Technical analysis and fundamental analysis are the two main approaches to valuating stocks in an effort to determine how prices might move. These approaches are complete separate schools of thought, and the same as other disciplines studied in our society, the proponents of each are at odds with one another. Ideally, in my opinion, deploying both approaches to some extent in tandem will get the best job done.
Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. At the company level, fundamental analysis involves examining the company’s financials such as operations, sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the stock market or technical analysis data.
At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.
To forecast future stock prices, fundamental analysis combines economic, industry, and company review to derive a stock’s current fair value and forecast future value. If this fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately correct itself and move towards the true fair value.
Fundamental analysis is a very time consuming endeavor, and if the truth were known, the amount of time required to do a proper analysis likely accounts for much of the argument against its use. In our tutorial series on stock valuation, we went to great length describing methods of corporate financial statement analysis because it is at the heart of fundamental analysis.
It can be argued you are not really investing unless you apply fundamental analysis. This is because any alternative approach is basically gambling, at least in the mind of those who believe it unwise to place money without fully understanding or at least trying to understand where you are putting it. Technical analysis, if used at all, is borrowed only to determine entrance and exit points.
Fundamental analysis then, is similar to the type of analysis made by the banking industry in an application for a corporate credit line. When the objective of the analysis is to determine what stock to buy and at what price, fundamentalists maintain markets might misprice a stock in the short run but the correct price will eventually be reached. So, profits are made trading the mispriced stock, then waiting for the market to recognize its mistake and redirect the share price.
The opposing school of thought, technical analysts maintain all important information is already reflected in the price of the stock price, so fundamental analysis is a waste of time.
Unlike fundamental analysis, technical analysis ignores the company underlying the stock and instead tries to predict price changes by studying movement and activity of the stock in question and study of the market itself.
We examine technical analysis concepts like moving averages, support and resistance, advance/decline lines, relative strength, momentum, and volume. They prescribe to the old “trends are your friends” line. The point of technical analysis is to identify non-random price rhythms and trends in financial markets, fix them to a pattern, and exploit those patterns. So, the methodology is to analyze the statistics generated by the stock market’s activity and use that information to predict where the price of a particular stock might be headed.
The fundamentalist will plot past prices, volume, cyclical variations, oscillators-which are mathematical formulations aimed at indicating if a stock is overbought or oversold, and price rate of change indicators-which calculate the velocity of price changes to attempt a measure of when a stock will change direction. Collectively, those who use technical analysis never usually analyze any part of the fundamental business. Due to things like earnings, revenue and profit margins not being considered, technical indicators are of little value to a long-term investor.
Active traders or day traders make most extensive use of the technical analysis because they are designed for short-term positions. It can be compared to weather forecasting, which does not result in absolute predictions about the future but rather, states the anticipated likely-hood or probability of what will happen. And, like the weatherman, technicians have the charts, graphs, plot lines, and other visuals to illustrate and present their logic. They love their charts. So much so, it can be argued they are completely detached from the real companies they represent.
Is technical analysis a convoluted achievement of oversimplification? That seems an appropriate statement here because all technical results are based upon three basic assumptions.
1. At some time or another, the market discounts everything.
2. Prices always move in trends. Most technical analysis strategy is based upon the assumption that once a trend has been established, future price movement will be in the same direction.
3. History has a tendency to repeat itself.
Let us express that advocacy of one approach over the other is not the point here. Individual investors must establish for themselves what is most comfortable or reliable for their personal approach to investment decisions. Obviously, not all fundamentalists have become rich putting their money into the stock market and not all technicians have become wealthy investing with technical acumen. With one approach you are investing in the company and with the other you are taking a chance based on past trends. Which of the two to follow depends upon your personal make-up.