Technical vs Fundamental trading

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Let’s discuss some basic trading concepts.

I started out as a “technical” trader and then became more of a fundamental trader, and now I am a hybrid of the two, with a healthy dose of sentiment trading. After 15 years of doing this, I think I’ve found the right mix. But I will tell you what doesn’t work: starting at charts in a vacuum. At least, it didn’t for me.

You can have a solid base of knowledge about technical analysis, and find yourself in situations where you observe a “breakdown,” so you sell into it and the stock rips in your face and you cover your short, skulking off in the corner to lick your wounds. What happened? If you were ignorant of the fundamentals, like, maybe the company was a takeout candidate, then shame on you. But people do this, they trade on charts in a vacuum. This is partly how I got myself into trouble with Time Warner Cable.

Correspondingly, you can’t trade on fundamentals alone, either. Fundamental analysts tend to have this very narrow view of the world where they can determine the “fair value” for a security and the market will converge to it over time. The first hard lesson to learn is that there is no such thing as fair value, and the second hard lesson to learn is that even if there was, the market is going to take its time getting there, and your risk tolerance is path-dependent. Cheap things can get cheaper and rich things can get richer. So what is the silver bullet, if there is one?

Before we address that, first of all, you have to understand that the goal isn’t to buy things on the lows and sell them on the highs. The goal is actually to own them over the period of time that they go up the fastest. For example: if I buy a stock at 20, and it goes up to 100, I am happy. But what if it takes 5 years to go from 20 to 30, then goes from 30 to 90 in a few months, then takes another 5 years to go from 90 to 100? You bought the lows and sold the highs. But the rate of return calculation is entirely different than if you bought it at 30 and sold it at 90 a few months later, and then did something else with your money.

Very few people understand this. It took me 15 years to figure it out. I am that dumb. But it’s worth thinking about when you’re dumpster-diving for out-of-favor stocks, and you do the math on this distressed equity that it’s worth a lot more than the market is giving it credit for, so you buy it, and...nothing happens. For a long time. It doesn’t go down, but you’re tying up precious capital. That’s not a good situation to be in.

I think the most contemporary example is AA, which I bought last week (not enough). The stock was scudding around in the single digits for months. You could have bought it for 8 or 8.5 or 9 and it would have used up capital, until it finally moved, then--kablammo. Arguably, I waited too long. But now the stock is on the move. It’s not the speed, but the acceleration. 10 percent in just a few days.

So one question that people ask, especially in the hedge fund business, is, what’s the catalyst? And that is a reasonable question to ask. Why buy AA at 8? What is the catalyst? Are aluminum prices suddenly going to go up? Is there going to be a sudden demand for aluminum? As it turns out, there was a catalyst--the F-150, the most popular car in America, is going to be made out of aluminum, but the stock moved before you found out what the catalyst was, which is usually what happens. So when is the right time to get involved? When the stock moves.

So is the name of the game really to sit around all day and look for stocks that move? Well, it would be a gross oversimplification to say yes, but, sort of, yes. But it is part of the overall mosaic. Like, I like commodities for x, y, and z reasons. Do I buy commodity stocks the moment I decide I like commodities? No, because to do so would be pretty arrogant, to believe that the market just conforms to your expectations. You buying it doesn’t make it go up. Everyone buying it makes it go up. Back to Keynes and the beauty pageant. You want to be there when everyone else comes to the same conclusion at the same time.

It is okay to have an opinion that is different than the market. Like, I liked miners long before I started buying them, when they were out of favor. But I didn’t buy them when they were out of favor. I waited for them to start to come back into favor. I don’t always get this right, I’m just saying. The stock market is a pretty sophisticated psychological game that is essentially un-masterable and non-stationary (just when you get the hang of it, the rules change). But if anything, I hope this illustrates more than anything the sheer futility of getting into a fight with the market. Losses are inevitable. I don’t mind losing money so much, I just really hate being in a position where I am fighting it. It is the worst feeling in the world. Give up and come over to the winning side.