Confirmation: The Art of Market Analysis
A Multi-View Approach to the Stock Market
At any point in time, there are several forces exerting their pressure on equities. Geopolitical conditions, economic activity, federal reserve stance, corporate fundamentals, technical indicators or market sentiment and the appetite of investors all play a role in defining market directional bias. Analyzing these complementing, or conflicting forces to navigate the uncertainties of the market is an art more than a science. A contextual view where an investor equipped with a proper methodology put things in perspective is what confirmation is all about.
Confirmation in Market Analysis
Confirmation in market analysis refers to the concept of incorporating multiple data points or views to reach a conclusion. Rather than relying on a single clue to initiate a trade, an investor will try to confirm his hypothesis by looking at the same situation from multiple dimensions.
There are no certainties when it comes to the market. All what an investor is doing is increase his chances of a successful trade by incorporating different viewpoints. Confluence of these views make a strong argument in favor or against a specific trade. When the weight of evidence is enough to justify an action, making a move should reduce emotional burden as well. The lure of deciding on an individual data point could be tempting, but whoever has experienced market ups and downs appreciates the value confirmation has to offer.
Market participants tend to agree that there are several ways through which the market can be analyzed, and the most well-established ones are fundamental analysis and technical analysis. Here is a brief about each of them.
Fundamental Analysis
This is a method of analyzing a company’s intrinsic value by conducting qualitative and quantitative analysis. This includes assessing its goodwill, recognition within the market, financial standing, together with evaluating the strength of the industry it belongs to and the health of the economy. By combining these factors, an analyst determines whether the stock is trading below or above its fair value. A buy recommendation is given, for example, if the stock was found to be undervalued under the assumption that stock price should eventually match its fair value.
Technical Analysis
This is a method of predicting market future price movement by analyzing historical prices and statistics. The prices are depicted on charts which can be analyzed by themselves or with the help of indicators. Technical analysis assumes that market discounts everything as all selling and buying in the market already reflects all forces such as fundamentals and psychology. It further assumes that prices move in trends. Another assumption is that price movements can be detected through identifiable patterns that reflect market psychology of fear and greed. These patterns tend to repeat themselves as crowd psychology tends to remain the same. By recognizing patterns on the chart, or analyzing the outputs of various indicators, an analyst aims to initiate trades with higher probability of success.
We can argue about the way we should analyze the market, whether we approach it fundamentally, or confine it to technicals. Both offer strong perspectives, but the concept of confirmation will remain valid. Whether you want to exercise it within the same discipline or go further by analyzing inter-market dependencies, confirmation should remain an integral part of your analysis toolkit. Confirmation can be applied on a specific domain such as technical analysis, or it can span over multiple areas and combine them together. Let’s explore these two topics one at a time.
Confirmation Within the Same Discipline (e.g. Technical Analysis)
Confirmation can be applied in the same knowledge sphere as technical analysis. In fact, it serves as a cornerstone of any solid analysis using technical tools. Combining multiple data points to form a firm opinion on the validity of a trade is a practice preached by seasonal traders and investors alike. However, it is essential to view the situation at hand from multiple dimensions rather than adding data points form a similar study. Technical analysis offers multiple tools categorized in different classes that view the same problem from different perspectives. Picking samples from these categories is the key to achieving proper diversified confirmation.
There are basically two types of technical analysis.
Price Action
It is a method by which price is analyzed over time for clues to determine future price movements. Examples include support and resistance, trend lines and chart patterns.
Indicators
These are mathematical calculations based on historical data that are assumed to have predicting power of market future movement. By analyzing statistical data of an activity, such as price or volume, a technical analyst identifies opportunities that have a higher probability of success.
Indicators themselves can be further divided into four categories.
· Trends such as moving averages
· Momentum such as RSI
· Volume such as On Balance Volume (OBV) or simply Market Volume (although not technically an indicator as no calculation is involved)
· Volatility such as Bollinger Bands
To reach a conclusion, one can combine studies and data from different types or merge studies from different categories of the same type to solidify one’s thesis regarding a position he wants to initiate. This can mean for example combining chart patterns with indicators like volume or blending different categories of indicators themselves such as trend and volume to come up with a more confirmed view. If a trader reaches the same conclusion from various viewpoints, the significance of a signal increases and the chances of a successful trade mount.
Let’s take an example to clarify the idea.
In July 2021, a confluence of setups suggested a profitable trade in AMD. We can see AMD stock was range bound between 73–75 and 95–100 for a year from Aug 2020 to July 2021. A break above the resistance occurred in July 2021. This was accompanied by heavy volume that gave significance to the breakout. To further solidify the position, golden cross (where 50 EMA crossed above 200 SMA) occurred as well. Note that the resistance was formed around a psychological round number 100 giving the resistance and the subsequent breakout further significance. Confirming psychological resistance breakout (price action) with volume and a golden cross (trend indicator) gave further validity to the generated signal.
One could initiated a trade at area A when the initial breakout happened or waited for a pullback at area B to take a position.
There were various ways profit could be taken here, ranging from liquidating position around 120 after the pullback in B or applying a money management technique to reap further benefit of the subsequent move to around 160.
Confirmation as a Broader Concept
Confirmation is not necessarily restricted to the same discipline. A broader view of the market and its dependencies on several economic and fundamental factors requires that an investor puts matters in context. Contextual view where various economic, fundamental, and technical forces act in tandem is a more natural way of looking at the markets. Hence it is vital for an investor to look for cues in various areas and seek confirming signals when building a position in a portfolio.
I have explained in a previous article how macroeconomic conditions play a role in defining ups and downs of the market. The same can be said for an individual stock where deteriorating fundamentals can drag the price down. Technicals, on the other hand, can for example surprise the market to the upside even during economic and fundamental turmoil. At any point in time, there are various forces applying their influence on the market and different viewpoints through which you can analyze them. When these views confirm each other, a stronger signal can be generated. One can confine to a specific area of analysis but analyzing market inter dependencies has proven to be a wise idea.
Certain sectors of the market have an inherent ability to weather economic storms. Others show strong fundamentals that can withstand economic downturn. Some firms might be affected by several negative factors that contribute to the downward trajectory of the entire sector even when the fundamentals of a specific company look attractive. On the other hand, when the economy is booming certain sectors perform better than the overall market, offering higher return on capital. Knowing the intricacies of these firms and sectors would be an added benefit when approaching investment decisions.
One can argue then why combine technical analysis at all? Confining yourself to a view where you consider macroeconomic conditions and drilling down to the specific fundamentals of the company and sector should be sufficient to initiate a profitable investment. And one can rightfully do so. In fact, numerous accounts of long-term investors do not pay too much attention to technical analysis when filtering out their investments. However, regardless of how much fundamentals have shown their significance in considering a company for investment, technicals have provided vital clues in timing the market appropriately. Whether it was the volume that showed buying significance, or a momentum indicator that highlighted an overheated stock, technical analysis has added layers of information not available through fundamental analysis. Furthermore, not every individual has the capacity or the personality to buy and hold or invest for a long term. Some successful traders execute swing trades that rely heavily, if not solely, on technical analysis.
A possible approach would be to combine the best of the two worlds. Use fundamentals for stock selection by determining the intrinsic value of the company and the significance of the sector given economic conditions. Then utilize the technical toolkit to confirm the fundamentals and find the optimal time to initiate the trade.
One drawback of confirmation is that it limits the number of possible trades. Adding more filters and requiring further confirmation will reduce your potential trades but it should increase your chances of success. Markets are full of trades and opportunities and the upside of more profitable trades should outweigh the downside of fewer possible ones.
Let’s take two examples to elaborate on this concept.
In this example we take Encore Wire that was trading in a range during market turmoil in the beginning of 2022. Encore Wire belongs to the Industrial sector which was performing relatively well during the downturn. Drilling into the fundamentals of the company itself, one can observe it had a strong balance sheet and impressive earnings that were beating analysts’ expectations on a regular basis.
Taking into consideration its strong fundamentals, one could incorporate technical tools to time the trade. At area A, the price hit the support zone around psychological round number 100. Confirming the signal, stochastics indicator was showing a buy recommendation as the price bounced back around 100. Impressive fundamentals, even during economic slowdown, coupled with several technical clues offered a profitable trade.
Position could be liquidated around the resistance zone of 147–151 or money management techniques could be applied for further gains.
In this example, Microsoft’s stock is shown in a downturn during almost 2022 in its entirety. A channel can be observed in which the stock was trading in a downward trajectory. When the market hit a bottom in October, so did Microsoft’s stock. By early 2023, Microsoft announced a multi-billion-dollar investment in ChatGPT creator OpenAI. ChatGPT went viral, and investors sought to pile into prominent artificial intelligence firms. ChatGPT success gave Microsoft an early leadership in the AI race and a strong fundamental boost for the stock.
Observing the fundamental boost Microsoft stock had, one could couple that with technicals to time the trade. The chart depicts a triple bottom pattern formed between October 2022 and the beginning of 2023. A breakout at area A was significant as it marked almost the breakout from both the down trendlines and triple bottom pattern. A trade could be initiated then or a pullback at area B could be used to build the position. Note how area B marked a combination of pullback to the extended trendline and a golden cross (50 EMA crossing above 200 SMA) confirming each other and adding to the significance of the signal.
Taking profit is subjective but an initial target has already been reached in the 300 zone.
These examples illustrate the power of blending the best of the two worlds into your analysis. Fundamentals are great for assessing economic conditions and a firm’s valuation. Technicals provide their own signals, that when confirmed with fundamentals offer a valuable and deterministic entry and exit points.
It is evident that the market is an uncertain environment. Navigating it with prudence and proper judgment equipped with appropriate knowledge is the key to a successful journey. As the market is a product of competing forces, analyzing it is an art that requires putting things in perspective and confirming an action from a variety of viewpoints that the market has to offer.
