Stock trading models that use fundamental analysis, e.g. PEG ratios?

Question

I'm a finance undergrad writing a dissertation on fundamental analysis vs technical analysis applied to trading.

I'm finding it easy to build technical indicators such as moving averages, while it seems hard to identify a model for fundamental analysis. I've tried using companies' PE ratios vs sectors' PE ratio, which doesn't give me many buy and sell signals as they tend to stay pretty much fixed over time. So I was wondering if I could use PEG instead, in order to generate buy/sell signals even when growth is negative.

Otherwise, do you know of any other fundamentals that could be used? It doesn't have to be too complicated as it's a undergrad dissertation only, but something that at least generates a few buy/sell signals over a few years of trading.

Any information would be of great use, thanks very much!

Maria

Answer 1

One idea: If you came up with a model to calculate a "fair price range" for a stock, then any time the market price were to go below the range it could be a buy signal, and above the range it could be a sell signal. There are many ways to do stock valuation using fundamental analysis tools and ratios: dividend discount model, PEG, etc. See Wikipedia - Stock valuation.

And while many of the inputs to such a "fair price range" calculation might only change once per quarter, market prices and peer/sector statistics move more frequently or at different times and could generate signals to buy/sell the stock even if its own inputs to the calculation remain static over the period. For multinationals that have a lot of assets and income denominated in other currencies, foreign exchange rates provide another set of interesting inputs.

I also think it's important to recognize that with fundamental analysis, there will be extended periods when there are no buy signals for a stock, because the stocks of many popular, profitable companies never go "on sale", except perhaps during a panic. Moreover, during a bull market and especially during a bubble, there may be very few stocks worth buying.

Fundamental analysis is designed to prevent one from overpaying for a stock, so even if there is interesting volume and price movement for the stock, there should still be no signal if that action happens well beyond the stock's fair price. (Otherwise, it isn't fundamental analysis — it's technical analysis.)

Whereas technical analysis can, by definition, generate far more signals because it largely ignores the fundamentals, which can make even an overvalued stock's movement interesting enough to generate signals.

Answer 2

Maria, there are a few questions I think you must consider when considering this problem. Do fundamental or technical strategies provide meaningful information? Are the signals they produce actionable? In my experience, and many quantitative traders will probably say similar things, technical analysis is unlikely to provide anything meaningful. Of course you may find phenomena when looking back on data and a particular indicator, but this is often after the fact. One cannot action-ably trade these observations. On the other hand, it does seem that fundamentals can play a crucial role in the overall (typically long run) dynamics of stock movement. Here are two examples,

Technical: suppose we follow stock X and buy every time the price crosses above the 30 day moving average. There is one obvious issue with this strategy - why does this signal have significance? If the method is designed arbitrarily then the answer is that it does not have significance. Moreover, much of the research supports that stocks move close to a geometric brownian motion with jumps. This supports the implication that the system is meaningless - if the probability of up or down is always close to 50/50 then why would an average based on the price be predictive?

Fundamental: Suppose we buy stocks with the best P/E ratios (defined by some cutoff). This makes sense from a logical perspective and may have some long run merit. However, there is always a chance that an internal blowup or some macro event creates a large loss.

A blended approach: for sake of balance perhaps we consider fundamentals as a good long-term indication of growth (what quants might call drift). We then restrict ourselves to equities in a particular index - say the S&P500. We compare the growth of these stocks vs. their P/E ratios and possibly do some regression. A natural strategy would be to sell those which have exceeded the expected return given the P/E ratio and buy those which have underperformed. Since all equities we are considering are in the same index, they are most likely somewhat correlated (especially when traded in baskets). If we sell 10 equities that are deemed "too high" and buy 10 which are "too low" we will be taking a neutral position and betting on convergence of the spread to the market average growth. We have this constructed a hedged position using a fundamental metric (and some helpful statistics). This method can be categorized as a type of index arbitrage and is done (roughly) in a similar fashion. If you dig through some data (yahoo finance is great) over the past 5 years on just the S&P500 I'm sure you'll find plenty of signals (and perhaps profitable if you calibrate with specific numbers).

Sorry for the long and rambling style but I wanted to hit a few key points and show a clever methods of using fundamentals.

Answer 3

First, fundamental analysis and technical analysis should be complements of one another; they both help you gauge the health of a company. Second, it is easier to look at fundamental analysis as a way of rating companies health with an A through F; by that I mean you can know if the management is doing great (an A, for example) versus their liquidity (a D, again for example) or poorly. If they score A's or B's across the board, you may want to invest in the company long-term (ala Warren Buffet & Berkshire Hathaway) or short-term (ala Jim Cramer & Mad Money) That is where technical analysis can be of benefit. I currently use EMA's (16, 32, 64, 128, 256) to better gauge when to get in and get out of short orders. As soon as the 16 crosses below the 32 (think 13 & 20) you start watching the stock. As soon as the 16 crosses below the 64 (think 13 & 50) you start considering selling. The reverse is also true. As soon as the 16 crosses above the 64, you start watching the stock. As soon as the 16 crosses above the 32, you start considering buying. Now, that being said, while I enjoy looking at Bollinger Bands, they tend to give false indicators; you sell to late or buy too soon.