Fundamental and technical (or momentum) trading are two major investment strategies in the stock market. Both have been shown to work and be profitable for investors. They have different goals, methods and time frames, but what I find fascinating is the perspective that can be gained when looking at how these two groups of people interact with each other, that is buy from and sell to each other, in the market.
Fundamental trading is a balancing feedback loop. It buys when the price is below fair value and sells when the price is above fair value. This has the effect of bringing the stock price back closer to its fair value. Technical trading is a self-reinforcing feedback loop. It buys when the price is going up and sells when the price is going down. This has the effect of exaggerating the fluctuations in stock price. What kind of behaviours result from these opposite two tendencies?
It is a source of volatility and of market inefficiency. When a stock price is near its fair value, there will be very little activity (volume) from trades by fundamental investors. The movement of the stock price will respond instead to the activity of technical traders, which will give it increasing momentum in whichever direction it happens to be moving. As the stock price moves further from its (perceived) fair value, fundamental investors will begin to act (buy low, sell high) in greater numbers, slowing and finally reversing the direction of the movement. As the movement slows, due to the buying or selling pressure from fundamental traders, technical traders will realize that momentum is being lost and will slow then stop their activity. This increases the influence of the actions by the fundamental investors.
As this pattern is repeated, a stock price would be expected to oscillate around its fair value. The size of the oscillations would reflect the strength (volume) of the two groups and the size of the range within which fair value is perceived to fall. For example, a stock where the fair value of the company is generally perceived to be between $34 and $35 will have smaller oscillations than the stock of a company where fair value might be anything between $7 and $10. Stocks that are more broadly researched, such as U.S. large caps, will likely have more fundamental investors pulling the price nearer to fair value and should experience smaller swings from momentum trading than a small cap with no institutional research coverage.
There is an older investors’ warning that says: “Remember, when you’re buying a stock, someone else is selling and when you’re selling, someone else is buying.” It’s a good moderating reminder, but in reality the people you are buying from and selling to may be using a different strategy and the interaction between people with different strategies explains volatility and market inefficiencies which manifest as the oscillations of stock prices around their fair value.