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FUSION ANALYSIS:
Blending Your Ability to Generate Risk-Adjusted Excess Returns
What is “fusion analysis?” you ask…
By contemporary definition, it is the proper blend of technical, behavioral and fundamental analysis. Proper use of fundamental techniques are required for selecting investments that are designed to generate risk-adjusted excess returns. Whereas users of technical and/or behavioral analysis (institutional investors to short-term traders) need to get another perspective in activities such as market timing and minimization of transaction costs.
Below, we have an excerpt from a recently published article by John Palicka (see bio on this page), the president and chief portfolio manager of Global Emerging Growth Capital.
This article appeared in “The Technical Analyst” May/June 2005 edition and is reprinted with permission.
THE SELLING CLIMAX
FUSION ANALYSIS IN ACTION
By John Palicka
The number of managers, especially hedge funds, using a combined fundamental and technical approach to investing has been rising. Achieving risk-adjusted excess returns is not easy and it makes sense to be pragmatic. Yet while there are numerous books and journals devoted to fundamental and technical analysis, each in isolation, there is little written about the two combined.
Here, I present an example of how a quantitative fusion trading strategy can be built from a combination of fundamental, technical and also behavioural considerations, to identify and trade the Selling Climax –
a fairly common occurrence in the markets.
Technical considerations
Based on the definition of leading technical
analyst, John J. Murphy, a selling climax is a significant reversal occurring at a chart bottom. (One can also have the reverse, a Buying Climax at a chart top). It is "…usually a dramatic turnaround at the bottom of a down move where all the discouraged longs have finally been forced out of the market on heavy volume… The subsequent absence of selling pressures creates a vacuum over the market, which prices quickly rally to fill."
While it may not mark the final bottom of a falling market, it usually signals that a significant low has been seen. Edwards and Magee in their
Technical Analysis of Stock Trends (8th Edition) state, "It is a harvest time for traders who, having avoided the bullish inflection at the top of the market, have funds in reserve to pick up
stocks available at panic prices".
So, a selling climax based on the observations of leading technicians appears to provide good return opportunities.
Fundamental considerations
Selling climaxes may reflect various corporate imbroglios, such as earnings disappointments and governance issues. Optimistic earnings models of PEG (price/earnings to growth) and DDM (dividend discount model) are scaled down substantially, leading to lower earnings estimates and the removal of buy recommendations.
Upon sell-off, however, a stock may reach valuation levels that are more attractive (e.g. lower price/book ratio, smaller market capitalization). Some value players would also claim that the lower P/E ratio of the stock should enable it to show future risk-adjusted returns as well. This is based on the belief that over long periods low P/E stocks perform better than high P/E stocks, because investors tend to overpay for the perceived expected growth associated with a high P/E ratio. Under the Gordon Growth model, a P/E increases as growth increases, assuming the other variables remain constant.
Behavioural considerations
James Montier, a leading observer of behavioural finance on Wall Street has commented, "... if a stock price drops, then in theory if the analyst were correct in their initial price target, it should become even more attractive to buy. However, in practice, analysts actually reduce their target prices in response to a drop in the current market price."
One behavioural influence on analyst forecasts is Representativeness. This is a "…tendency to evaluate how likely something is with reference to how closely it resembles something else, rather than using probabilities." For example, one could see the initial accounting scandals of Tyco as similar to those of Enron, even though based upon subsequent events they weren't even close.
Representativeness generates inappropriate forecasts, which partly explains why stocks trade at much lower levels than would otherwise be expected.
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A specialist in portfolio management and mutual funds, John has over two decades of hands-on experience in the global, emerging and domestic equity markets. Currently, John is the Chief Portfolio Manager for a global small cap fund that has been ranked in the number one spot by Money Management Review for the 10-year period ending 6/05.
John is involved in financial engineering and acts as a sub-advisor for an offshore institutional global fixed income fund for a major European bank. He also provides financial advice to global small-cap companies, especially in the service and IT industry.
He has been awarded several prominent assignments, including the award of a major Polish government fund, and the assignment of evaluating the largest private equity voucher fund in Bulgaria. He has created an institutional research list of Central and Eastern European companies which has outperformed the IFC and MSCI indices. In his remarkable career, John has also created corporate finance deals and negotiated joint investment ventures in Russian and the Ukraine as well as working with other managers to develop various asset management products for Asia and Eastern Europe.
John specializes in the instruction of many topics, including: Mutual Funds, Hedge Funds, Technical Analysis, Corporate Finance Accounting, CFA, Portfolio Management, and Fixed Income Credit Analysis, amongst others. He also instructs in banking standards for credit analysts.
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| Interested in having John Palicka deliver a seminar for your group? |
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Presenting Credit Markets Updates & Enhancements for Magellan On-line Learning
Responding to the popularity and demand for in-depth knowledge in the Credit Markets, Chisholm Roth has enhanced their Magellan On-Line Learning programs.
Credit Default Swaps (CDS):
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Thorough analysis of relationship between asset swaps and CDS |
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Expanded section on structural and reduced form pricing |
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Using reduced form models to estimate the default probabilities (hazard rate function) implied in the observed CDS market rates by a bootstrapping technique |
Structured Credit Derivatives:
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Expanded information on cash and synthetic CDO’s, CLNs and managing correlation products
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Structuring first-to-default and higher order default baskets |
Credit Risk Models:
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Expanded sections on CreditMetrics and KMV models |
As is Magellan’s strength and uniqueness, these new sections include Excel-based models to illustrate the techniques being presented.
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