The Marriage of Fundamentals & Technicals: Its a Delicate Balance

…How do you square a long-term “bearish” outlook on future returns with a short-term “bullish” bias when virtually every measure of fundamental analysis suggests the markets are very expensive? [Here’s how!]

Valuation Measures Are Horrible Market-timing Indicators

…Whether it is Market Capitalization to GDP, CAPE, Tobin’s Q, or Price-to-Sales, the problem with all valuation measures is that they are horrible market-timing indicators. As shown in the chart below, if you had gone to cash when the S&P first crossed into “expensive” territory greater than 23x CAPE, you would have missed most of the current bull market cycle.

Being doggedly attached to valuations and fundamentals can prove just as dangerous to long-term returns as getting caught in a bear market. While a bear market does indeed destroy capital, not participating in a bull market has an equal impact on ending results…

Fundamental Analysis

In the short term, fundamental analysis has a near-zero correlation to performance outcomes. Therefore…we use basic technical analysis to determine when the overall market risk exceeds potential returns in the short term. From that basis, we can adjust portfolio risk accordingly. The chart below is a simplified chart for example purposes only.

As shown, we are not talking about “going all to cash” during a “sell signal” but instead just reducing exposure, taking profits, and rebalancing overall portfolio risk. When “buy signals” are triggered, it is just a process of reversing actions.

There are times when we increase the size of the “risk” adjustments and a good example [of that] was in February 2020 as the market was pushing well into 3-standard deviations above the 50-dma (pink shaded areas), and a “reduce” signal got triggered. Such required a more significant reduction in “risk” as the market began a much deeper correction. As the correction ensued, we continued to reduce risk accordingly.

Technical Analysis

However, therein also exposes a problem with technical analysis. While price action, which is a reflection of market psychology, can undoubtedly help mitigate portfolio risk, technical analysis does not distinguish between a short-term pullback (0-10%), a correction (10%-20%), or a full-blown bear market (a reversal of the bullish trend.) Unfortunately, the magnitude does not get revealed until after it has started. As such, it is essential to treat every signal with the same respect and act accordingly. For most investors, by the time they realize a correction is in process, it is too late for them to do anything about it…

The marriage of fundamentals and technicals is always a delicate balance.

• Fundamentals provide the basis for successful long-term returns but can lead to underperformance during momentum-driven markets.
• Technical analysis, likewise, has short-term benefits but can provide long-term challenges.

Blending the two is like a “marriage of opposites.” Such can be highly successful, but it requires a lot of work…

Conclusion

Yes, given we are in a strongly trending bull market, driven by massive amounts of exuberance and liquidity…[that] is why we overlay analysis to align expectations with reality. Implementing a solid investment discipline and applying risk management leads to the achievement of those expectations…Our goal is to [be] prepared.

Editor’s Note:  The original article has been edited ([ ]) and abridged (…) above for the sake of clarity and brevity to ensure a fast and easy read.  The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.  Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.

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