Fundamentals or technicals? A third view

Fundamentals or technicals? A third view

Introduction

There have been long debates in the last 20 years about which approach is better as a forecasting means of the foreign exchange market. The two main schools of thought are traditionally the fundamental analysis and the technical analysis. As a matter of fact, this has been the case regarding also the securities and the bonds markets, but in this essay we will limit our interest to the huge FX market. Usually economists are the fierce advocates of the first school, while statisticians, mathematicians and other quantitative-oriented people give the battle on behalf of the second. Before drawing any conclusions let us try to describe briefly these two approaches. Actually, the main philosophical difference between them is the starting point of analysis, i.e. the question is «must one study the cause or the result?».

Fundamentals or technicals? A third view

The fundamental approach

In fundamental analysis analysts study the national and international economic facts and variables. Inflation, growth, unemployment, balance of payments are just a few of the objects under observation. Until the early 70’s economists used to draw more general conclusions about the course of the Economy. However, the use of quantitative economics mainly applied by Friedman and the Chicago school led to more specific forecasts through econometric models. Since then such models have been more and more sophisticated and have been used to derive forecasts of the various markets. In this context, assuming that the model parameters are correct and also hoping that they will keep behaving properly in the future, the fundamental approach reaches conclusions as to whether something is overvalued, undervalued or at par. In the FX case «something» is each individual currency. Hence, according to this approach, the market forces have to take care of this imbalance through arbitrage by selling whatever is overvalued and buying whatever is undervalued. Theoretically this process in the long term will lead to market stability.

Whether this is the case in the real world is debatable. After all, during so many years governments have been trying (have they?) to achieve this stability. Either at economic forums or through co-ordination teams (like the Group of 7) top officials keep talking about the so desirable stability even intervening massively in the market but not always with success. In fact, the market itself does what is expected from it to do. The problem here, unfortunately for economic planners, is that both the time horizon and the idea of overvaluation and undervaluation out there differs a lot from that of economists.

The technical approach

Technical analysis is not interested in the cause of a fact but only in the fact itself. In other words technical analysts’ starting point is that once there is an established trend in the market it is no more necessary to deal with its origins but only with its course. The existence of a trend implies that there is a given market psychology and until it changes, no matter why, market movements are subject to this mass psychological effect. It is then up to the market to decide what is «overbought» and what is «oversold».(there is a qualitative slight difference between these terms and «overvalued-undervalued» that are more often used by fundamentalists). According to technical analysis, once we reach such conditions the market will proceed with arbitrage by selling what it regards as overbought against whatever it considers as oversold, until some relative equilibrium is reached. In this case the market enters a period of consolidation. Resistance and support points, moving averages, momentum, Elliott wave analysis, Gann angles are only but a few of the numerous techniques used to derive results for drawing conclusions.

The advantages of the technical approach are closer to the real world in terms of shorter time horizons. It is true that the market usually discounts future changes in fundamentals and moves fast in anticipation of the coming effect. Indeed, one very well known motto says «buy on rumours and sell on facts». The problem with this approach is that there have been so many different techniques developed over the years that it becomes very difficult to reach a final decision to be applied in the real market. The argument can be taken even further by saying that there is a grave risk to reach contradictory conclusions depending not only on the individual technical study but also on the time element of one and same study. Hence, it takes a lot of experience for one to have the ability to make selections or even better to develop his own personal technique, to a degree that he can trust it.

Fundamentals or technicals? A third view

A third view

So far so good with debates. The real problem for the international speculator in the Foreign Exchange market arises when the moment of truth comes. Unfortunately, the market environment calls for something more than math equations and geometric curves. This is so because the FX market (as all markets) does not consist only of economists, technical analysts and investors. Let us be frank, there are billions of dollars to be earned by some and lost by others. Back in the 80’s the daily volume was only a «pitiful» $250 billion. In our days this amount has exceeded the $ 7,1 trillion figure. It is easily understood that even minimal percentage changes in rates lead to colossal changes in absolute money terms. Hence, we have to see the truth face-to-face and keep our feet down to earth as to how these immense amounts are manipulated.

Apart from individual investors there are the big predators. In the name of hedging or market stability, huge institutional investors and central banks are all in the game, the former for own-account and the latter for national account. One has nothing but look at companies’ and hedge funds’ balances to understand the sizes. In certain countries corporations have reached the conclusion that financial activities sometimes are more profitable than their own manufacturing activities, deciding, hence, to establish affiliate companies that deal only with financial matters. On the other hand, central banks have discovered that, apart from normalising erratic market moves, market operations like interventions yield a very nice hefty income.

Of course, this is not kept in their books but passed to their governments to cover part of balance deficits. On a yearly basis many big and famous central banks publish their results from open market operations and it is very interesting that they always show profits of some billions. Given that not all interventions are «advertised» this implies that they operate on both sides of the market for if they do not sell what they buy they cannot book profits.

Fundamentals or technicals? A third view

We must mention the use of foreign exchange rates as a tool of politico-economic pressure. Without going into details we have numerous examples of such action. This is true not only within any given country but also (and more common) among countries. Either through market operations or by official and sometimes «anonymous sources»’ statements a currency is lead to appreciation or depreciation of its currency until the goal is achieved. A lot of agreements have been reached at in this way, some of them financial and some others political.

Finally, the explosive spread of the information industry and the use of computers for trading have lead to even faster and harder to control markets. News breaking events reach investors in seconds all over the world. Trading through a screen and keyboard has made operations simple but decisions more complex. In addition, psychological changes have occurred as a result of new technology that has almost killed human contact and in the financial cyberspace one has only to kill if he does not want to be killed. Furthermore, it is much easier now-a-days for only a few operators to gather through technology much more information than in the past about trading orders flooding the market, being thus able to cause big movements via «stop-loss» activated chain reaction.

Fundamentals or technicals? A third view

What is then the conclusion from these rather «horrifying» thoughts? As a matter of fact, nobody can change market conditions, neither anybody is able to predict what the environment will be in the next few years. Having said that we must try to make a synthesis on how can one decide what to do or not do. Doing nothing is not the ultimate solution because, everybody is subject to all market changes, whether he likes it or not. The bottom line is that we do not discard economic fundamentals for the longer term, after all if one lives on credit one has to pay at some point. Therefore, the economic environment says the truth in the end of the day, it remains to determine which is the day. We do not discard technical’s as they represent a rather good picture of the present and one cannot ignore the present. We do not discard the «big guys» as they are the people who really make the market. We just believe that operations in the Foreign Exchange market call for much caution, thought and if possible top professional advice. The last one is a difficult task, indeed. For the top professional adviser is not necessarily somebody who is a top economist neither someone who is only an expert in technical analysis. It takes more than this, it takes inspiration. front-line experience and ability of synthesis

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