In the early 1400's it was generally accepted the world was flat. When you looked in any direction, the horizon and the sky met well beyond the reach of any known land, and anyone who ventured too far out to sea would surely fall of the edge of the earth and into the black abyss.

Of course, later in the 14th century, Christopher Columbus insisted the world was round, and set out to prove what only a few other people at the time even considered possible. Though we now indeed know the earth is round, back then, nearly everyone was absolutely certain the earth was flat.

In the same sense, is it possible many investors can be certain of something, yet still be wrong?

Flawed Logic?

Though not to an absolute degree, it seems there is a misguided idea within the investment community that stocks always trade at appropriate levels. That is, the notion that a company's fundamental picture will translate into a predictable per-share values. Many - if not most - investors use some variation of this fundamental model when making investment decisions.....determining if a stock is currently 'expensive' or 'cheap' relative to a baseline level.

The logic is sound. However, the results of a pure fundamental style of analysis could leave something to be desired. In reality, after a stock goes public, the only real determinant of a share price is the amount of supply or demand for a particular stock. The demand and supply levels? Since they're ultimately established by humans who want to own or want to sell those shares, they are only the manifestations of opinions of worth....the price at which a buyer or seller is willing to make a deal.

The flaw in the strategy is simple to spot - human logic is easily twisted by emotions (like fear or greed) to the point where 'logic' is, as Spock would say, illogical. When this happens, current stock values are very likely not to reflect what they 'should', rather reflecting what other traders collectively feel they're presently worth at the time.

So how often does a stock trade at its actual fundamental value? Far less often than the average investor may like to believe. There's the rub...trying to invest logically in an often-irrational market.

Pick and Choose When to Apply 'Logic'

Once a stock is trading publicly, any capital you put into an investment isn't given to the company to use in their venture. You're giving that cash to someone else who no longer wants to own a piece of the venture.

Obviously most everyone understands that, but how often do we rationalize it the other way?

Remember, for you to make money on any stock other than an IPO, the demand has to outweigh the supply later....more so than it does today. That's what causes prices to move higher.

This is why we constantly look at the underlying fundamentals along with the chart. Sales, earnings, and fundamental growth are all important when determining whether or not a company is even worth considering as an investment. But, a chart is the more powerful way we have of spotting when any strong fundamental progress is going to translate into real gains for shareholders.

Granted, a good fundamental story is the cornerstone of a good investment, or even a good trade. These types of companies seem to attract a large number of buyers over time....the same buyers that will eventually drive demand in excess of supply, and force the price higher. However, potential buyers are fickle about their timing. Maybe they'll buy now, or later. Maybe they'll never buy at all. No matter what though, you generally don't want to be the first and only one into a stock trade...you want other buyers to come along with you (preferably after you).

An Example

Take Baxter International (BAX) as an example of illogical stock pricing. Think you know what a reasonable P/E ratio for a medical supply company like Baxter should be? Some people would say the typical P/E for this industry should be 25 or so. Take a look and see just how inconsistent - and unpredictable - a fundamental strategy for this stock would have been since the year 2000.

• January 200l: Priced around $43.50, with the prior quarter's earnings per share coming in at 45 cents. The average annualized P/E was 24.16.
• October 2002: Priced around $28.00, with the prior quarter's earnings per share coming in at 51 cents. The average annualized P/E was 13.72.
• January 2004: Priced around $30.00, with the prior quarter's earnings per share coming in at 61 cents. The average annualized P/E was 12.3.
• October 2005: Priced around $38.00, with the prior quarter's earnings per share coming in at 18 cents. The average annualized P/E was 52.7.

Sure enough, the average P/E for Baxter in recent years has indeed been 25.5...right in line with the norm. BUT, it was rarely actually there. More often than not, it was well undervalued, or well overvalued. Had you made a purchase based on a static (single point in time) P/E reading, you may have been disappointed, or extremely-elated. However, you wouldn't have known which until after the fact....there was no consistency with the way the stock responded to the company's earnings.

On the other hand, by adopting a simple moving average line crossover strategy, it would have been very easy to spot the point in time when it made sense to buy in June of 2002, made sense to sell in May of 2002, and made sense to buy again in October of 2003. The earnings data wouldn't have helped you to do the same.

The Bottom Line

There probably was a time when a good company with solid fundamentals also meant some nice appreciation in share prices. Those days, however, are gone. Today's environment requires you not only to be a good fundamental analyst in terms of finding candidates, but also a good technician (chart watcher) to spot the instances when you can actually reap some reward from a strong balance sheet and cash flow statement.

Charts can help you get more out of the market. Simply by keeping an eye on momentum, volume, and other simple clues, the average investor can find superior entry points, as well as stay out of trouble when it appears as if a stock has started to weaken. The fundamental picture alone can't help you buy low and sell high, as those same fundamentals don't actually pin-point where those highs and lows are.