Today I’d like to discuss some nuances when taking trades and investing.
Some great investors swear by company fundamentals refusing to consider technicals and sometimes even macro conditions.
A great example of this is Warren Buffet. Other traders swear by technicals, refusing to look at fundamentals, and using a systematic approach, not allowing themselves to fight the tape, and following price action alone. One of the most successful of these was Richard Dennis.
Other traders trade macro, looking at factors such as the economy and interest rates. These include legends such as Stanley Druckenmiller and Ray Dalio.
Each of these approaches has positives and negatives and may be traded over different time frames. Traders should be careful to avoid the trap of confusing elements of each and switching timeframes and styles in the middle of a trade to avoid taking stop losses.
Most Investors who trade purely based on fundamentals have a very long timeframe. To quote Mr. Buffett, “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.“ They usually trade the business and the company rather than the stock, as might a technical or day trader. These traders often follow a similar strategy to Warren Buffet and are avid students of Benjamin Graham’s work. These include fund managers such as Seth Klarman.
Now traders who trade mainly fundamentals must have a very long timeframe for one simple reason. If the price of the stock goes down, that makes the value of the company or business even more attractive to these investors, all else being equal. Unless the fundamentals of the company, such as cash flows or competition changes, there is fundamentally no reason for these types of investors to sell, and in fact, they should buy more stock at attractive prices.
Some of the best trades of all time were based on fundamentals. And as a matter of fact this is how most pension funds are managed all over the world, investing in the best companies. However, when applied the wrong way, this strategy can lead to some large drawdowns and losses. Warren Buffet famously said, “You’ve got to be prepared when you buy a stock having them down 50 percent or more and be comfortable with it — as long as you’re comfortable with the holding.” In fact, his company Berkshire Hathaway has been down 50% 3 times.
Investors who hold stock for fundamentals need to be wary of 2 things: getting too big in one stock and not exiting when the fundamentals have changed. Because, as the price of a stock falls, the value of a company becomes more attractive, Investors should have a plan to add into any price disconnection beforehand to avoid getting too big in any one trade. This error can wipe out portfolios and trading accounts if the fundamentals of a company change.
Personally, I research company fundamentals and like to understand the business of the stock I am trading. Understanding the company and its sector adds conviction to the trades I take on a technical basis. Sometimes I too will take a trade purely on fundamentals, but I am always very careful with my position sizing. Personally, I prefer to use a hybrid approach of Fundamentals, Technicals, and Macro in my trading. The key is to understand the nuance of how to apply each method and be aware of which approach I am leaning on beforehand.
There are many traders who focus solely on technicals. Most of these are shorter timeframe traders. Their timeframe is much shorter than 10 years. Many intraday traders use solely technicals. The reason for this is because often there will be counterintuitive trading setups in a short timeframe. For example, a classic gap-fill setup may occur on a stock with great fundamental news. Some longer-term Investors use these liquidity events as an opportunity to trim positions and take profits.
In addition, with the move to computerized exchanges, there are now more quant funds than ever. Rocket scientists with Ph.D.’s and programmers run millions of simulations to develop purely technical trading strategies. Because these funds manage huge amounts of capital, their timeframe may be longer and may range from a few days or weeks to a few months or years.
I use technicals to help me identify the trend. Most of my trades are over a few days or weeks, so I use technicals to identify entries and exits but, most importantly, to manage risk. However, it is not enough for me to just look at a chart to take a trade. A simple crossover of averages is not enough for me to take a trade. I look at the fundamentals of the company, try to understand the market sentiment, and then use technicals to identify points of entry in setups I have seen work in the past.
Finally, some great fund managers trade macro. Sometimes this is used to trade currencies; a great example was when George Soros and Stanley Druckenmiller broke the Banks of England in the ’90s. Additionally, investors such as Ray Dalio use macro to trade market cycles. These traders are acutely aware of Central Bank Policy and how governments can affect GDP and growth. You see, company profits do not occur in a vacuum. In the medium to shorter term, they are affected by the business cycle.
This is why I listen to Fed policy and try to understand what is happening in the world. News and macro events help me come up with great trade Ideas. This is as important as ever, especially in a time when Central Banks play such a huge role in how the market is behaving.
There are many different styles, and setups traders and investors use. Some focus solely on fundamentals, others on technicals, and some on macro. These various styles have all been proven over time. However, they each have their nuances and are usually traded over different timeframes and holding periods. The key is to understand how these various styles work and not apply them in the wrong timeframe. I personally prefer a hybrid approach of all 3 styles and use it in my swing trading strategy, which usually plays out over a few weeks. For me, understanding the fundamentals of my stocks and the macro environment we are in aids in my decision-making when making entries and exits on a technical basis.