Investing or Trading? To use Technical or Fundamental Analysis?

Technical Analysis vs Fundamental Analysis

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 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.

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

Technical analyst usually has the advantage when we are dealing with immediate market action. 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 may envy Buffett of his wealth, you may probably hope for a much shorter time horizon in multiplying your money.

Having said that, there isn’t a clear cut to get rich or multiply your money. 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

 

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 analyse 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.