Fundamentals of trading, and basic principles of understanding the market
Many friends have asked me a rather simple question – where do I start?
Even though the question may sound simple, it is impossible to give one simple answer to it. Why is that? Because right from the start many other questions arise, like – Which viewpoint should I take to look at the market? How do I choose a financial instrument to trade? How do you understand when to buy and when to sell? In another words - what’s the logic of the process and is it possible to find a way to do it gradually, step-by-step? So, let’s dive into the matter and see if you can get a grasp of all this.
There are two basic approaches to the market: Technical Analysis (TA) and Fundamental Analysis (FA).
TECHNICAL ANALYSIS (TA) is a price analysis method for forecasting price trends by studying historical price data. Practitioners of this method use stock charts to identify patterns and trends that suggest what a stock will do in the future.
The basics of TA were first introduced by Charles Dow which now is known as “The Dow Theory". One of the most popular books on the TA is “Technical Analysis of Stock Trends” by Robert D. Edward and John Magee. Due its simplicity TA nowadays is widely criticized. A lot of fundamental analysts deny TA because it does not provide any deeper insight into the underlying asset. However, TA still is rather popular since it is "relatively simple" and quick to grasp. I will look at TA in more detail in the next blog post.
FUNDAMENTAL ANALYSIS (TA) is a valuation technique that attempts to understand the fair value of a security or financial instrument. Fundamental analysts study everything from general industry and economic conditions (from the macro-economic to the micro-economic) to the company's financial position and management. The aim is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued. As you can see, the FA is much more sophisticated. It covers a very wide spectrum, basically everything (top down).
To make it easier for you to grasp it, let’s start with an example. Something rather simple, without getting into detail at this stage of our learning process.
Let's have a look at the S&P 500 index. Simply because this index is considered a market benchmark for understanding the overall economy. Why? Because the correlation of this index with the general economy is obvious. For example, if we look at the percentage increase in the S&P 500 index from quarter to quarter and compare it with US GDP data for the same period, the correlation is very strong:
The same pattern is very clear when viewed period by year-over-year:
If we look at the S&P 500 quarterly data versus US real GDP data over the longer period of time, then we get the following correlation (92%):
Now that we understand that real economic data has a direct relationship to the S&P 500 index, we need to understand the key factors affecting GDP. Of course, GDP is affected by very, very, many factors, but there are several leading indicators by which GDP still can be predicted.
#1 INDICATOR. One of the most important factors is the ISM Manufacturing Index. The index is often referred to as the Purchasing Manager's Index (PMI). Based on a survey of purchasing managers at more than 300 manufacturing firms by the Institute for Supply Management (ISM), the index monitors changes in production levels from month to month. The index is the core of the ISM Manufacturing Report.
Here you can see the correlation between ISM and GDP:
There is also an obvious correlation here. A PMI Index of more than 50 indicates the expansion of the manufacturing segment in comparison with the previous month. A reading of 50 indicates no change. A reading below 50 suggests a contraction of the manufacturing sector. This gives us the following guidance - if the PMI index is up, stocks will also grow. If the data tends to fall and fall below 50, the stock index will fall as well.
#2 INDICATOR. The service sector or Non-manufacturing economy index is also important. The Non-Manufacturing ISM Report On Business® is based on data compiled from purchasing and supply executives nationwide. Survey responses reflect the change, if any, in the current month compared to the previous month. For each of the indicators measured (Business Activity, New Orders, Backlog of Orders, New Export Orders, Inventory Change, Inventory Sentiment, Imports, Prices, Employment and Supplier Deliveries) this report shows the percentage reporting each response, and the diffusion index. An index reading above 50 percent indicates that the non-manufacturing economy inthat index is generally expanding; below 50 percent indicates that it is generally declining.
As you can see, the correlation between both sectors is very similar:
#3 INDICATOR. The third indicator we will look at is The Consumer Sentiment Index.
According to The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100. Each month at least 500 telephone interviews are conducted of a contiguous United States sample. Fifty core questions are asked.
Consumer sentiment is an economic indicator that measures how optimistic consumers feel about their finances and the state of the economy. In the U.S., consumer spending makes up a majority of economic output as measured by Gross Domestic Product (GDP). As much as 70 percent of GDP is driven by a consumer spending component, so the sentiment or attitude of consumers goes a long way in gauging the health of the economy. If people are confident about the future they are likely to shop more, boosting the economy. In contrast, when consumers are uncertain about what lies ahead, they tend to save money and make fewer discretionary purchases. Consumer sentiment indexes are lagging indicators because it takes people several months to notice and feel the effect of changes in economic activity.
As you can see, the correlation here with S&P 500 persists as well:
So, what can we get from knowing these three indicators?
Before you start any trading you need to get understanding of common trends and market sentiment. You need to understand how economic cycles work. For example, if a friend tells you that it is time to invest in the stock market, but both the manufacturing and the service sectors show "weak data" and a downward trend, you should not invest. And vice versa.
I always look at the FA data first and then check my assumptions using TA. Even though FA data might look promising, if the TA shows the opposite, I do not proceed with an action.
Always look at the trends and these indicators before jumping on any action. Don’t get easily influenced by the news or any type of media. All the time you’ll see some unreasonably optimistic or negative messages or narratives that may influence your current state of emotions. Nevertheless, always check the data yourself. If you are aware of the leading indicators, then over time you’ll start to realize that a great deal of news is just a "noise".
So, before I’ll dive in my approach with combining FA and TA analysis, I’ll write one blog post on each topic, so you can come back and read that whenever you feel you might need to.