fundamentalists are for the most part hostile to chartists, the reverse is not true. Chartists will agree that there should be some relationship between the way in which a company is run and its future share price. Certainly it would be unreasonable to expect that a company that is continually making losses will show a strong share price. Chartists are of the opinion that all the positive aspects of a company’s performance are reflected in the share price, and therefore an analyst can take a shortcut by looking at the share price and not the fundamentals. This author stands with the chartists on this point about the relationship between the share price and the fundamentals, believing that what moves a share price upwards is not the quality of the management or the products or the balance sheet, but investors’ views about the company’s potential. Some investors’ views may indeed be influenced strongly by the fact that they have carried out an analysis of the company’s balance sheet or market strengths. Other investors may simply have read comments in the press. Yet others may have applied some technical analysis of the share price chart and come to a conclusion about the future movement of the share price. It is the sum total of these different views, many of which will be contradictory, that will add up to the pressure in the marketplace that will cause the share price to move. When all views are the same, the price will move rapidly, while if they are nearly in balance, the price will drift more or less sideways. Grafted on to all of this will be the views of the market makers, since they have to balance their books also. There will be some shares which attract no comment and attract no technical analysis because they have generated no excitement in the past. In such cases, therefore, it is unreasonable, however strong the fundamentals are, to expect the share price to move upwards.
This author takes the position that everything an investor needs to know about a company is stated in its share price movement. It will be simpler and quicker for an investor to discover how to analyse share price movement than to study the company itself, and the result of this price analysis will tell the investor the most important fact: how other investors feel about that company.
Where this author does not stand with the chartists is in their simplistic approach to share price analysis. In its most trivial form chartism depends upon sets of rules which have to be followed without any other understanding. Thus the chartists will make statements such as “buy when the share price moves above the x-day moving average,” where x depends upon the chartist you are speaking to, or “sell when the ten-day average falls below the twenty-day average.” Such a set of blind rules should play no part in the thinking man’s investment armamentarium. The human race has always striven to understand the reasons for the behaviour of the physical world, and share price movement should be no exception. A Pavlovian response to a set of circumstances will ultimately lead to disaster, since the stock market is always ready with the unexpected. Experienced chartists can probably correctly predict whether a share price will move up or down about 55% of the time, but this means they are wrong about 45% of the time. The dangers of a set of rules which work only just over half of the time are obvious. Investor psychology is such that the investor is always trying to avoid selling a holding in the belief that an adverse movement is only a minor aberration in the expected upward trend, and will surely correct itself before too long. Nearly all investors have seen a good paper profit from a good buying decision evaporate because of this reluctance to sell. If we are going to work to any set of rules, the reasoning behind them must be perfectly clear, so that those occasions when the share price does not seem to be following the rules can be understood for what they are – times when we have to be more flexible about our interpretation of the rules.
By this more logical approach of trying to understand why share prices move as they do, we should be able to improve our predictive techniques so that we can almost always recognise the start of a new upward or downward trend. We will be able to recognise when we have made a mistake about the start of a new upward trend, and be able to act quickly to close the losing position before the loss is anything other than a trivial one. We will be able to follow the old stock market rule: “let your profits run and cut your losses”. This will be a great advance for most investors, who seem to do exactly the opposite, selling the share when there is still plenty of profit to come, but staying with a share which is falling rapidly, because they are convinced that it will soon change direction.
ARE SHARE PRICES RANDOM?
The simple response to this question would be to point out that the world’s stock exchanges depend upon prices not being random. If they were random, then one might as well pick shares for investment with a pin, or forgo the stock market altogether and leave one’s money in the money market, earning the best rate of interest available. The vast array of stock market analysts employed by various institutions would be totally superfluous and investment writers like myself would have to turn to other activities.
The existence of investment commentators, besides indicating that the movement of share prices may not be random, also raises an interesting philosophical point. Their existence may be the reason that share prices are not random, in the sense that their comments in newspapers may distort what would otherwise be a random process. Just suppose, for example, that Guinness shares were moving in a random fashion until one day the investment columns of two or three newspapers suggested that Guinness shares represented a good buy. Many of their readership will take their advice and start buying these shares. The inevitable logic of supply and demand dictates that the price of Guinness shares will then start to rise. If these same newspapers continue to push Guinness shares as a good buy, then more and more readers will begin to take notice, and the share price will continue to rise. The rise will not continue forever, but at some point will reverse itself. This is because an increasing number of these new holders of Guinness shares will decide that they have now made sufficient profit to have satisfied their objectives, or will decide that all good things must come to an end, and will now act in a contrary way to the advice being offered and will sell their shares. This selling pressure will increase, thereby causing the Guinness share price to fall. Eventually we can conclude that the Guinness share price has reverted back to its original random movement.
This example serves to show quite clearly that even if we accept the premise that some or most of the time a share price is behaving randomly, then there will be occasions when because of press comment the price will move in a non-random manner. This can be illustrated by the type of movement shown in Figure 2.1.
Figure 2.1 Random price movement becoming non-random for a period of time due to favourable press comment
Just to restate the position so far: we assumed that the Guinness share price was moving randomly until a random event (comments in newspapers) caused the price to move in a non-random fashion for a period of time. The non-random movement was caused by a bandwagon effect of investors reading and acting on comment in their newspapers.
A closer inspection of Figure 2.1 shows that the day-to-day fluctuations, when viewed in isolation, are still apparent even when the underlying long-term trend is rising.
Since we can accept that a random event such as a newspaper article was the trigger to an upward and then a downward price movement, it is but a short step to an improved model of share price movement:
1 Share prices contain random day-to-day movement.
2 Share prices contain upward and downward trends.
3 The start and end of a particular trend is a random event.
By the word “trend” we mean an underlying price movement that lasts for more than a few days, and may last as long as many years.
To determine that prices are or are not random is difficult, and would take us into a realm of mathematics that would be out of place in a book of this nature. However, we can make some progress by taking a simpler approach. To
