Value-based investment and technical analysis

It is only a few decades since the idea of passive index investment was realized in Vanguard's

first equity fund

. For the first ten years, few listed the fund, whose controversial name was finally approved by the practical reason that it was thus sorted by the parent company Wellington.

Anonymity was perhaps not so surprising given the extremely negative conditions with high inflation and volatile and weak stock markets that prevailed in the mid-70s.

When the stock markets picked up after Business Week's historic face "Death Of Equities" in August 1979, index investments eventually became recognized and other managers began copying the concept in the mid-80s.

About 40 years ago, and today, passive investments with as low fees as possible are more popular than ever. There are, among other things, index funds, index ETFs, industry ETFs, as well as momentum funds and technical analysts, who also completely disregard the underlying value of the companies whose shares are traded.

Sooner or later someone else's problem becomes yours

The theory behind non-value-based investment is that "someone else", e.g. the "market" is assumed to do the valuation and that it is not an idea to either reinvent the wheel or try to do a better job than these supposed super pros.

In short, it can be said that technical analysis is based on the idea that fundamental value-based investment means too much, too difficult and too hard-competitive work with too little hourly compensation to be worth it.

Technical analysis hopes for the whole result and none of the job

The TA people ignore, among other things, two important factors. Firstly, if too few do a proper analysis then the courses can move very far from their motivated value and partly that the competition is harder in TA because there are many more who are doing it. Thus, it should be both more difficult to sustainably make money from technical analysis and make you subject to the risk of sudden non-linear corrections from unjustified peaks or bottoms – e.g. as in the IT sector after the year 2000 or story stocks, where the story of the company over a period gained priority over the cash flow statement.

However, there are advantages also with technical analysis, e.g. that it can make you follow all the way up, even during a manic final phase of a bubble, which a pure value investor never does.

In a few years' time, economies, group psychology and financial markets are often procyclical, which is just a nice way of saying that they are moving in self-reinforcing trends.

As a result of rising share prices, both existing and potential shareholders must be confirmed in the right to buy the share. This means that courses that are rising continue to rise, as long as nothing very clearly negative occurs. Good and cheap companies first rise to a reasonable valuation and then become expensive and then even more expensive. Both individual shares and entire markets are therefore periodically overvalued (and mirrored sometimes undervalued, but more rarely because there are value investors ready to pick up all shares whose value justifies the risk of total collapse). Passive investors and technical analysts can float all the way up to an overvaluation without restrictions in the form of "not justified".

Another advantage is that the self-reinforcing trends created by passive investors have a shorter phase, and are thus better suited to a normal person's perception of time. Different forms of non-value trends are up to a few years long, while the best correlation between valuation and return on the US stock market is measured in twelve years ahead.

Oddly enough, some still think that it is easier to buy and keep their shares in an entire lifetime rock and roller coaster, than to make re-sorts of just over a decade's view based on the valuation level.

Three investment strategies

Three of the most effective investment strategies take into account both trends, cycles and valuation:

Monthly savings in shares

Firstly, one can passively invest in monthly savings in a broad global stock index and hope that most of the investments will not be made during an overly expensive 20-year period. In this way, you spend minimal time and resources on something you do not yet have the ability to do. This strategy allows you to get the same return as everyone else but without effort.

Asset Class Allocation

Secondly, one can save monthly in a basket with different asset types, e.g. shares, gold, real estate, raw materials and interest rate instruments, but with the addition of folding the parts differently according to predetermined rules. You can adjust to the same weight for each piece at the end of each year. Or, one can slightly more aggressively fold to overweight for shares if the share bit has fallen for two consecutive years, because two-year decline is usually excessively negative and emotionally controlled, and then often soon leads to a larger upturn.

Value-based index weighting

Third, you can own a maximum of shares (even more than 100% if you are comfortable with it) when a certain historically reliable valuation measure is unusually low, and minimal when the valuation is unusually high. For example, one makes a moving adjustment on the road between the extremes so that one has normal weight when the market's valuation is historically normal. This strategy can lead to many years in a row with poor returns on the way up to euphoric peaks and down to depressive bottoms. You rarely get to be happy and the waiting times are long. In return, the volatility is lower and the total return is at least as good as the other strategies.

Very few can handle the third strategy, i.e. pure value-based investment. It is easy to give up in exactly the wrong location, or for that matter to place too aggressively close bottoms and tops when the strategy screams too early that one should go short or borrow the portfolio to the max.

Fundamental and technical combination

However, there is a compromise, which works both in practice and has a sound theoretical base without requiring too much time and resources by the user. Warning that it can still be experienced as a little uncomfortable for a purely fundamentalist.

1.         Start by noting whether the stock exchange as a whole is expensive or cheap given a few parameters such as the market price per share / book value per share to measure the market’s valuation of a company relative to its book value. Market price per share / Sales per share to value a company with little or no profit. Stock market capitalization / Gross domestic product to determine whether an overall market is undervalued or overvalued compared to a historical average. Market value per share / Earnings per share to anticipate high growth in the future as long as the P/E ratio is high. Or any other ratio can be used.

2.         Then estimate the degree of one-sidedness in the market sentiment, e.g. based on the trend for moving averages, or if few or many shares and industries move in the same direction and put new peaks or bottoms. Macro numbers, such as consumer confidence or market data, such as the development of certain interest rate spreads, can also contribute to the picture of the market's stability and risk appetite.

3.         If the market is expensive but with positive sentiment you remain with your positions, but also buy a crash insurance in the form of cheap sales options.

4.         Sell your core positions only when the market is both expensive and the sentiment has become clearly negative.

5.         Act in a similar way in a negative market, i.e. do not start buying seriously even though it is cheap until the sentiment turns up, and then possibly first with derivatives.

This process can also be adapted to investments in individual companies, but then one has to make a thorough analysis of each individual company you buy in cheap markets or sell in expensive. This often places much greater demands on time, resources and knowledge than most private savers have access to. In individual companies, it is much more difficult to determine whether a particular sales or book multiple is reasonable than it is for entire economies and markets. Single companies can make sudden innovations or mistakes that completely change the calculation, while whole economies are governed by relationships between the country's total assets, wage mass, gross domestic product (GDP) and much more stable cyclical patterns in these variables and their valuation.

There should not be much for a single company to double its profit, but this is mostly done at the expense of profits elsewhere. Sweden's GDP or the business sector's sales and surplus as a whole, however, rarely move more than up to ten per cent per year. This means that the valuation multiples are retracted against an average value after temporary sentiment-controlled extreme values. The simplicity of this analysis means that many more can de facto perform it at the same time as almost no energy can invest after it because of the long lead times.

Technical analysis, as I said, has its points, but be sure to use them to reinforce your fundamental game rather than letting it be the basis of your investment strategy.