|
Portfolios can be managed actively or passively. In our previous two articles of this series, we discussed two different streams of active management strategies, both of which are based on fundamentals.
Active portfolio strategies - bottom up - fundamentals based : (Click Here)
Active portfolio strategies - top down - fundamentals based : (Click Here)
A completely different stream of active portfolio strategies that are popularly used, which have nothing to do with the fundamentals either of the economy, or a sector or a company - are in the realm of technical analysis based active strategies. Technical analysis relates to forecasting prices and trends of stocks, sectors and markets based on studying past patterns of market data, which is primarily stock prices and trading volumes.
While fundamental and technical analysis have the same objective - of picking stocks that one believes will outperform the market - the approach towards stock picking is very different. A fundamental analyst will look to understand the business of a company deeper than others, with a view to arriving at a better forecast of its future business performance or its present intrinsic worth. If he believes that his estimation of the worth of the business is not fully captured in the price of a stock, he would look to buy the stock, in the hope that his view will come good and that the market will in due course value the business at where he sees it.
A technical analyst on the other hand does not pay attention to the underlying business and its prospects. His belief is that everything relevant is captured in the share price and its trading patterns. He only focuses on understanding market behavior towards a stock or a sector, deciphering trends and patterns and will make his projections of future price performance solely on the basis of studying these trends and patterns in market behavior. One can argue that technical analysis is more objective and carries less possibilities of emotional biases that may at times creep into forecasting on the basis of fundamental analysis.
Several portfolio managers rely almost exclusively on technical analysis in casting and managing portfolios, although this is less popular within the mutual fund world. A more detailed analysis of the difference between fundamental and technical analysis is available in a previous Jargon Busters article (Click Here). In this article, we will therefore focus more on the different strategies and techniques employed by technical analysts in managing equity portfolios.
Moving averages
Technical analysis focuses on understanding trends and patterns - it attempts to cut away from the noise and the sound bytes that typically define any active market, and instead discern patterns that can provide some clues to future price movements. One simple trend analysis that many technical analysts rely on is moving averages.
A stock's price may move up 3% on a day and down 2% the day after. The next 2 days may not see much action, but on the 5th day, the stock could say be up another 3%. Such volatility on a day to day basis sometimes makes it difficult to discern patterns accurately. Rather than looking at movements on a day to day basis, patterns are more easily discernible if one were to take a look at the average price for say 20 trading days and see patterns in how these averages are moving. When you take an average of the previous 20 trading days prices on a daily basis and plot a graph that shows the trend of these averages, you are essentially plotting a 20 day moving average graph (20 DMA). A moving average graph essentially smoothens out short term fluctuations in stock prices and enables one to discern patterns more clearly.
Technical analysts use combinations of daily prices and a pair of moving averages to look for trends. A 200 DMA for example gives a good indicator of the long term price trend of a stock. When a stock's price rises above its 200 DMA after being under it for a while, an analyst would usually flag that stock for a deeper study to see signs of potential long term trend change. A pair of DMAs are also useful in highlighting trends. When the 20 DMA moves up above the 50 DMA after being under for a while, it is usually taken as a sign of momentum gathering in the stock - which could portend better times ahead for its price. Moving averages are seen as useful filters by analysts to decide which stocks to study deeper - as they are simple but often useful early signals of trend changes.
The chart above is a 5 year chart of BSE Sensex (blue line) with a 200 DMA of its prices shown in the green line. As discussed, a 200 DMA usually is an early predictor of medium and long term trend changes. Looking at this graph (and with the benefit of hindsight!), one can observe that in Feb 2012, when the daily price line (blue) went below the 200 DMA (green) after staying above it for around 2 years, it did turn out to be a decent predictor of a trend change, as the market trended downwards for the rest of the year. Likewise, in Feb 2013, when the daily price line moved above the 200 DMA after staying under for a year, it did turn out to be a good predictor of a medium term trend change as the market stayed relatively more buoyant over the rest of the year.
The image above represents BSE Sensex closing levels for the last 2 years, along with its 20 DMA (green line) and 50 DMA (red line). These two moving averages can loosely be taken to indicate short and medium term trends. As the theory goes, when the short term DMA cuts the medium term DMA from below, its usually a sign of an upward medium term trend change. The opposite (green cuts red from above and heads below the red) is taken as an early signal of a bearish medium term trend setting in. And, during corrections in daily levels, if the short term DMA continues to stay above its medium term counterpart, the theory suggests that the basic uptrend remains intact, until the time that the green line remains above the red line. Looking at the image above, you can draw your conclusions on how reliable these indicators would have been over the last 2 years. In both the images above, the bottom part of the images shows daily traded volumes. Any spike in volumes coupled with a sign of a trend change gives technical analysts a lot more confidence about the sustainability of the trend change, as there is more market participation to confirm this.
These images above are for the broad market, and are simple tools shown here for illustration purposes. In reality, a technical analyst will typically equip himself with an array of sophisticated technical analysis tools and will sift through various filters - with moving averages being one important component - to identify stocks from hundreds and thousands that are traded daily, where he can spot early signals of interesting trends that seem to be developing. Once he short-lists stocks that get flagged on filters like moving averages, he can then zero in on those where he will do more in-depth study before shortlisting stocks that will eventually make it into his portfolio.
In the next article, we will introduce a few more technical analysis tools and techniques that are popularly used not just in our market, but worldwide.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
Share this article
|
