[TonyM]

TA, Fundamental Analysis, and Islamic Banking by Tony Morland
July 2007 / Jumada Al-Akhirah 1428


In this, the second article in “defense of ...”, we follow on from our previous discussion of the Lunar Indicator. As some of you know, it was my intention to distribute that article to several members of the international investment community in the major financial centers of New York and Dubai. In the course of a pleasant phone conversation with my friend and colleague in the USA, I learned that the fund manager in NY had stated that he: “Does not believe in Technical Analysis”. !!!

So now, before we launch into the “Defense of Technical Analysis” (TA), let’s just ponder about why there are skeptics about TA, and then finally come back once again to our Lunar Indicator, this time as case study illustrating the need to take a wide and broad-minded view in our investment and trading strategies.

TA, the study of the price behavior of financial instruments, is not new. It has been used for centuries. Candlestick patterns were used in Japan during or before the 17th century. (All dates here are given in years A.D., or C.E. as it is called in some other countries). The modern western pioneers of TA include Edwards & Magee (“Technical Analysis of Stock Trends”) and many others such as R.N.Elliott and W.D.Gann, all of whom have their “true believers” as well as their determined detractors.

The main problem with most of the writings on TA is that they are qualitative rather than quantitative, and often they are not very rigorous. Anyone can find a chart example of some indicator working nicely at some particular time, but that does not make it a reliable indicator. (In scientific terms, one example is a “necessary but not sufficient condition”). Most of the writings such as: “… the head and shoulders (or whatever) pattern is one of the most reliable ……. ”, are not at all quantitative and lack scientific rigor. The truth is that sometimes patterns and indicators work, and sometimes they don’t. Unless one has done a lot of testing and analysis (and sometimes even after one has done that), it is not always easy to know whether an indicator REALLY is effective, or whether it’s apparent success was due to luck, or to the general market trend, or to statistical anomalies, or all of those. That’s why fundamental analysts are often skeptical about TA. Sometimes they have good reason to be skeptical, so let’s not judge them for it. Touching deeply on this topic is an excellent and recently published book on applying the scientific method and statistical inference to technical trading signals: David Aronson’s “Evidence-Based Technical Analysis” published by Wiley this year, 2007.

In contrast, and sometimes in opposition to the TA’s, we have the Fundamental Analysts, those who study what they consider to be the “true” or “fundamental” value of stocks and other financial instruments. The pioneer in this area was Benjamin Graham, and today his investment style is exemplified by Warren Buffett. How one determines “true” value depends on the conceptual valuation models that one uses. In the case of stocks, one of the dominant methods is to (attempt to) calculate the Present Value of the future earnings, dividends or cash flow stream, discounted at an appropriate rate according to the principles of Discounted Cash Flow (DCF) analysis. In other instances the Net Asset Backing or Book Value may be a more appropriate valuation measure. However whatever method is used, the fundamental investment concept is to seek stocks (or other financial instruments) that are priced below their “fundamental value”, to buy those, to wait until the market realizes their “true” value and the price rises, and then to sell them at a profit compared to the original purchase price. The converse approach is used in the case of short positions. The theory is basically good. But there are problems……..

The main problem is that of time, or timing, or both. I can illustrate this with the personal story of the first time that I ever bought shares of stock. I didn’t have much money, so I made my selection very carefully. A paint company. All the financial ratios looked good to me. The price was steady All the rest of the market was roaring upwards at a crazy rate and everyone was making lots of money. I was sure I would too. This stock was obviously (or so I thought) an overlooked bargain. The stockbroker whose advice I had chosen not to follow (this was in the days before online trading) looked at me scornfully and said rather pompously, “Well, I suppose there will always be something that needs painting”. Anyway I bough my carefully chosen shares and I waited. And waited. And waited. Nothing happened. The price of my paint shares continued going nowhere, even though I knew they were an “overlooked bargain”. The rest of the market was heading straight up. Everyone else was making money. Everyone except me. I waited some more. I KNEW these shares were undervalued. They just HAD to go up. Eventually the price started creeping up ….. 5%, 10%, 15%. Reached 25%, and then flattened off. I sat looking at my 25% gain. Finally I decided to sell. Almost everyone else had made 50%, 70%, or more in the same time, but at least I was happy that I had “taken my first profit”, a 28% gain after transaction costs. Compared to everyone else in the market, I had waited a long time to get this gain. Maybe my analysis had been wrong. But then I noticed the price of this paint company shares starting to creep up again. It was now too late to do me any good (or so I though then), because I had already sold. I now watched the price moving up without me. Up 45%, 50%, 60%. And then the price exploded, up nearly 300% in one jump. Takeover offer! My fundamental analysis had not been wrong at all. In fact it had been very good for a beginner, but my entry timing had been terrible, and I had wasted too much time in the market holding a stock that was going nowhere. I had not been using TA in those days.

My question then was: Does fundamental analysis work? My answer now is: Yes, usually, because stocks will generally adjust their price, one way or another, sooner or later, to find their “true” value, BUT … you may have to wait a VERY long time, and maybe your “undervalued bargain” will go a long way further down in price before it finally goes up to it’s “true value” price. Hence the importance of TA. It’s not enough to know that the stock will EVENTUALLY go up (one of these days … or months, years, or decades). It’s also important to have a means by which to get the timing right. Technical analyst friends, I know that I’m already “preaching to the converted” here, but the point I am trying to make is that, with regard to TA and Fundamental Analysis (I prefer not to abbreviate the latter), its better to have BOTH /AND, rather than arguing about EITHER / OR.

My personal conceptual investing and trading model is like that of a tripod, with the three legs being Fundamentals, Technicals, and Risk Control. Just as a tripod with 3 legs = stable and strong, but with only 1 or 2 legs = weak. I am sure that most of the readers here have a good understanding of Technical Analysis. Next, under the heading of Risk Control, I would include Stop Losses, Asset Allocation, Money Management, and various other items. Under Fundamentals, I include not only valuation methods per se, but also a broader understanding of “what’s going on”.

To me, really good TA is not just about knowing some mathematical or software tricks that (sometimes) work, but also about understanding the fundamentals of WHY those TA techniques work. In this way, we can get a better understanding of the times when they may or may not be so likely to work, and especially whether a particular type of indicator is likely to become more useful or less useful in the future. Many of the commonly used indicators have been around for years or decades (e.g. %R-Williams-1972, RSI-Wilder-1978, CCI-Lambert-1980, MACD-Appel-1994, etc). Does this mean they are no longer useful? No, of course not. But do these types of indicators generally work better in newer markets or in more mature markets? I leave you to think about that. It’s a topic worth investigating.

Now, as a case study, let’s return to the Lunar Indicator from last month’s article.
Question: Does it work, and is it reliable?
Answer: Sometimes it works, but it’s not very reliable.
In general it’s rather less reliable than other types of calendar indicators.
OK, now let’s ask a better and more interesting question:
Is the Lunar Indicator likely to become more reliable or less reliable in the years ahead?
What do you think, or do you think this is an unanswerable question?

Without hesitation, my prediction is that the Lunar Indicator’s reliability will INCREASE with time.

How can I make such a strange prediction? Well, last month we looked at what the lunar indicator is and why it works, even though its reliability is not (yet) high in comparison to timing indicators based on the conventional western or Gregorian calendar. We know that the predictive value of the Lunar Indicator, if and when it works, is primarily due to the correspondence between the moon phase and the Islamic or Hijri calendar. The main reason, or so I believe, that the lunar indicator is currently less reliable than other calendar indicators is simply that far fewer investors / investment decisions are currently based on the Hijri calendar as compared to the Gregorian calendar. However, this balance is likely to shift in future, and the reason is a good one that has little to do with “politics”. The use of the Islamic calendar in the investment world, and hence the potential value of the lunar indicator, is likely to increase because of an important phenomenon known as “Islamic Banking”.

Let me tell you very clearly in advance that I am not a Muslim, I am not promoting any particular religious viewpoint (but I respect the religious views of others), and I am definitely not promoting any political viewpoint either. But as the pace of change in the modern world increases, for us to be successful in investment or trading or many other activities, it is in our best interests to at least understand the important influences shaping the world around us.

“Islamic Banking” is not simply a banking system for Muslims. It is a concept of banking and investment based on the application of some specific ethical values and principles. Islamic Banking has features in common with other systems of “ethical investment” and potentially has wide appeal not only to Muslims but also many non-Muslims, such as those who consider that, when making money, consideration should also be given to certain standards of ethical conduct. Irrespective of whether you personally share this view now or not, the reality is that the concept of ethical investment is on the rise, particularly in the form of “Islamic Banking”.

What are the likely consequences of the increasing importance of Islamic Banking in the investment world? The most likely consequences are:

a) Selection by fund managers of certain types of investment vehicles in preference to others. This means that the trading volumes of some types of shares are likely to gradually increase relative to others. It may be useful for you to know what these are, and you can find out more background about this on websites related to Islamic banking. A good place to start looking is on Wikipedia, under “Islamic Banking”. URL: http://en.wikipedia....Islamic_Banking

b) Some of the leading investment funds of this type have their offices in world financial centers such as Dubai, and are likely to be making at least some of their investment timing decisions based on the Hijri calendar, which, as we know is a lunar calendar.


Conclusions:

1) The lunar indicator may not work as well as other calendar indicators… yet.
But just wait a while. See what happens as some of the new international financial and investment institutions start to enter the market, with their big buying orders, their stock selections based on the principles of Islamic Banking, and their timing decisions based on the Hijri (lunar) calendar. It’s almost certain that the lunar indicator will gradually become a better indicator over time!

2) As some of the (so-called) financial “news” on TV has become more like low grade “financial entertainment”, the old technical analyst’s motto of: “Don’t watch the news, just watch the stock price” regains some of it’s appeal . However, whether you consider the financial news channels on TV are worth watching or not, some of the developments in the world around us are definitely worth knowing about. I suggest to you that “Islamic Banking” is one such development. If you don’t already know about it, it may help you to learn.

Even if, as a technical analyst, you believe that the most important thing is “just watching the prices and the indicators”, it is very useful to also have a “bigger picture”, so that you can better understand why sometimes your indicators don’t work and sometimes they may actually start to work even better as time goes by.


Safe trading and best wishes to all from TonyM.

[jose]

A gem of a quality article from Tony - I urge TC members to post a link to it on other forums if they can.

And perhaps it's time for the Lunar cycle indicator to be renamed the Hijri calendar indicator. ;)


jose '-)

[PTJim]

One can only imagine the "penalties for early withdrawal" under the Terms & Conditions of Islamic Banking. :(

[TonyM]

Author's response:

Transaction costs and bid-ask spreads can be a problem for all investors and traders (especially when trading options or other illiquid financial instruments). For many commercially available investments funds, including those from the USA and Europe, the entry charges and exit penalties can be quite high. Generally investors try to search around for products that are appropriate to their needs and that don't also "cost them an arm and a leg". This applies everywhere, for any investment product. Smart investors look, amongst other things, for acceptable transaction costs, including favorable entry and exit fees. This search becomes easier with the Internet and with increasing transparency of financial products and services.

Perhaps some traders may be tempted to think that, because they don't use commercially available investment fund products themselves, all this talk about investment funds, Islamic or otherwise, is not relevant to them. Not so. It is the buying and selling activities of large financial institutions that add significant liquidity, sometimes adding huge volumes and often moving prices. Standard & Poor's (Ref. "The Economist", December 9th 2006) currently estimates that the market for Sharia-compliant financial products is around US$ 400 billion, which a very significant (and growing) force to move markets.

In addition to just following prices, it can also be interesting and potentially rewarding for us as traders to also watch:
a) Changes in investment trends among financial institutions,
b) Volume,
c) Timings of those volume or price changes.

Let us remember that good Technical Analysis is not just a matter of turning the handle with indicators that someone else invented long ago. Those indicators may still be useful, but the leading edge is always moving, and we can be a part of that leading edge if we want to be.

At least we are probably ahead of the game compared to someone who said that he "doesn't believe in Technical Analysis". Probably, but not necessarily. Warren Buffett said that he doesn't believe in TA either, and few of us have done as well as he has. However, be that as it may, it is useful for us to keep our eyes on the emerging changes that move financial markets and stock prices.

To come back specifically to Islamic financial products, I read that Citibank has already been awake to this financial services opportunity for over ten years. So, even if it is not a major part of your trading system, the Lunar Indicator (or as Jose has suggested, perhaps it should be renamed the Hijri Calendar indicator) is something that is at least worth knowing about and understanding.


Best wishes, good trading, salaam,
TonyM.