Introduction
“There is no free lunch”, so says the Efficient Market Hypothesis (EMH). The overall track record of market participants who beat the market, whether by using mutual fund returns or doing corporate mergers and acquisitions is not good. The vast majority of funds underperforms the indices, and acquiring companies (as compared to those being acquired) don’t have much to show for it. Getting risk-adjusted excess returns is not easy.
The EMH in its Weak form casts doubt on technical analysis, and in its Semi-Strong form, it casts doubt on the use of fundamental research. Perhaps, only in the Strong form of the EMH can one outperform by using material inside information. However, that invites an orange jumpsuit at the local jail.
Still, exceptions and doubts on the EMH are growing. In Technical Analysis, studies on certain common practices, such as the use of Moving Averages to create buy/sell decisions, seem to provide an exception to the Weak form, and there are others[1]. Eugene Fama’s work has also cast doubt on the Semi-Strong, by creating buy/sell decisions using historical financial ratios. Behavioral Finance, which has recently attracted attention as a Nobel Prize winning topic, has also cast doubt on a rational market. At times, the market may not exhibit an expected symmetrical mean-variance efficient profile. This may be due to various human emotions. Somewhat of a kissing cousin to Technical Analysis, Behavioral Finance indicates that these emotions create irrational decisions by market participants.
Thus, the door is open to exploit anomalies and exceptions to the EMH. A blended discipline using exceptions in both fundamental and technical arenas should prove beneficial to the investor. These blended approaches have been used for many years by investors and have gone by many names, but I like Fusion Analysis. The prestigious CFA Institute devoted articles to Fusion Investing in their CFA Magazine, Sept-Oct 2003 issue. Prior to this, for years I have seen Wall Street research that has had a fundamental write-up and then at the end of the report provide some technical outlook on a stock as well. However, academic research usually focuses on one or the other (mostly fundamental). Generally, it does not try to examine investment issues by using both fundamental back testing and at the same time, technical/behavioral overlays. Thus, we are lead to believe that either a basic set of fundamental or technical factors leads to say outperformance, but there is an uneasy feeling that maybe it was not just technical or fundamental factors alone that explain the outcome. Maybe, each had some influence that was not picked up by the research.
So, academic journals seem to evaluate investment hypothesis either on a fundamental basis, if it is a fundamental journal, or a technical basis if it is a technical journal, etc. It would seem that benefits should grow if one uses Fusion Analysis. To my knowledge, there are no Fusion textbooks, nor Fusion journals, nor Fusion back testing approaches. One learns one or the other, but not both combined. Nobody uses 1 plus 1 to get 3 that Fusion may offer. Hence, I have for the past few years provided the only Fusion course in the United States, and have done workshops both in the US and abroad.
The Introduction To Fusion Analysis in this article will give a flavor of the many topics that are discussed in my Fusion Analysis workshop courses.
This introduction will include:
- An introductory discussion of the Fusion’s overview, niche, and bodies of knowledge,
- Selecting one area to illustrate the use of Fusion, namely, the Selling Climax
- Concluding remarks
Overview
An increasing number of portfolio managers have realized that Fundamental Analysis alone often does not make the best investment approach. The number of managers, especially hedge funds using a combined approach of Fundamental and Technical disciplines, Fusion Analysis, have been rising. Also, more applicants are taking both the CFA and CMT exams, with a growing list (although still small) having earned both designations. Distrust of accounting and other fundamental issues, has lead more investors to use technical analysis. Also, the volatile trading markets have focused increasing attention on the proper blend of Fundamental and Technical analysis for a broad array of investors with various timing requirements. Most major MBA schools and leading textbooks now devote specific sections to technical analysis. Even the CFA Institute requires some basic knowledge of technical analysis for the CFA exam. CAPM assumptions are increasingly being challenged with Behavioral Finance considerations. It seems that the strict fundamental investment world of Graham and Dodd is becoming only part of the story.
Bodies of Knowledge
My Fusion workshop stresses three bodies of knowledge and uses some of the leading tools of:
- Technical analysis and Behavioral Finance
- Fundamental analysis
- Generating AI quant stocks screens that can be customized to meet investor risk profiles, and thus provide promising investment ideas using Fusion Analysis.
Sample Topic- Selling Climax
A fairly common occurrence in the market is the Selling Climax. This provides opportunities for traders and even longer-term investors. One can blend Technical, Fundamental, and Behavioral tools to reach an investment decision.
Technical Considerations
Based on the definition of a leading technical analyst, John J. Murphy[2] a Selling Climax is: A significant reversal occurring at chart bottom. Once can also have the reverse, a Buying Climax at a chart top. It is “…usually a dramatic turnaround at the bottom of a down move where all the discouraged longs have finally been forced out of the market on heavy volume…..The subsequent absence of selling pressures creates a vacuum over the market, which prices quickly rally to fill.” While it may not mark the final bottom of a falling market, it usually signals that a significant low has been seen. Edwards and Magee in their Technical Analysis of Stock Trends (8th Edition), page 171, state,” It is a harvest time for traders who, having avoided the Bullish inflection at the top of the market, have funds in reserve to pick up stocks available at panic prices.”
So, a Selling Climax based on the observations of leading technicians appears to provide good return opportunities.
Fundamental Considerations
Selling climaxes may reflect various corporate imbroglios, such earnings disappointments, governance issues, etc. Optimistic fundamental earnings models of PEG and DDM are scaled down substantially, evidence by lowered earnings estimates and the removal of Street Buy recommendations.
Upon sell-off, however, a stock may reach valuation levels that offer the opportunity to generate future risk-adjusted excess returns (Alpha). That would then be an exception to the Semi-Strong Form of the Efficient Market Hypothesis. Under this form of the Efficient Market Hypothesis, historical financial information should not be useful for generating an Alpha. The Selling Climax would also be an exception to the Weak form which precludes the use of technical analysis.
At the relatively low levels, the stock would show more attractive valuations evidenced by relatively lower price/book ratios and even smaller market cap sizes. These historical measures, based on the work of Fama and French[3]would provide better opportunities for investors to outperform a seemingly efficient market. Some value players would also claim that the lower p/e ratio of the stock should enable it to show future risk-adjusted returns as well. This is based on the belief that over long periods, low p/e stocks perform better than high p/e firms, because investors emotionally overpay for perceived growth associated with a high p/e ratio on estimated earnings. Under the Gordon Growth model, a p/e increases as growth increases, assuming the other variables remain constant.
Behavioral Considerations
James Montier[4], a leading observer of Behavioral Finance on Wall Street has commented:
“ ..if a stock price drops, then in theory if the analyst were correct in their initial price target, it should become even more attractive to buy. However, in practice, analysts actually reduce their target prices in response to a drop in the current market price.”
One Behavioral influence on analyst forecasts is Representativeness. It is a “…tendency to evaluate how likely something is with reference to how closely it resembles something rather than using probabilities.” For example, one could see initial accounting scandals of Tyco as similar to those of Enron, even though upon subsequent events it wasn’t even close.
“Representativeness generates excessively extreme forecasts…” This would partially account for the willingness to trade the stock at much lower levels. Other behavioral factors would also come into play.
Example- Impath
We can demonstrate our Fusion process by examining the stock of Impath. Impath was medical diagnostic company that reached lofty valuation levels and eventually went into bankruptcy. Along the way, it had several investor disappointments. These included, at first, earnings disappointments and later, announcements of management governance violations, thereby causing Selling Climaxes. The chart below indicates a Selling Climax in late April, based on a disappointing earnings announcement.
One a technical basis, when IMPH went below 30 at the end of April, a short-term Fusion trader would have bought the stock at that point because the combination of the stock plunge and relatively high volume would seem to indicate a Selling Climax. Thus, one would expect some sort of rally once calmer days set in.
On a fundamental basis, the stock’s P/E and P/B relative to the market was markedly more attractive at the approximate 30 selling climax low and appealed more to value investors. The expected P/E was 26 (1.2 x the SP 500), the trailing P/E was 33 (1.3 x the SP 500) and the P/Book was 3.3 (about 60% of the SP 500). Just a few months ago, IMPH traded at 60 with much higher absolute and relative valuations. IMPH came down significantly to more relatively attractive valuations, and close to the sweet spot of FAMA/value valuations. The stock subsequently rallied nicely. About two years later, upon announcement of fraud issues, IMPH would have another massive Selling Climax, this time to about $0.75 and subsequent rally within a month to over $5.00 a share. On a valuation basis, one could easily make the ultimate Graham and Dodd calculation of liquidation value which subsequently proved true, as IMPH paid off its creditors and as of today will soon return about $4.50 per share to stockholders. Of course, not all Selling Climaxes end up in bankruptcy, and many times they are just storms in a long prosperous voyage.
Thus, to play a Selling Climax only may lead to profitable opportunities, but combined with valuations that have been shown to exhibit better than average results for acceptable profits, greatly enhances profit potential. One can also get a better feel for the psyche of the holders by scanning SEC documents such as Schedule 14A to determine the level of nervousness that Behavioral Finance may impose. A stock with mostly index fund holders should show low need to panic sell, as compared to “hot money” funds that shoot first and ask questions later. In the case of IMPH, of the three major 5% holders as of April 26, 2001, all lowered or eliminated their positions by the time of the next filing on April 12, 2002. Perhaps, the Representativeness issue of IMPH reminded them of similar torpedo stocks in their portfolios.
Other Considerations- Derivatives 1
Selling climaxes in my opinion, are becoming more common, especially with the increased use of momentum strategies in rising markets by hedge funds.
In a Selling Climax, one can attempt to buy the stock at the low and hedge risks with derivatives, namely buying a protective put option with an elasticity that is a close as possible to -1.0. Naturally, upon a stock rally from the low, the price of the put should expire worthless, but its loss would be offset by the much larger gains of the stock.
In the case of Impath, one can use an upside target price objective of around 40 based upon drawing a downward trendline that connects the peaks of near 58 in February and 48 in April. Thus, buying around 30, the Selling Climax, would lead to a 10 point potential gain, using technical analysis use of trendlines. For illustration purposes, should a 30 put strike price with about a months expiration left cost under 3, the ensuing risk/reward of over 3 to 1 would be very attractive. Since the Selling Climax tends to reverse in a few days, one would not pay much for an option’s Theta (time value) but one would seek a near term put with a strike price close to Selling Climax price. Should the stock not have options, one could create a synthetic option from other securities. This would be more for professionals and, in this paper I shall not do the computations for this strategy (discussed in another section of the course).
Other Considerations-Derivatives 2
One can also do a “spread” trade on an intermarket basis. For example, if the stock was a housing stock that sold off because of a Selling Climax, one can evaluate against which area (most likely the industry ETF) was the sell-off overdone, and try to position a ‘spread’ trade. A ‘spread” trade may try to buy the “cheaper” security, say the housing stock, from the proceeds of a short on the “more expensive” asset, say the ETF. Hopefully, the spread will narrow and thus generate profits after carrying and transaction costs.
Other, more complex strategies that play up behavioral aspects could also be used, such as Vega analysis of the implied and historical volatility of the stock’s option. One would then exploit the Vega mispricing (again, discussed in another section of the course). Since a Selling Climax would lead to panic selling, this could artificially boost the option’s price based on investors expecting relatively higher volatility in the security going forward, as compared to the past.
As we can see, a Selling Climax combined with derivative strategies could lead to many trading permutations that should satisfy the utmost leveraged speculator.
Other Considerations-Quant/AI
Traders and Hedge Funds may seek Selling Climaxes as a major strategy for profitable trades. Using Fuzzy Logic one can create algorithms to identify technical patterns[5]. Fuzzy logic has been applied to more complex patterns such as Head and Shoulders, and a Selling Climax can be more easily programmed. These should lead to a Quant decision-making process. This is discussed in another section of the course.
Using fundamental databases, one can select fundamental filters to screen for optimal valuations, say those similar to Fama. Combining both, one can have Artificial Intelligence programs automatically present real-time trading opportunities. In fact, these trades could be done without human intervention under strict parameters. Yes, the Fusion black box!
Leading Wall Street funds spend millions of dollars per year on quantitative trading techniques. Fusion should be a part of this program. A very simple approach that I use for my own funds is demonstrated in the Fusion workshop, using Excel spreadsheets.
Concluding Remarks
In physics, Einstein unsuccessfully tried to reconcile the key forces in the universe into a Unified Theory. Each force explained a key aspect of the universe, yet was there some way they could be blended to explain the entire universe? Some say that today unification has been solved with String Theory. In investments, we should also try to find out the unifying force that blends the major forces of Fundamentals and Technical/Behavioral. Fusion Analysis could be the start to such an approach. It can enable better decisions for profitable trades.
The challenges are formidable. Few can master the combined Technical, Fundamental, and Behavioral Aspects of an investment situation. Academic journals must get a mindset that all disciplines are somehow related. Back testing should use all the bodies of knowledge of Fusion Analysis.
In my Fusion Analysis seminars, I examine other investment situations with other technical tools, such as:
- Evaluating the current real estate outlook in the context of the Elliot Wave Cycle,
- Hot IPOs and Gann Analysis,
- Momentum trading and SUE fundamental analysis
- Strategic Asset Allocation using sentiment and momentum technical measures with the fundamentals use of the Fed Model.
Endnotes
- Alexander, Sharpe, Bailey, Fundamentals of Investments, 3rd Edition (New Jersey:Prentice Hall,2001), 291-292.
- John J. Murphy, The Technical Analysis of the Financial Markets, (New York Institute of Finance, 1999), 91-93.
- Eugene Fama and Kenneth R. French, “The Cross Section of Expected Stock Returns,” Journal of Finance: 47 (June 1992):427-465. This is cited in a leading financial textbook by Bodie, Kane, Marcus, Essentials of Investments, 5th Edition (New York:Irwin, 2004), 241. There is ample literature exploring the Fama/French thesis. Note also, that in the Bodie textbook, Chapter 19 is devoted to behavioral finance and technical analysis.
- James Montier, Behavioural Finance, (West Sussex:Wiley, 2002), 9,11,79.
- Xu-Shen Zhou and Ming Dong, “Can Fuzzy Logic Make Technical Analysis 20/20?”, Financial Analysts Journal 60:4 (2004), cited in CFA Institute (2004) www.cfapubs.org,54-75.