THE CHICKEN (TECHNICALS) AND THE EGG (FUNDAMENTALS)

An interesting question for swing traders is as follows:

"Which comes first: the technicals or the fundamentals?"

In other words, which is the chicken and which is the egg? An analysis of the recent behavior of Emulex (ELX) should help us to answer this question.

The relationship between fundamental analysis and technical analysis can be puzzling. My take on this issue is that the fundamentals are the "cause" and the technicals are the "effect." In other words, important changes in a company's sales and earnings outlook or fundamental changes represent the "cause." Investors then respond to these items by buying or selling the stock. These purchases are reflected in a stock's price chart, which constitutes the "effect." In that sense, the fundamentals are the chicken, since the cause must come before the effect.

Looked at another way, the reverse is true. A stock's chart pattern often anticipates important changes in sales and earnings. In this manner, changes in chart patterns can alert watchful technicians to key changes in fundamental outlooks days (and in some cases even weeks) before they become public knowledge. From this perspective, the one I personally believe, the technicals are the chicken and the fundamentals are the egg.

To help us get a better grasp for this issue, I've decided to provide you with a good example of the technical chicken coming before the fundamental egg. You can see this clearly below in the chart of Emulex Corp. (ELX).

Let's start with some history. As you may remember, I suggested shorting Emulex in our June 7th Swing Trader issue when the stock was trading at $17.82. The trade set up well. If you review that old issue, you will see that I pointed out the stock was in a strong stage IV decline. ELX had rallied off a very high-volume spike low that occurred in late April. The low occurred when the company announced earnings which met expectations, but gave cautious forward guidance. On June 7th, the stock was about to break its uptrend line off this recovery low. Stochastics was on a sell signal; ADX had just given a sell signal and MACD was poised to do so. RSI had just broken below 50. A small rounding top was about to form.

After we entered the position, the stock drifted sideways for several days. Then, on Thursday, June 16th it plunged from a previous close of $17.63 to a close of $16.11, fulfilling our $16.31 target and netting us a profit of +8.3%. This was followed by another sharp drop to $15.38 before the shares finally stabilized. In my analysis in our June 21st newsletter, I pointed out that after a bounce I expected ELX to continue lower. I had searched but there was no news to explain why the stock had declined so sharply on June 16th and 17th.

As predicted, the stock rallied for a few days on light volume before resuming its downtrend. On June 30th I again flagged ELX as a stock to watch from the short side since it continued to look vulnerable technically and did not have major support until near $11. This time, I did not have long to wait.

On Thursday July 1st, nearly a month after ELX had given a series of strong technical sell signals, I found out the fundamental reason for ELX's near-unrelenting decline. On July 1st ELX warned that first-quarter earnings and revenues would fall well short of estimates. Analysts had forecast that the company would earn 25 cents on revenues of $101.4 million. Instead, ELX announced it would in fact deliver sales of only $85-$86 million and earn only 18 cents a share. Emulex makes host bus adaptors, a product that connects computer servers with storage devices. The company blamed weaker-than-expected customer demand for the earnings shortfall.

In reaction to the announcement, J.P. Morgan cut its rating on ELX from "Overweight" to "Neutral." Meanwhile, Merrill Lynch lowered its guidance from "Buy" to "Neutral." It is important to note that these changes in rating were reactive, not proactive. The fundamental analysts, whose job it is to be experts on the company, were very late in seeing what was coming. In fact, before the July 1st announcement the mean analyst recommendation on ELX was 2.2 (1 is a strong buy) vs. 2.44 for the S&P 500. In other words, the analysts were saying ELX would outperform the market despite the fact that the stock was in a stage IV downtrend! The mean analyst target price on the stock, according to the latest information, is still $26. I find it very difficult to imagine ELX reaching that level anytime soon.

When Emulex announced its projected shortfall last Thursday, the got absolutely hammered. From a close on Wednesday of over $14, the stock gapped down sharply, opening at $12.53, hitting a low of $11.30 and bouncing feebly to close at $11.46, off nearly -20% on the session. As I stated in our most recent Mid-Week Update, the stock has major support near $11. ELX is now trading at a forward P/E of approximately 10 times 2005 earnings, so it will probably be attractive to value-oriented investors. Paradoxically, once it stabilizes (and definitely not before!) it may be an attractive short-term trade from the long side despite being in a massive downtrend. On both the weekly and daily chart ELX is massively oversold with RSI on the weekly at 22 and on the daily at 18. The stock is now entitled to a bounce.

In my stock market classes I always say that the fundamentals represent what "should be." Meanwhile, the technicals describe what "is." Sometimes the two are in harmony. Other times, however, such as in the case of ELX, they are not. It is always valuable to look at the fundamentals when making any investing or trading decisions. However, the price chart frequently anticipates news and other fundamental events before they become public knowledge. That is one of the main values of technical analysis. A chart represents the beliefs and behavior of the marketplace. It doesn't lie and often predicts fundamental changes days, weeks and even months in advance of when they happen. When there is a conflict between the technical and the fundamentals, it is usually wise to believe the price chart. As in the case of ELX, the technical chicken often precedes the fundamental egg.

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