Last Updated March 1998

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OW DID THE ASIAN CRISIS affect your portfolio? Your answer is probably determined by your exposure to foreign stocks. A lot of advisors recommend you own foreign equities (even foreign bonds). Have your investments ventured outside the U.S.? Is now the time to seriously consider it or should you keep your assets within our shores? Let us help you decide if you should be Home or Abroad?.

Regardless of where you invest, there's always the question of how to invest. Do you make your decisions based on boring corporate ratios or even more arcane indicators? While this site sticks with the fundamentals -- book value, corporate earnings, debt management …, it's interesting to see how the other half lives. If you've ever wondered about indicators, support levels, and oscillators, check out Fundamental Technical Analysis. This won't make you one of Louis Rukeyser's elves, but it'll be easier to see how they differ from the rest of us.

Do you have any opinions? Of course you do (if you're not dead). Forward them on and you might star in an upcoming Stating the Obvious essay. Here's your chance for your fifteen minutes of fame.

Home or Abroad?

"Well, I learned a lot...You'd be surprised. They're all individual countries."

-- Ronald Reagan

 

K, HERE'S THE SITUATION: IN 1997, Japanese stocks were down 25%, Singapore's markets were off 40%, and South Korea's were down 60%. Europe showed signs of emerging from recession, and the U.S. markets averaged over 20%. Either this is a great time to buy low in the Pacific Rim or hunker down in the U.S. There's two different schools of thought on this. Each has compelling arguments but of course, they're mutually exclusive.

Like everything in the inexact science of investing, there's no definitive answer. What does exist, however, are the facts -- something both sides often overlook. To make some sense of this situation, let's start by looking at the arguments and then see how they stack up against the facts.

The S & P is well over 20 X earnings, the U.S. expansion has gone on for almost 15 years, and the bull market has run right along with it. Historically the U.S. economy has moved through cycles -- periods of expansion followed by contractions (recessions).

One thing most people agree on is the fact that our expansion will at some point slow down, if not stop altogether. Investors who rely solely on U.S. stocks will be faced with something unheard of for over a decade: actual losses. But other economies move in different cycles, too. When the U.S. enters a bear market, foreign markets may be in the opening stages of their bull run.

This isn't unprecedented. From 1970 to 1978, the U.S. stock market returned only 4.6% a year while foreign stocks (as measured by the Europe, Australasia and Far East (EAFE)Index) jumped 13.5%. Now the reverse is true. Since 1988, the S & P has returned an average of 18.2% per year vs. 4.3% for foreign stocks. Just as the 1978 investor would have been better off buying low U.S. stocks, the 1998 investor would probably fare better in foreign stocks.

It's essentially a matter of diversification. You spread your investments over different companies of varying size in assorted industries to avoid too much exposure to one stock or sector. This reduces your risk since you aren't too closely tied to any one company or sector. Investing abroad adds additional diversification by reducing your dependence on the U.S. economy. When the cycle does turn down (it's not if, but when) other economies will be headed up. If you're totally tied to the U.S., you'll lose. If you have some foreign exposure, it'll at least partially offset your domestic losses. It's just that simple.

Or is it? Investing xenophobes (what a great word!) ask why anyone would put a dime in any foreign market when we can invest in the world's strongest economy right here at home? What do you know about the industries of Korea, Japan, Yugoslavia, or for that matter, even Canada? Unless you're quite the world traveler, you're probably much more familiar with the stocks of companies right in your own back yard.

U.S. companies are regulated as far as their accounting and reporting practices. Unless you're buying a penny stock from some boiler-room huckster, you can probably find more than enough information about any domestic stock. Foreign countries don't have such consistent reporting. In fact, you never know what effect some goofy foreign government intervention will have on their country's stocks.

And even if you find a foreign stock that does well, foreign taxes or currency exchange rates may take your profits before you can repatriate them. It's hard enough to find a good foreign stock, much less have to deal with external factors. There's plenty of good (and bad) stocks right here in the U.S. You don't have to leave our shores to find them.

Enough Already! Here's the Facts

Fact 2: A Little Diversification is good, but a lot is bad. Diversification is like fertilizer: when used in moderation, it has positive effects; but when overdone, it's destructive. Just as this holds true for domestic investing (see [Structuring Your Portfolio]), it also applies to foreign investing. You've got to do your homework even if you use a mutual fund to invest abroad.

You see, some funds hedge their bets by mirroring the EAFE country weightings. They say this is an advantage since they aren't trying to outguess the markets, just index them. Well that's OK, but it's also stupid. There's no reason to pay the high foreign fund expense ratios if all you're really doing is indexing. The ultimate benefit here is supposed to be exposure to improving markets when domestic ones are down, but this purpose is defeated if you're in all foreign markets since many of them will be down, too. Pay for management, not blind indexing.

Fact 3: The Potential Benefit of Foreign Investing is Much Greater for Short-Term Investors. Sure economies move in different cycles. It's also true that some are up when others are down, but so what? If all you're doing is investing for one or two years, it's really important that you seek out expanding markets. But if you have a longer-term horizon, it all comes out in the wash. Although domestic markets have recently trounced foreign ones, while the reverse was true in the 70s, since 1969 the S & P 500 has averaged 13% per year vs. 12.5% for the EAFE. The long-term investor doesn't get a lot of extra value for the additional risks associated with foreign investing.

Fact 4: You Can Benefit from Foreign Economies by Investing Domestically. Over 70% of Coca-Cola's profits are derived on foreign soil. Financially sound U.S. companies are swooping in on troubled foreign companies to buy market share on the cheap. They're also able to "outsource" production into troubled economies where costs are significantly lower. But since these are domestic companies, they trade on U.S. stock exchanges, file consistent financial disclosures, and report earnings in U.S. dollars. If you want foreign exposure, they would seem to offer the best of all possible worlds.

Fundamental Technical Analysis

"Men, forever tempted to lift the veil of the future -- with the aid of computers or horoscopes or the intestines of sacrificial animals -- have a worse record to show in these "sciences" than in almost any scientific endeavor."

-- Hannah Arendt

 

NE OF THE GREAT THINGS ABOUT the Internet is the wealth of information available for the individual investor. Company homepages provide recent statistics (along with management's spin) while other sites offer research and opinion… There's a lot out there -- if you know how to use it.

If you've visited these sites or heard some alleged experts being interviewed, you've probably noticed that some of them don't just deal with the economy, earnings, ratios, and prices. Instead, some base their selections and opinions on "support levels", "trading volume", and other "indicators". This latter group is the "technicians" -- those who rely on technical rather than fundamental analysis.

…[F]undamental analysis involves studying a company's financial position, its market, and earnings potential. On the other hand, technical analysis focuses on the forces at work within the marketplace itself. The underlying assumption is that equity markets are no different than any other economic market. Prices are determined by supply and demand -- the greater the demand for a stock (with limited supply) the greater its price, and vice-versa. Technical analysis offers methods to study these forces and (presumably) use them to make buy and sell decisions.

Is it helpful? Does it work? Well, it all depends on where you're sitting (or what you're drinking). While some technical analysis appears to be just this side of voodoo, there are some instances where it's uncannily accurate. Here's a brief overview of the two main types of technical analysis. If you want more detail, let us know and we'll include it in a future update.

Whither the Market, or Will the Market Wither?

• MARKET VOLUME The market is healthy if on days it goes up, volume is high while on days it goes down, volume is low. When this trend reverses, the market will deteriorate.

  
  

• MARKET BREADTH No, not breath, breadth. This is essentially the difference between market winners and losers. The assumption is that breadth measures investor demand for stocks. It's not enough that advancing stocks outnumber decliners, it's also important that this difference steadily increase. If the gap begins to narrow or losers actually outnumber winners, this is a sign of falling demand and lower prices ahead.

• BELLWETHER STOCKS Remember that old saying, "What's good for GM is good for the country"? Well, this indicator puts that into practice. It assumes that certain bellwether stocks actually serve as market proxies. When they do well -- by reaching a succession of new highs -- the market as a whole should also perform well. But when the bellwethers stall or reverse course, the market will as well. The key to this indicator is figuring out what your bellwethers are. The 1970's "nifty fifty" certainly aren't appropriate now.

• SHORT INTEREST This is a "contrarian" indicator, so follow this closely. Traders who sell stock short essentially sell high so they can later buy low. They accomplish this by selling shares of stock borrowed from other investors. To close the transaction, they have to replace the sold shares by (hopefully) buying them back at a lower price. "Short Interest" is a measure of the number of stocks currently sold short. It is appears at least once a month in publications such as The Wall Street Journal and Baron's. Now here's where things get contrarian: A rise in short interest indicates that traders are pessimistic, having sold more stock short than they've replaced. But ultimately, all short positions have to be closed, signaling a future increase in demand and therefore prices. When short interest falls, the opposite should hold since demand will fall off.

• ODD-LOT TRADING This is perhaps the most cynical indicator out there. As commission structures have changed, it's lost a little of its backing, but technicians still rely upon it. Here's how it works: When institutions and large investors trade, they normally do so in "round lots" -- blocks of stock evenly divisible by 100. On the other hand, individual investors often don't have the cash or courage to purchase such large positions so frequently trade in smaller amounts or "odd lots". Professional investors historically look down on this group since their investments and timing are frequently wrong. There is some evidence to indicate that small investors typically jump in the market when it's nearing the top. As a result, technicians using this indicator believe increases in odd-lot trading indicate the market is reaching a top. Perhaps this indicator will need to be revised given the small investor's fortitude after the October 1997 market decline.

Some technicians use a few of these indicators; others group them together and assign various weights; effectively creating models. As odd as these may seem, before dismissing them you should know, studies have shown that between 20 - 50% of a stock's performance is determined by market forces. The only question is, are these the correct way to measure market forces?

52 Weeks on the Charts

Although technicians' charts are usually all based on price, they can be quite different. Most, such as bar, candle, or flow charts, map the equity's high, low, and closing price. Others, such as the "point and figure chart", follow price changes rather than daily prices. Regardless of the type of chart used, the technician's goal is to identify trends that can be predictive.

The accompanying price chart illustrates several of these techniques. This is a "bar chart" with the length of each line spanning the distance between the day's high and low. The additional point on each line represents the closing price. The "moving average" line shows the average of the previous period's closing prices. Periods usually range from 14-200 days. For the technician, this line not only shows the general price trend, it also represents the stock's long-term "support level". If the daily closing price drops below this line, this is a indication that a major downtrend is underway. On the other hand, if daily prices are below the moving average, a close above it signifies an uptrend.

In addition to these long-term trends, technicians look for short-term signals from "formations" in the daily closing prices. These have some really cool names like "Double top", "Pennant", "Falling wedge", "Head-and-shoulders", or (our favorite) "Dormant bottom". When recognized in a stock's chart, these formations are buy or sell signals.

Finally, stock prices tend to stay above certain points (called "support levels") while bouncing off higher ("resistance") levels. Once a resistance level is penetrated, it then becomes a support level. It's really uncanny, but almost any stock chart has these characteristics. When short-term price trends reverse, there's a "breakout". This is again, a buy or sell signal.

A true technician doesn't care at all about the underlying fundamentals of the company he or she is studying. All that really matters is the price movement and formations on that particular equity's chart. The secret to technical analysis is knowing the price patterns and their related predictions.

Cause and Effect

But before you go making any decisions involving real money, there's one important thing you need to decide for yourself -- Do technical tools really reflect a causal relationship between prior performance and future price movements? If there's no causal relation, there's no predictive reliability. All you have is some interesting coincidences.

Wow! What did all that mean? Well, here's an example. One of the most celebrated "indicators" is the so-called "Super Bowl Indicator". It goes something like this: In years in which the game is won by an old NFL team, the stock market goes up. In years in which an old AFL team prevails, it goes down. Do you see a causal relationship here? Of course you don't, there isn't one! But guess what? This indicator has been accurate about 90% of the time. Coincidence? Of course it is, but if you see it enough, you might start to believe in it.

Is technical analysis any different? Well, that's up to you to decide. If you think there's a causal relationship between technical charts and indicators and what will happen in the future, go with it. If, on the other hand, you think it's just so much voodoo, stick with fundamental analysis. Of course, if you want the highest degree of accuracy, consider the Super Bowl Indicator.