Section 6: the essence of fundamental analysis- 123docz.net

From the John Magee Market Letters, December 15, 1984 by Richard McDermott

The Elliott Wave Theory: perspective and comments

This week we had the pleasure of attending the December meeting of the Market Technicians Association of New York.

Long-term subscribers will remember the MTANY as the organization that honored John Magee with its “Man of the Year” award in 1978. The speaker was Robert Prechter, publisher of “The Elliott Wave Theorist,” an investment advisory which bases its forecasts on interpretations of R. N. Elliott’s work on the stock market.

Of primary interest to SAS subscribers are Prechter’s comments on technical analysis itself. The Elliott Wave Theory, it must be remembered, is really no more than a “catalog”

of stock market price movements, laid one on top of the other, so to speak, until a grand, underlying, and enduring pattern is observed; in short, pure technical analysis. Among Prechter’s defi nitions and observations regarding fundamental analysis are the following:

1. “First let’s defi ne ‘technical’ versus ‘fundamental’ data … technical data is that which is generated by the action of the market under study.”

2. “The main problem with fundamental analysis is that its indicators are removed from the market itself. The analyst assumes causality between external events and market movements, a concept which is almost certainly false. But, just as important, and less recognized, is that fundamental analysis almost always requires a forecast of the fundamental data itself before conclusions about the market are drawn. The analyst is then forced to take a second step in coming to a conclusion about how those fore- casted events will affect the markets! Technicians only have one step to take, which gives them an edge right off the bat. Their main advantage is that they don’t have to forecast their indicators.”

3. “What’s worse, even the fundamentalists’ second step is probably a process built on quicksand… . The most common application of fundamental analysis is estimating companies’ earnings for both the current year and next year, and recommending stocks on that basis… . And the record on that basis alone is very poor, as Barron’s pointed out in a June 4 article, which showed that earnings estimates averaged 18% error in the thirty DJIA stocks for any year already completed and 54% error for the year ahead.

σ =

( )

∑ Ri – μ

n − 1

i = 1

n 2

Diagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate the average return; (2) calculate the deviation of each return; (3) square each period’s deviation; (4) add them together; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take the square root.

The weakest link, however, is the assumption that correct earnings estimates are a basis for choosing stock market winners. According to a table in the same Barron’s article, a purchase of the ten DJIA stocks with the best earnings estimates would have produced a ten-year cumulative gain of 40.5%, while choosing the ten DJIA with the worst earnings estimates would have produced a whopping 142.5% gain.”

We enjoyed Prechter’s polished exposition of a technical approach different from our own. As for his observations about fundamental analysis, we simply could not agree more.

Portfolio Analysis Screens

PORTFOLIO RISK ANALYSIS (.30 Filename)

OMS+ .30 PORTFOLIO RISK ANALYSIS 3/24/87 10:55:28

--STOCK-- ----DELTAS----

SYM POS OPTION TOTAL PROFIT BETA $BETA $DELTA $GAMMA $THETA $RISK %RISK FDX 2800 –3063 –263 16734 1.60 –32081 –7017 158136 –121 18075 7.3

GE 3200 –3089 110 12632 .95 11374 2993 120104 –16 13000 5.3

HWP –6200 5682 –517 8270 1.20 –45959 –13404 –522208 734 56617 22.9

LIT –6700 0 –6700 0 1.40 –569834 –122107 122107 49.3

NSM 3600 –4080 –480 10411 1.45 –21076 –7267 150464 –169 17436 7.0 XRX –3600 3991 391 –882 1.05 18132 4835 186506 –260 20232 8.2

*TOT –6900 –559 –7459 47165 –639444 –141969 93000 166 247470 100.0

AVERAGE VOLATILITY: .338

EQUIVALENT MARKET EQUITY: –419613.40 PORTFOLIO PROFIT RATIO: .191 PORTFOLIO PROFIT GAMMA RATIO: 4.815

0 0

Diagrams B.2 and B.3 deal with portfolio risk and proﬁt analysis. Illustrated are the sophisticated quantitative portfolio Proﬁt and Risk reports of Delphic Options Research as implemented for Standard & Poor’s trading systems and Prudential Securities to give the reader an appreciation of the depth and complexity of professional thinking about risk and portfolio analysis. The originals of these reports were designed by Blair Hull and Lester Loops for their own use in market making.

Diagram B.2 Risk analysis.

Key: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profi t, and several measures of risk for a portfolio of user-specifi ed stocks and options.

The screen displays:

STOCK SYM = The stock symbol;

STOCK POS = The stock position, or number of shares owned;

DELTAS TOTAL = The sum of the stock deltas and option deltas;

BETA = The stock beta for each stock (implementation pending);

$BETA = $The dollar risk due to movement of the general market: $Beta = (Delta × Stock Price) × Beta;

$DELT = An annualized risk fi gure based on Position imbalance: $Delta = (Total Delta × Stock Price) × Volatility;

$GAM = An annualized risk fi gure based on curvature of the position. A positive $Gamma indicates a backspread, and a negative $Gamma indicates a vertical position: $Gamma = Total Gamma × (Stock Price × Volatility);

$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remains unchanged;

PORTFOLIO PROFIT ANALYSIS (.31 Filename)

OMS+ .31 PORTFOLIO PROFIT ANALYSIS 3/24/87 10:55:28

--STOCK-- ----DELTAS---- ---PROFIT--- %

SYM POS OPTION TOTAL MTO M TOTAL /DY/RISK RISK RISK

FDX 2800 423162 16734

GE 3200 704006 12632

HWP –6200 53787 8270

LIT –6700 –407025 0

NSM 3600 157293 10411

XRX –3600

–3063 –3089 5682 0 –4080 3991

–263 110 –517 –6700 –480

391 –4431 –882 /DAY

213 107 150 0 105 –18

4.31 3.01 .97 .00 2.21 –.34

18075 13000 56617 122107 17436 20232

7.3 5.3 22.9 49.3 7.0 8.2

*TOT –6900 –559 –7459 926792 47165 557 /RISK

.93 .97 .15 .00 .60 –.04

.19 .00

THETA –121 .16 734 0 –169 –260

166 247470 100.0

AVERAGE VOLATILITY: .338

EQUIVALENT MARKET EQUITY: –419613.40

PORTFOLIO PROFIT RATIO: .191

PORTFOLIO PROFIT GAMMA RATIO: 4.815

$ $

Diagram B.3 Profi t analysis.

Key: portfolio profi t report. The Portfolio Profi t Analysis screen summarizes delta, profi t, and several measures of profi t for a portfolio of user-specifi ed stocks and options.

The screen displays:

STOCK SYM = The stock symbol;

STOCK POS = Stock position, or number of shares owned;

DELTAS OPTION = Total delta of the option position;

DELTAS TOTAL = Sum of the stock deltas and option deltas;

M TO M = Mark to market: Total value of stock and options positions based upon market prices;

PROFIT TOTAL = Total theoretical profi t for each position;

PROFIT/DAY = Theoretical profi t divided by the number of days to expiration;

PROFIT/RISK = Ratio of theoretical profi t to risk;

PROFIT/DY/RISK = Ratio of theoretical profi t per day to risk;

$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remains unchanged;

$RISK = The annualized standard deviation of the position based upon a composite of $Delta and $Gamma;

%RISK = Percent of portfolio risk in each position;

TOT = Totals for each of the above categories;

AVERAGE VOLATILITY = Average volatility for the stocks;

EQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;

PORTFOLIO PROFIT RATIO = Total portfolio profi t divided by the total portfolio risk;

PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profi t divided by the portfolio $Gamma squared.

Diagram B.2 Risk analysis. (Continued)