Technical Analysis v. Fundamental Analysis

The argument for technical analysis vs fundamental analysis often comes up when people examine the available methods for making money in the stock market.

Is one type of analysis better than the other? Should you concentrate on one method? Can they be used together?

Let’s investigate…

Technical Analysis Defined

Technical analysis is the study of a stock’s price and volume data. Its purpose is to determine which way a stock is likely to move in the near future.

The stock chart is the weapon of choice for this type of analysis.

There are a few different types of technical analysis, but generally speaking, it’s used to evaluate trends, identify significant price levels, and ultimately locate trade entry and exit points.

Technical analysis can also be used to select stocks to trade.

Fundamental Analysis Defined

Fundamental analysis is the study of a company’s financial details. Its purpose is to determine whether a company would make a good investment based on an assessment of its financial health, potential for profitability, growth prospects, and the value of the company compared to the price of its shares.

The balance sheet, profit & loss statement, and cash flow statement are the focus of this type of analysis.

Fundamental analysis can also include a consideration of a company’s ‘story’. To examine a company’s story you look at what it does, how it makes its money, and how it is positioned to perform in the future given the current economic climate.

Technical Analysis or Fundamental Trading?

Fundamental Analysis vs Fundamentals

This leads to a discussion of the differences between technical analysis and fundamental analysis. Technical analysis is the province of traders, and fundamental analysis is more likely to be used by investors. Technical analysis deals with market action without much concern for the underlying causes, whereas fundamental analysis involves research into those causes which will indicate future strength or weakness. The fundamental analyst will examine company financials, price/earning ratios, capitalization and a host of other factors to determine what a company’s shares should be worth.

Do Successful Traders focus on Technical Analysis or Fundamentals?

When you’re talking about what a market is going to do soon, the technical analyst has the advantage. Dealing with the actual price movements that are happening and using them to anticipate the next moves is the territory of the trader. The fundamental analyst can spend a lot of time in research, and may know very well what a company’s true value is after checking all the numbers—but unless the people buying the shares right now also share his point of view, for some time the share price may not reflect the true value he has calculated.

On the time scale that the trader is interested in, fundamental analysis may not provide a correct indication. Whether a price is undervalued when considering the fundamental factors does not guarantee that there will be an increase in price anytime soon.

The investor is prepared to wait out the up and down fluctuations of the market, content that the true value will be realized in due course; and the trader does not give himself the luxury of that much time. This is the way that Warren Buffett invests. This billionaire leader of Berkshire Hathaway, whose ‘A’ shares are currently trading well over $100,000 each, spots value in the markets and hangs on to the company shares for decades. As you are taking this course, you may envy Buffett his wealth, but you are probably hoping for a much shorter time horizon in multiplying your money.

Having said that, there really isn’t such a clear cut difference between technical and fundamental analysis as there may seem. Financial experts may like to argue the merits and failings of each, but they are in some ways intertwined. Almost by definition, technical analysis must include fundamentals, because those fundamentals are already included in the market action. It’s just that the technical analysts did not need to do separate research to anticipate their effect. And it’s also likely that the fundamental analyst has a passing acquaintance with the technical side. Even for investors, a little technical analysis may show a market dip that would represent the best opportunity to get into the investment. If you can invest after a retracement, then you get a good start to your long-term returns.

What is clear is that fundamental analysis alone may be great for the long term but would not be a good basis for trading. Analysis of intrinsic value is one thing, but trading relies on good timing, and fundamental analysis has little to say on this topic, whereas timing is inherent in technical analysis. Fundamentals may identify correctly the overall trend, but fluctuations may mean that such a trade could initially be a loser, and the trader would cut his losses before seeing any gains.

That is why traders rely on technical analysis to show them where to make their short-term profits. The data that the fundamental analysis reveals is just too much information. It is not necessary, because the markets discount everything, and could even confuse if it conflicted with the technical analysis.

There are several other advantages to technical analysis over fundamental analysis for the trader. One is that technical analysis, once learned, can be applied across different markets and different types of securities, such as stocks, futures and currencies (Forex). While there may be some nuances to be learnt, and these will be covered in later modules, the principles are universal. Contrast this to the position of the fundamental analyst, who researches and knows in detail the mechanics of the market that they are exploring, but may be hard-pressed to apply their experience to different fields.

A financial expert who advises investors may be very good at fundamentally analyzing the accounts and prospects for financial companies, but not know much about investing in mining. It is not even reasonable for him to know the processes that the mining company goes through, extracting ore, processing and refining it. There are too many types of companies and industries for anyone to be an expert in them all.

The flexibility of technical analysis to be applied to different securities means that the trader can select what he feels are the best markets at any particular time. As mentioned, a sideways price movement is one of the possible trends. It is easier and less risky to make money from a clearly rising or falling price trend, and the technical analyst can select whichever market is representing the most favorable market action at the time of trading.

You can add to this the fact that an investor will usually want to ‘go long’, that is buy shares of a company in anticipation of an uptrend in the stock. On the other hand a trader, using technical analysis, may decide that a company’s stock is going to lose value in the short term, and ‘go short’ on the shares. This gives a further range of choices to the trader, as opposed to an investor, when looking for a market to follow.

Another strength of technical analysis is that it can be applied across any time frame. Day traders typically use time frames that are measured in minutes, and swing traders may look at daily charts to decide on their trades, but technical analysis can be applied to weekly or monthly charts with equal effect. In fact, many trading techniques require review of several time frames in order to confirm the overall trends before making a trade.

Hint: When utilising technical analysis, avoid using just one indicator or method for identifying trends, entry points and stop loss levels. Use different forms of analysis, timeframes and confirmation tools to add weight to your decisions. If your analysis shows conflicting views, be patient, step aside and wait for another signal.

Comparing the two types of Analysis

No discussion on technical analysis vs fundamental analysis would be complete without considering the pros and cons of each one.

Technical Analysis Advantages

Technical analysis is based on objective data. You can look at a stock chart and plainly see what’s happening right now. You can see which direction the price is moving in. You can see how popular the stock is based on its volume characteristics.

Technical Analysis Disadvantages

Technical analysis doesn’t care about the company behind the stock. You might want to know what industry the company is in, but apart from that, the underlying company isn’t really a concern.

The company might be carrying more debt than it can handle, its revenues and cash flows might be weak, and it might not even be making a profit – who knows? Technical analysis doesn’t concern itself with such matters.

Conclusion: For most investors, technical analysis is about “timing” your entries and exits. For traders using technical analysis exclusively (i.e. no fundamental analysis), they also use technical analysis to determine which stocks to buy.

Fundamental Analysis Advantages

Fundamental analysis gives you an idea of what a company’s future prospects are likely to be. Large institutional investors like to buy shares in companies with good fundamentals.

Fundamental Analysis Disadvantages

The timing of the financial statements used with fundamental analysis can sometimes cause problems. If you get the information too late you might end up buying the stock after it leaves the buy zone.

Also, do the numbers make sense? Do they tell a story, or do they just add to the confusion?

Conclusion: Fundamental analysis is useful for stock selection. It isn’t ideal for determining entry and exit points, and for this reason, it’s mostly used by the long-term buy and hold crowd.

The Market Rally

Over the past couple of years the markets have rallied sharply from their lows. The economy on the other hand has hardly improved and everyday there is more and more negative news about how things are not getting better or actually getting worse fundamentally. Sure over the long run the fundamentals and the technicals will merge, but over the short to intermediate term they can diverge wildly, case in point, right now!

While I respect the fundamentals I never defer to them. Market psychology, sentiment, and technical forces significantly outweigh fundamentals 80% of the time. Those odds are all I need to know and want to know.

Let’s take, for example, the financial crisis of 2008, the technicals clearly showed you that the markets were reversing their trends and it was time to get out or go short. The fundamentals lagged by 3-6 months before telling you the same thing. Then in early 2009 the markets reversed course and by late spring, early summer the technicals told you to reverse your positions again, while the fundamentals were just telling you that nothing was improving. While some of the fundamentals have turned positive, the technicals turned positive well in advance of any of those fundamental indicators.

The fundamentalist will argue that the technicals have predicted impending recessions 26 times over the past 30 years and yet we have only had 4 or 5 real recessions. I would counter that by saying risk management, protecting capital, and making money are more important than being right over the long term.

Do the technicals always get it right? The answer is no. Do the fundamentals always get it right? Again, the answer is no. Can you make money using either methodology? Yes. The caveat is that you need to manage your risk and whether or not you believe in technicals you must always remember to protect your capital by managing your risk. I just happen to find the technicals more responsive and thus better for making money trading.

Lastly, fundamentals work great in normal market environments, but last time I checked we seem to be experiencing 50 year storms every 5-7 years . Case in point, 1974, 1981, 1987, 1994, 2000, 2001, 2008. In addition, we have gone nowhere for the past 10 year, the lost decade as it is being called, and yet many technical money managers have made considerable amounts of monies.

Combining the Merits of TA and FA

Technical analysis vs fundamental analysis – is this the right question to be asking in the first place?

Some people use only one type of analysis and that’s fine. As long as they’re making money, I don’t think it really matters. Personally though, I like to use both methods of analysis.

I use fundamental analysis as an initial filter to determine what to buy. The second part of my stock filtering process uses technical analysis. Once I’ve found a batch of fundamentally sound stocks, I analyze those stocks further to find the ones with the best stock chart patterns. It’s a two-tiered filtering approach.

When will I buy and when will I sell? That’s where technical analysis comes in.

To sum up

The argument for technical analysis vs fundamental analysis isn’t really valid when you understand that each method of analysis can be useful depending on your approach to making money in the stock market.

You can use either or both methods. It’s really up to you.

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