Daryl Guppy

Charts offer best way to find financial fraud

By Daryl Guppy (China Daily)
Updated: 2010-04-26 11:15

American financial giant Goldman Sachs has been charged with fraud over one of the subprime investment products it created and sold. The only surprise in finding fraud in the subprime products area is that it has taken so long to bring the charges. Investors have been bringing allegations of deceptive subprime product descriptions to courts throughout 2009. More fraud charges in relation to the creation and sale of these products are probably under development.

Unfortunately, fraud and financial markets go hand in hand which is why strong financial market regulators and regulations are required. However, the investors cannot afford to rely only on regulators for protection. Investors must take action to protect themselves against fraud in the market. Fraud comes in many forms, and the global financial crisis quickly exposed many cases of fraud which had been undetected by the conventional analysis of financial fundamentals.

The collapse of US company Enron in 2001 was a good example of fraud that was undetected by conventional analysis. Those investors who do not learn from history and doomed to repeat it. So many of the recent frauds follow the same patterns as the Enron fraud.

Just weeks before its suspension from trading and after a near 80 percent fall in its share price, Enron was hailed by American business magazine Fortune and financial analysts as "one of the most innovative US companies". The Enron share price was to fall to 26 cents, down from $100. This unrelenting downtrend had been in place for eleven months. Who should investors believe? The chart or financial analysts?

The audit reports showed a clean bill of health. When the share price had fallen by around 70 percent a respected analyst declared that the company was financially sound and a wonderful buying opportunity. After a short rally from $30, the downtrend returned, closing six weeks later at $0.26. The long-term downtrend showed the market did not believe the company reports or the financial analysts. In 2002 the truth emerged as the full extent of the fraud was revealed.

Investors should listen to the behavior of the market when there is a contradiction between market activity and financial reports.

Turn the clock forward nine years and very little has changed. The gap between the conclusions of conventional financial analysis and the conclusion of technical analysis remain unbridged. The behavioral analysis methods for detecting potential irregularities remain the same, and unfortunately, remain underutilized. These are the essential recognition features which can be applied by any investor to add to the layer of protection already offered by financial market regulation.

There is one simple rule; Look for contradictions between financial analysis and market behavior shown on the chart. When there is a contradiction always believe the chart. Investors who applied this rule to General Motors, Citibank and Bank of America all avoided substantial losses in 2008. Analysts and company reports were defensively bullish, blaming irrational behavior for the initial price falls. Market behavior shown by the price charts and simple technical analysis showed the market did not believe the financial analysts.

Technical indicators are the only true objective gauge of market psychology and money flows. That doesn't mean investors get every call right. Understanding charts and price activity is part science and part art. But the investment discipline of technical analysis gives a significant advantage over analysis methods that rely on the unfailing honesty of company financial reports.

Subprime products were not traded on the open transparent market so there was no method to independently assess the information provided by the promoters of these products. The rating agencies were unable to overcome the inherent conflict of interest in their business model.

Financial product developers, such as Goldman Sachs pay a fee to the rating agencies to "independently" provide an investing rating for their financial products. Conflicts of interest are inevitable and unavoidable. The solution for truly independent rating of investment products is complex and difficult.

Transparency in all financial market trading is essential. Transparency provides the additional layer of protection against fraud because investors can see the behavior of the market and identify contradictions. The methods are cheap and available to anybody who wishes to use them.

The author is a well-known financial technical analyst