Select Stocks by Combining Technical and Fundamental Screens
Before we look at the stock selection method, a brief note about the relative merits of fundamental and technical analysis might enhance the understanding of some readers. Fundamental considerations are most important for long-term holders of a stock. A stock may gain 10% or more over a one-year period. That move will likely be driven by the fundamentals of the company. However, as holding periods shorten, there tends to be more randomness (noise) in stock behavior. The short-term forces at work in the environment (wars, indictments, terrorist threats, Fed meetings and decisions, etc.) cause investors to be concerned about one thing and then another. That is, stock behavior becomes less dependent on fundamentals and more dependent on short-term shifts and trends in investor psychology and mood. Hence, on the way to making a return of 10% for the year, a stock may go through several cycles in which it swings up and down 15% or more.
Announcements of a fundamental nature (earnings sales, return on equity, product development, and so on) can cause a stock to spike up or down. The fundamentals can also cause a stock’s price pattern to have an upward bias. However, fundamentals generally have less influence on the short-term behavior of stocks than they do on long-term trends. That is why technical analysis is so important in volatile markets. Technical indicators are extremely useful in the timing and analysis of short-term as well as long-term turning points and in estimating the probability of trend endurance. Fundamental analysis is more useful for long-term thinking and valuation considerations. Fundamentals give investors the psychological endurance necessary to hold a position long-term through numerous gyrations. However, the way the market weights and values the fundamentals of a company can change, even if the fundamentals remain unchanged. Such changes can make it unwise to continue holding a security that moves outside the "probability envelope" of its behavior pattern. Nevertheless, even in a volatile market where a position is likely to be held less than 4 months, it is better to invest in a stock supported by good fundamentals than in one that is not. The good fundamentals should give a stock a positive long-term bias, and this may very well enhance the short-term behavior of the stock. When fundaments are sparse, doubtful, or unavailable, traders may use the long-term trend of the stock as a substitute for the fundamentals and as a context for the short-term and intermediate-term behavior of the stock.
The stock selection methodology illustrated here could be implemented by using Daily Graphs or The Value Line as a valuation reference. We consider The Value Line to be the best of these for our purpose because we like to use estimates based on the last 6 months combined with earnings estimates for the next 6 months. We believe such estimates are far more accurate than those that look ahead a full year, and that they are more relevant than those based on last year’s results. Value line does provide data based on approximately 6 months past and estimates for 6 months future, but you must put the data together and compute the ratios. For that reason, we prefer to use The Valuator. It combines data from approximately the last 6 months with analyst projections for the next 6 months to derive its valuation measurements, including its PE and PEG ratios. For the purpose of implementing this strategy, it is a far more efficient tool than either Daily Graphs or Value Line, but you should use the reference that works best for you (do a Google search on any of these for more information). Use any publication that works well for you. In implementing the strategy, I prefer to see at least one value measurement that looks good. For example, when reviewing the lists generated in The Valuator (these are lists of stocks ranked in the top 10% for each valuation measurement), I usually find a number of interesting candidates that then need to be screened for their technical attractiveness. For example, stockdisciplines.com traders scan the chart patterns of the more than 40 stocks with the lowest PE ratio listed in The Valuator. They use the list of stocks that are most depressed below their historical fair value, the stocks with the lowest PE ratio, the stocks with the lowest PEG ratio, and the stocks that have the highest ranked composite valuation (a measurement that combines several other measurements). All of these measurements are based on one-year data that combines approximately the last 6 months actually achieved with analyst estimates for about 6 months ahead.
They scan the charts of these stocks looking for technical patterns known as "setups" because these configurations usually precede a continuation of upside price movement. They include breakaway gaps, ascending triangle patterns with an upside breakout, declining flag patterns with an upside breakout, Bollinger Band squeezes with an upper band penetration, a "bounce" off of a rapidly rising 50-day moving average, and so on. They look for volume surges with any of these setup patterns.
The technical pattern is very useful in the timing of purchases and sales. If the fundamentals are good but the technical pattern is not attractive, the stock is not purchased. Though the stock may be a great purchase from a valuation point of view, it is not from a timing point of view. We do not want to waste time in great stocks that are not on the move. On other occasions the pattern may be attractive, but we will not buy unless the fundamentals have something positive to offer. Let me illustrate the reasoning behind the decision process by the use of an example. At one time I wanted to buy Apple because the technical configuration of the chart looked very good. It had formed what is known as a "cup without a handle" and it broke out above the rim of the "cup" on 8/12/05 with heavy volume. Then it had the normal profit-taking sell-off (with declining volume) that follows such moves. It fell back to support at 45 (which held and then drove the stock upward again). That is when I bought. The bounce off of support was my trigger signal. However, because of the industry it was in, I was determined not to buy unless there was some fundamental reason (other than the technical reason described above) that it could sustain an upward trend. The Valuator showed that it could rise 18.7% before it would reach its historical fair value. That is, based on how the market has valued the financials (earnings, etc) of the company in the past, and based on current 6-month forward analyst estimates, the stock could rise 18.7% before reaching what the market considered to be its "fair value." Also, The Valuator displayed a star showing that the stock was rising faster than fifty percent of all rising stocks. Most of the other valuation models in our reference gave a poor showing for Apple, and its overall valuation ranking was only in the 41st percentile. However, the PE-ratio relative to the company’s projected 3 to 5 year earnings growth rate gave a PEG ratio of only .6. A reading of 1.0 usually means "fairly priced," but 1.5 is perhaps a more appropriate "fairly priced" reading for technology companies. A reading of .6 suggested that Apple was a bargain relative to its earnings growth rate. All I wanted was one good fundamental reading to justify a purchase. Apple gave me two, so I bought it. The stock subsequently climbed from a closing price of $46.89 on 8/31/05 to a closing price of $85.58 on 1/13/06.
It had a combination of both a good technical setup and two attractive metrics of a fundamental nature. The technical pattern showed only that the timing was right for a purchase. Short-term traders tend to buy a stock that has a good setup and that has begun to move from that setup as anticipated. This creates a momentum surge that attracts others. Investors of a fundamental persuasion notice the stock and invest in it because of the fundamentals. The fundamentals are what enabled the stock to sustain its "flight" to a much higher valuation. If the fundamentals were not there, the stock would likely have declined shortly after its initial surge. That would be sufficient for very short-term traders, but those who are looking for a more sustained move should include timely fundamentals in their filtering requirements.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses