Many people in the investing world make predictions about the stock market. Every January economics gather to publish their predictions in such prestigious places as the Wall Street Journal. About the only thing we have learned over the years is that most predictions are wrong.

Why is it so difficult to predict the stock market? If you get the prediction right you can make millions and billions of dollars. That is a huge incentive in any ones books to work on this project.

We can predict the flight of a baseball, the trajectory of a rocket, the terminal velocity of a falling object, even the expected output of a nuclear reactor. Yet after a century we are still unable to predict the stock market.

First lets look at the methods that people use to predict the stock market. They generally fall into two different camps of thought. The first camp of though is the Fundamental camp. They believe that the fundamentals of the stock market will over rule any other influences to provide a consistent method of determining where the market will end up. They believe the fundamental analysis will lead to the intrinsic value of the stock.

What are some fundamental measures they use? The foundation of fundamental analysis are financial metrics. Things such as the earnings of the company, the management team in place, overall industry performance, projected sales volumes, new product development, changes in inventory ratios, changes in sales over the last four quarters. These items are usually published in the companies public filings (10Qs and 10Ks). They will listen in on the conference call to determine the management teams expectations. Call suppliers and other industry analysts to measure how the overall industry is going and see if the company is gaining market share. All of these go into developing an intrinsic value of the company.

Unfortunately over the years, we have seen companies lie about their numbers in their public filings. Enron is a recent example where they basically lied for many quarters on the companies performance. When you have faulty numbers, you always get faulty results. But what if we could guarantee the numbers in the filings were accurate? Would fundamental analysis be the right way to go?

Long term valuations in the stock market are usually driven in some measure by the company fundamentals. The problem happens when you try to make short term decisions based on long term factors. Even if you are making long term decisions, the fundamentals of the company can change before the market recognizes the intrinsic value of the company. Fundamental analysis is a good way to understand the company and how it will perform but has done a relatively poor job of predicting short and medium term moves in the stock market.

Price to Earnings ratios (P/E) are usually good indicators of when a stock is expensive or cheap but they can range from the high single digits to the high 100s.  The average has been around 17.  This range can swing a lot depending on how you measure earnings too.  If you look at trailing twelve month earnings you unfairly punish growth companies but looking at projections can leave you with a mere guess on where you are going. 

So what does the other side look at? They are referred to as technicians or technical traders. They don't care about a companies fundamentals. They predict stock movements based on indicators that are separate from the company. The only measurement that both camps look at is the price of the stock.

Technical indicators?

Many technical traders use calculations based on the price of the stock. They look at moving averages on different time frame. They look at various types of moving average calculations. You would be amazed at the number of moving averages that can be calculated with every one of them having a raving fan who will swear to how well they work.

When moving averages cross over each other, this is considered a signal from the technical side that the stock may be getting ready for a move. Moving average cross overs are usually an indicator that the stock is priming to change direction. Moving averages are also used as barriers as well.

Resistance or Support

Depending on which side of the moving average the stock price is on, the moving average line can act as resistance or a floor. If the price is below the moving average but moving up, the line can act as resistance when the price nears the line. It usually takes several attempts to break through these lines of resistance.

If the stock is above the line but falling, the line can act as support for the price. It will limit the fall of the stock and allow it to continue higher at a later date. You will often hear stock prices described in very human terms. They are taking a breather. They are an a run. They are collapsing.

Technicians have developed an array of metrics that revolve around price and volume of the stock. These two base measurements form the fundamentals of technical trading. Does technical trading work? Just ask any technician and they will swear to it. It does seem to take a PhD to understand it though.

So should you be in the stock market right now? Check out one guy's opinion at Stock Prediction Market