Traders Trading the Fundamentals

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A paper written by Abarbannel & Bushee (1997) highlights a number of traders who use Fundamental analysis in making investment decisions. The information from which they get there signals to base their trades are can be described as detailed financial statement data. This report goes on to say that this data is used when analysing risk based on past performance. The paper shows evidence of traders who look purely at values such as gross margin, inventory, earnings and growth of earnings over x number of years. The base of FA can be described by all the above content. It can imply that prices move due to public information about a certain security including macroeconomic news and events.

fundermental analysis tradingLiterature by Xue & Zhang (2011) supports the work of Abarbannel & Bushee by describing investment methods using variables such as market to book ratio and future earnings. Variables derived from financial statements that are available publicly are used in their analysis.  The events talked in Arbannel & Bushee (1997) don’t completely adhere to the ‘EMH’ and the ‘Random walk theory’ talked about in Kendall (1953) and Samuelson (1965). The information they are using to predict future price movement is already public information which studies have shown are already discounted efficiently into the price. Even if they base their investment decisions on information that profit has risen for the past three years and is expected to continue to do so. Never the less the actual public results can still be randomly better or worse than expected.

Rise of the contrarians

As empirical findings began to pile up in support of stock price movements following a ‘random walk’ questions were raised about the theory underpinning this assumption in Mills (2002).

Despite the fact that many academics have tried to prove that prices are random and follow no pattern there are many others, including mathematicians and hedge fund managers that believe differently. They still believe that prices can be predicted using Technical Analysis (TA).  Menkhoff (2010) conducted studies and provided evidence of 692 fund managers worldwide of which the vast majority rely on Technical Analysis. These fund managers are as successful in their career, as confident in their decision making and as academically intelligent as any other fund managers out there. He mentions the work of Fama (1970) and how the use of TA was a highly debatable, mainly because of the Effiicient Market Hypothesis. Menkhoff goes on to describe how modern capital market theory has revolutionized the markets and fund management opening up non-fundamental methods of analysis (Technical Analysis).

Most traders either classify themselves a technician or a fundamentalist. In reality a lot of fundamentalist traders have knowledge of certain technical indicators and use this in their trading.  On the one hand a lot of technicians believe that the fundamentals don’t matter, they purely look at the chart patterns and behaviour of prices and believe that is all the information they need. On the other hand a lot of successful technicians have knowledge of some of the fundamentals also (Murphy, 1999).

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