The problem, of course, is that investors change their minds frequently
and dramatically about how much they are willing to pay for a dollar of
earnings, past or present. They may do this for several reasons:
1. Concerns about the ability of the company to continue to generate
earnings in the future
2. Concerns about inflation (which will erode the present value
of a stream of future earnings)
3. Current interest rates, which will determine how much money you
could earn risk-free in Treasury bills or bonds, or
4. The risk premium assigned to stocks, or the amount of return
above the risk-free instruments to compensate for the increased risk of
owning stocks.
Figure 1: Earnings yield vs. 10-year Treasury bond yield (April 1953-March 2001). Earnings yield and the 10-year Treasury bond yield have tracked each other closely.
...Continued in the December 2001 issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the December
2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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