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Who remembers when fundamental analysis was considered the only real or proper way to make trading decisions? When I started trading in 1978, technical analysis was used by only a handful of traders, who were considered by the rest of the market community to be, at the very least, crazy. As difficult as it is to believe now, it wasn’t very long ago when Wall Street and most of the major funds and financial institutions thought that technical analysis was some form of mystical hocus-pocus.
Now, of course, just the opposite is true. Almost all experienced traders use some form of technical analysis to help them formulate their trading strategies. Except for some small, isolated pockets in the academic community, the “purely” fundamental analyst is virtually extinct. What caused this dramatic shift in perspective?
I’m sure it’s no surprise to anyone that the answer to this question is very simple: Money! The problem with making trading decisions from a strictly fundamental perspective is the inherent difficulty of making money consistently using this approach.
For those of you who may not be familiar with fundamental analysis, let me explain. Fundamental analysis attempts to take into consideration all the variables that could affect the relative balance or imbalance between the supply of and the possible demand for any particular stock, commodity, or financial instrument. Using primarily mathematical models that weigh the significance of a variety of factors (interest rates, balance sheets, weather patterns, and numerous others), the analyst projects what the price should be at some point in the future.
The problem with these models is that they rarely, if ever, factor in other traders as variables. People, expressing their beliefs and expectations about the future, make prices move—not models. The fact that a model makes a logical and reasonable projection based on all the relevant variables is not of much value if the traders who are responsible for most of the trading volume are not aware of the model or don’t believe in it.
As a matter of fact, many traders, especially those on the floors of the futures exchanges who have the ability to move prices very dramatically in one direction or the other, usually don’t have the slightest concept of the fundamental supply and demand factors that are supposed to affect prices. Furthermore, at any given moment, much of their trading activity is prompted by a response to emotional factors that are completely outside the parameters of the fundamental model. In other words, the people who trade (and consequently move prices) don’t always act in a rational manner.
Ultimately, the fundamental analyst could find that a prediction about where prices should be at some point in the future is correct. But in the meantime, price movement could be so volatile that it would be very difficult, if not impossible, to stay in a trade in order to realize the objective.