<< Read Part 1:Why Stock Prices Are What They Are

<<Read Part 2: From Dividends To EPS – Why Stock Prices Are What They Are

This is the third installment in a series that explains why stocks are priced as they are (or for those who prefer a more precise view, why supply and demand trends for a stock are such as to cause the two to converge at one point as opposed to any number of others). Part 1 introduced the penultimate explanation, to wit, that the price of a stock is the present value of future dividends. Then, moving from Ivory-Tower dividend-discount approaches closer to the real world, Part 2 showed how EPS supplanted dividends as the metric upon which many investors hang their hats. Now, we’ll dive deeper into day-to-day reality and consider the logic behind many other approaches to stock selection, which, however varied they may seem, are all linked by a common core: a logical connection with the stock being worth the present value of expected future dividends.

Starting With a Bang: Technical Analysis

When considering how I would approach this installment, I had initially intended to present this as the last topic. On reflection, though, after all the theory discussed in the first two articles, it occurs to me that now would be a good time not just to enter the real world but to bang down the door and bull our way in. So let’s jump now to the style that might seem as far removed from theory as possible.

Imagine a stock whose price has been stable suddenly jumping up above the upper boundary of what had been its trading range. Perhaps the 50-day simple moving average crossed above the 200-day average. Maybe the price broke above the upper Bollinger Band. Also, let’s assume that whatever happened was “confirmed” by Chaikin Money Flow indicators. Can we expect the stock to rally going forward?

If we want to be strict logicians here, we absolutely cannot expect further stock price strength based on such factors or any other indicators or patterns. Price movements in the past do not cause price movements in the future.

“Phew,” say the Value Police. The crackpots aren’t going to come off looking good.

Actually, though, it’s not so simple.

Let’s try to imagine why a stock might show what some might label “technical” strength. It’s not random. We already know enough to make reasonable assumptions.

If a stock breaks above a trading range, absent comparable movement by the market as a whole, we might infer that investors who look at fundamentals saw reason to revise their assumptions and now notice that the present value of expected future dividends (or EPS) is higher than it once was. We may not be able to get more specific. We may not talk to any such investors. But unless we throw up our hands and conclude that the market is completely random (a lot of professors used to do that, but I think that view is becoming increasingly discredited), then we are justified in assuming that those who know, or those who think they know, or who think they know which others are in the know, have re-calibrated their expectations.

It’s just this simple. Whether practitioners of technical analysis acknowledge it or not (there are many in both camps), they are, in essence, piggybacking on the fundamental analysis done by others. Some openly combine fundamental and technical factors. Many don’t but wind up identifying and working with observed price-volume patterns they believe are consistent with behavior by investors collectively deciding to bid the stock price upward. Whether they succeed or not will depend, not on whether technical analysis is voodoo (it isn’t) but on (i) whether the fundamental expectations upon which they’ve piggybacked pan out, and (ii) whether the visual or data patterns upon which they rely are, indeed, properly reflective of the investor behavior they expect it to reflect.

By the way, this sort of thing can get quite complex. The market doesn’t turn bullish or bearish as if a light switch were being flipped on or off. Investor sentiment typically evolves through give and take. For example:

Again, good technical analysis hinges on relevant fundamental events combined with recognition, in the price and volume trends, of rational investor responses. Successful technical analysis does not involve tealeaves, tarot cards, etc. It involves development of a sound narrative to explain investment community behavior in response to events. And event number one is something along the lines of what we’ve been talking about – an understanding of and response to the factors that influence stock prices. 

With that framework in mind, let’s go back to fundamentals (my personal comfort zone) and consider how Dividend/EPS-based valuation can be stretched into other fundamental factors.

PS, Price-to-Sales

Back at the turn of the century, a lot of investors valued stocks on the basis of sales, and a lot of them got their heads handed to them. Hence PS went out of favor for a while, having been seen as a tool for the unscrupulous to hype the shares of companies that had no earnings.