Fundamental analysis fail to manage risk, and if you wait for the fundamentals to support the current U.S. technology sector you may arrive late to the party.

Last week, I was invited by a large investment dealer to conduct a technical analysis seminar for their experienced investment advisers.

I agreed because it is always a privilege to address one’s peers.

The only problem is that I have to wrap up the session by explaining the advantages of blending both technical and fundamental analysis in order to make better investment decisions.

I have a dilemma because industry experience has me convinced that technical analysis need not be supported by fundamental analysis, but fundamental analysis must always be supported by technical analysis.

A private investor or portfolio manager has an interest in four Canadian retail stocks but wishes to use only the fundamentals of the retail group in order to make an informed investment decision.

A top down approach on the likes of Canadian Tire, Dollarama, Loblaw Companies and Shoppers Drug Mart may study factors such as consumer debt, competition and their relative sensitivity to the business cycle.

I assume that unless you are a retail analyst you will not go the top down approach.

The technical analyst will simply break out the names into two distinct categories, Consumer Staples (Loblaw and Shoppers) and Consumer Discretionary (Canadian Tire and Dollarama) and then study the technical factors like relative performance or price momentum.

At this time, the Consumer Discretionary sector is displaying early signs of relative out performance over the Consumer Staples sector and so Loblaw and Shoppers are eliminated from our studies.

We will need to examine the recent balance sheets and profit and loss statements in order to calculate the ROE (return on equity) and traditional ratios such as the quick ratio, working capital ratio, debt to equity ratio, gross profit margin and net return on invested capital. Pile on the dividend yield, the payout ratio and the price earnings multiple and you’re almost done.

Now the bottom up fundamental analyst must always consider the reality of financial statements.

According to studies related to the securities industry, “Not every accounting entry is based on an actual transaction and involves an exchange of actual cash. The accuracy of a fair number of accounts relies on the judgment of the corporate auditor and management. Management itself is given a wide berth by the accounting profession to exercise that judgment. All in all, investors cannot take financial statements at face value.”

I assume that unless you are a chartered accountant you will have some difficulty in going with the bottom up approach

The technical analyst will instead apply studies to the two remaining names in the Consumer Discretionary sector (Canadian Tire and Dollarama) using technical studies like relative averages, relative performance, price momentum and pattern recognition.

At this time, technical studies have determined that following a period of strength over the past 20 weeks, both names are displaying early signs of relative under performance vs. their peer group and so both names are rejected for investment selections at this time.

The fatal torpedo for fundamental analysis is not the Nortel fraud trial but rather the failure to manage risk. In the case of our portfolio I refer to unsystematic risk which refers to a security’s price action that is not related to the fluctuations in the overall market. Unsystematic risk is unique to each security in the portfolio with one or two big losers savaging our overall returns.

All of the risk management tools that I know of are based on either price or some type of hedging strategy. It is rare for an analyst to review a company’s fundamentals and then issue a “sell” before the stock has begun a significant decline.

Our chart this week is the weekly closes of BMO Nasdaq 100 Equity Hedged To CAD Index ETF (ZQQ) plotted above the weekly closes of the iShares S&P/TSX 60 Index Fund (XIU) spanning about 18-months. The TSX listed ZQQ gives us direct exposure to the U.S. technology sector. Note the beginning of the strong performance of the ZQQ relative to the XIU that began from the August 2011 lows (A) and now to the current higher price at (B).

The technical analyst believes that price will precede the fundamentals and if you wait for the fundamentals to support the current strength in the U.S. technology sector you may arrive late to the party.