How I Balance Fundamentals and Technicals

09/30/2011 6:00 am EST

Focus: COMMODITIES

Recent action in the silver market shows that fundamentals alone are not likely to help the trader identify profit opportunities, avoid excessive risk, and execute successful trades.

Despite the fact that I look at hundreds of charts each day and probably utilize technicals more often than fundamental analysis, according to my StockTwits bio, I am a “fundamentalist.”

Why is this? Some technicians would rather shut out fundamentals and dismiss the macro news flow as noise. I completely sympathize with those who choose to focus on what they can control (their interpretation of charts) and avoid that which they cannot.

I guess you could say that I like to understand as much as I possibly can, even if it makes life more complex and confusing at times. Sometimes I will even miss a trade that I would have taken based on technicals due to my fundamental analysis.

Integrating fundamental and technical analysis is far from easy and requires a great deal of experience and expertise. I am still learning and probably will be for a long time to come.

Earlier this week, Steve Saville at The Speculative Investor offered some excellent quotes on fundamentals:

  1. “Short-term market movements are usually driven more by sentiment than fundamentals. Consequently, it is not uncommon for large price moves to run counter to the fundamentals.”
  2. “Intelligent people often disagree about the ‘fundamentals,’ and anyone who takes the position that their understanding of the fundamentals is 100% complete and correct is a financial accident looking for a place to happen.”
  3. “Major commodity tops occur in parallel with bullish fundamentals and major commodity bottoms occur in parallel with bearish fundamentals. The reason is that commodities only ever reach major price extremes when the fundamentals are so obviously bullish (for price tops) or bearish (for price bottoms) that almost everyone ‘gets it’.”
  4. “Fundamentals must be considered in relation to price. For example, it could be argued that silver’s fundamentals were bullish at $50/oz in late April of this year, but they were no more bullish at this time than they had been nine months earlier when the price was below $20/oz. To put it another way, at some level, the fundamentals will be more than fully discounted by the current price.”

The first point should ring very true to any experienced market participant. One must always ask “What is priced in? What has the market already discounted? What is obvious and what is lurking beneath the surface?”

And my favorite Saville quote, “Anyone who takes the position that their understanding of the fundamentals is 100% complete and correct is a financial accident looking for a place to happen.”

So true.

Let’s now apply these points to the silver market.

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What is an ounce of silver worth? What is it worth to you? What is it worth to your neighbor? What is it worth to the guy in the futures pit in Chicago? Does it matter? The answer to the “does it matter?” question depends upon who you are. If you are a trader, then it most certainly does not matter what you, your neighbor, or some talking head on CNBC thinks silver is worth.

Case in point: The recent insane volatility which we have witnessed in silver (both the futures contract and the iShares Silver Trust (SLV) traded above $40/ounce just one week ago; early Monday morning, it traded as low as $26.15; this morning, silver traded as high as $33.58).

Did any of this wild price movement have to do with the fundamental value of silver? No, the 30+% drop in less than one week had to do with the herd mentality of large institutions as they all ran for the exits simultaneously.

Moreover, the widespread use of leverage in futures markets causes a vicious positive/negative feedback cycle when markets make outsized movements in the short term.

See related: Learning from Silver’s Collapse

Another situation where short-term market moves can wildly disconnect from perceived fundamental valuations occurs during a short squeeze. Some recent examples of this phenomenon are Coffee Holding Co, Inc. (JVA) and Netflix, Inc. (NFLX), among many others.

During a short squeeze, a stock with fundamental momentum can garner technical momentum as shorts cover their positions at higher and higher prices. This can cause the stock to trade at unsustainable valuation levels, often for much longer than one might think possible.

Simply stated, short-term market movements are usually much more tactical in nature and have much more to do with temporary market dynamics than fundamentals. Fundamentals will take hold of a commodity such as silver over the long run, however, as the famous quote from John Maynard Keynes goes, “In the long run we are all dead.”

More importantly, the fundamentals are always changing; therefore, strong industrial and speculative investment demand for silver right now is often transitory and already discounted by market prices.

Finally, the best way to think about price volatility during market “panics” is to think in terms of “What is the price of liquidity?” In other words, how much are those who are in pain willing to pay to close out their positions and alleviate the pain?

In silver, we recently learned that the price of liquidity was very high indeed. In a matter of hours, stuck longs were willing to sell their positions at 10+% notional losses in order to exit the market and alleviate their pain.

Side note: I personally know of a prop futures trader who tried to be a “liquidity provider” in silver futures at $29 last Sunday night. He was “bagged and tagged” (stopped out) near the lows only a few hours later. Another market participant became his liquidity provider, as my friend paid a hefty price to alleviate his pain. As they say, timing is everything.

By Robert Sinn of The Stock Sage

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