Trading Price Action Instead of Fundamentals

Trading Price Action Instead of Fundamentals

“When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you?” – Paul Tudor Jones

“Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements.” Definition courtesy of

Technical Analysis is the examination of the current and past behavior of the participants that are buying and selling a particular financial market based on price action. The goal is to find patterns in price action that can be profited from.

Twenty plus years ago my father-in-law bought a used truck that he wanted to flip for a quick profit. He looked at the mileage on the odometer, the condition it was in, its make, model, age, and the fact that it was a stick shift and decided on a price that it should be worth based on all these fundamental factors. I thought his price was very high because there were plenty of used trucks in the world and not a lot of buyers looking for his particular truck. He asked me what I thought the real value of the truck was as he wanted me to confirm his decision to buy it. I thought about it and told him I thought the value of the truck was exactly what he could get someone to pay him for it. The value would be established as offers to buy the truck came in versus his initial sell price. The suggested value for the truck he would find in books were only a fundamental valuation, the publisher of Kelley Blue Book was not offering to buy his truck they were giving a guideline. The true technical value would actually be set by the first person with cash offering to buy his truck. Values are based on buyers and sellers not opinions or fundamental valuations. Prices can move so far away from fundamentals that they are useless. Needless to say, my thoughts about technical price action versus the belief of value did not go over great with my 50 something year old father-in-law and former drill sergeant. This was not the answer he was looking for and it made him slightly angry that a young kid would question his wisdom on buying a depreciating asset as an “investment”. He is not unlike the millions of fundamentalist investors in the financial markets who get angry when price does not match their beliefs about value.

This story reminds me of fundamentalist investors that buy companies based on what they should be worth but cannot make money off their investment portfolio during bear markets and down trends. Investors become frustrated as they purchase a great company at a great price and then the price drops 50% for no fundamental reason that they can understand. This book is about trading price action instead of investing in a company based on its balance sheet and stock price versus its book value. The concepts in this book will show you how to create actual trading plans for buying high probability set ups, trading on the right side of a trend, and exiting with a profit without having to look at any fundamental valuations. This is a book for traders that want to profit from price action not for investors wanting to buy a company that is undervalued for the hope that one day the true value will be priced in. There are trading systems that incorporate fundamental valuations like price-to-earnings ratios, return on equity, sales growth, and other metrics that create their watch lists based on fundamentals but still trade this watch list based on technical price action, a trading system, or chart patterns. Even if you can find the best value stocks or growth stocks to trade you still can’t profit unless you buy them and sell at the right time.

Inside the investing world this book will seem like blasphemy. Let price guide your decisions on buying and selling? This is madness. Regardless of what anyone believes a company is worth, the company and the stock are two different things entirely. The company is a corporate entity with a profit and loss statement that is charged with making profits for share holders and to make Wall Street happy with earnings guidance and then beating those earnings. Businesses must create earnings by selling its goods to customers in a way efficient enough through the control of expenses to make money. Corporate profits end up on the company’s balance sheet and can be used to reinvest in the company through capital expenditures or to pay a dividend to share holders of the company’s stock.

The company’s stock on the other hand is a different matter entirely. A company’s stock trades on an exchange and the buyers and sellers of that stock determine its price by what they are willing to pay for it. In my experience in the markets very little buying and selling is done based purely off fundamental valuations. Most market action is based on a trader’s or investor’s emotions of fear, greed, beliefs, or predictions. Every buyer and seller has a different motivation for buying or selling. The only rational reason that anyone ever buys a stock is simply because they think that the stock is going to go up in price and they will make money. Even when short sellers buy a stock back to cover their short position it is because they want to lock in their profits because the stock is likely to go higher. While there is only one reason to buy a stock, people will sell a stock they hold for many different reasons:

1. They need the cash.
2. They see a better investment or trade.
3. They are fearful that the price will go down.
4. A mutual fund manager has to sell his holdings to raise cash.
5. They believe the future of the company is not going to be good.
6. They are fearful about the economy.
7. They believe a new technology will disrupt the company.
8. Something on the daily news.
9. A popular rumor that is causing the stock to drop.
10. They are nearing retirement and changing their portfolio balance to more bonds.
11. They are rebalancing their portfolio by selling positions that have gotten too big.
12. The shares are inherited and the heir prefers cash.

All these reasons are real and happen all the time. None of them required a balance sheet or a price to earnings ratio. The markets are more driven off the decisions of the holders of assets than fundamental valuations. The buyers and sellers on stock exchanges can be value investors, high frequency traders, trend followers, day traders, swing traders, growth investors, mutual fund managers, or hedge fund managers. All the market participants have one motivation: to make money. Again, always remember: While there are many reasons to sell a stock there is really only one rational reason to buy a stock: because the buyer believes it will go up in value and they can sell it for a profit in the future. The ‘future’ can be different things to different people. For Warren Buffett the future may be ‘never’ and for a day trader it could be in 30 minutes.

The only thing that makes stock market participants money is exiting a position with a profit after price moves in their favor. Stock prices are driven by the specific supply and demand of their stock, not directly buy the underlying company’s results. It’s the perception of the company’s current and future results that interests buyers and sellers that are holding its stock or thinking about purchasing it. A company’s stock price has to go through the filter of all the market participants’ perceptions, opinions, and predictions about what the current price should be and what the future price will be. How all these participants’ actions can be determined by a company’s balance sheet in real time and filtered through all their emotions and beliefs is beyond me. Fundamental analysis is a very long term game that can last for years. Warren Buffett’s genius and success as the greatest investor of all time is not based on simple fundamental value investing. I believe the real key to Mr. Buffett’s amazing record and success is based on his own genius for creating the best margin of safety on his purchases, picking the right ones the majority of the time, holding a concentrated portfolio of only his best picks, his holding time is forever, and he compounded his returns for decades. The biggest key to his success was acquiring Berkshire Hathaway the textile company that was initially a textile company and converting it into primarily an insurance holding company and using the insurance premiums to acquire whole companies that have great cash flow. Warren Buffet’s watch list is for companies with great recurring cash flow, with ‘moats’ around their business models that make it difficult for competition to enter their industry. He can wait for years for the price he wants. Buffet’s buy signals are triggered in times of extreme fear where he can buy the stock at a huge discount to book value of what the underlying company should actually be worth that creates a huge margin of safety that limits the downside risk even if he’s wrong. His risk/reward ratio creates a huge upside potential gain if right and the stock returns to a price that better reflects the real fundamental value of the company. His sell signal is usually never. However Warren Buffett will at times exit his holdings when the upside is no longer as favorable as when he entered and business conditions have changed.

Very few people will have the patience, discipline, genius, and luck to be anything like Warren Buffet. However most people can trade simple price action trading systems on a timeframe they are comfortable with if they use position sizing they can emotionally deal with to beat the majority of other traders and investors along with the market itself.

Fundamentalists can have long losing streaks. Investors tend to have much bigger drawdowns in capital and can give back years of returns very quickly during bear markets and financial crises. A good trader will have very tight controls over losses, risk exposure, and drawdowns in their capital. Conservative buy and hold investors dealt with much more pain over the past 15 years than most traders did with the 2000-2002 bear market and the 2008-2009 financial crises. Buy and hold investors generally operate with their buy signals being on every pay day with a new contribution into their retirement account. Young buy and hold investors buy signals are all day, every day. Buy and holders sell signals are primarily at two times: when they are rebalancing their portfolios once a quarter or annually where they sell their winning positions that have grown and use the capital to buy positions that have not kept up like bonds our other equity sectors. The other time buy and holders start selling positions is when they get closer to retirement as they start to move their portfolios from stocks into more bonds to lower risk and keep returns more stable as they begin to need portfolio income. Buy and holders expose themselves to unlimited risk with no stops because their investing system is based in the belief that stocks will have good returns in the majority of ten year periods. This system seems to be more for the benefit of the mutual fund industry than investors. We will look into some simple trend following systems that easily outperform buy and hold investing with half the drawdowns later in this book.

Two simple examples that show the disconnect between fundamental valuations and stock prices is the internet bubble of 1999 through March of 2000 before the price plunge of the tech sector brought it back to reality. The NASDAQ 5000 was purely an irrational price trend based on the hope of the internet changing the world and commerce as we know it, and it did, but prices were about 15 years ahead of the fundamentals in even the best companies of the time. Most of the dot com companies were worthless but made millionaires out of traders that traded them based strictly off price action and exited with their profits when prices stopped going up. The other examples of a complete disconnect between fundamentals and price action was the market meltdown of 2008-2009. Was Ford Motor Company really worth $1? If Ford was worth $1 fundamentally at the time and then went up to almost $19 did the balance sheet reflect this? I was warning friends not to buy Ford all the way from the $9 price level as it kept falling. I did not examine the balance sheet but the chart was in a down trend. Investors and traders were pricing in a possible bankruptcy of Ford. Was CitiGroup really fundamentally valued at .97 cents in March 2009? Can investors price in government bail outs with their fundamentals? A price action trader would have had signals to exit the financial sector way before Lehman Brothers, Bear Stearns, and the whole financial sector started going down. Most fundamental investors lost a lot of money in 2008 with no real exit strategy from individual stocks or the stock market as the impossible happened and a decade of gains were wiped out for investors that simply buy and hold. The biggest problem I have with fundamental investors is that when they buy something and believe in what it should be worth it looks like even a better deal when the price goes lower and lower. It is also difficult for fundamental investors to know when to exit an investment. While buy and hold investors in 2015 feel really smart for holding through 2008-2009 and getting back to even the investors that were near retirement and had sizable accounts from a lifetime of compounding did not feel as clever holding through the 2001-2002 meltdown or when they were down 50% of their portfolio in March of 2009. A good trader controlling their risk and position sizing will very likely never have to suffer through anything like the drawdowns that investors take during corrections and bear markets. As traders we have exit signals that limit our losses. I had a profitable year in 2008 by following price action. A 50% drawdown in a brokerage account will break most people from ever wanting to trade or invest again, it must be avoided for the financial, mental, emotional pain, and stress it causes.

Now I admit that there are a ton of legendary fundamental investors and fund managers out there, but there are also wealthy technicians that simply and systematically trade price action. I believe that the greatest opportunities for retail traders and small investors lie in the ability to just let all the big investors and majority of other market participants place their bets based on their analysis, beliefs, market narratives, opinions, and predictions and simply analyze what they are doing and follow along. I have been doing this in some form or another in my personal accounts for over 20 years and it works. You don’t have to predict the trend you just have to find ways to ride the wave in the right direction.

There are systematic ways to create buy and sell signals to outperform the market’s returns. Even a simple trend filter can reduce your losses during corrections and bear markets dramatically. Regardless of how active you want to be in the stock market this book can help you. Even fundamentalist investors would do better if they let the fundamentals tell them what to buy and the price action and chart tell them when to get in and when to get out.

“I always laugh at people who say, I’ve never met a rich technician. I love that! It is such an arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician.” – Marty Schwartz

This is the first chapter of my book Buy Signals, Sell Signals. 

Trading Price Action Instead of Fundamentals