The debate over the relative merits of fundamental and technical analysis is a contentious one. Investors and traders alike often miss out when they pick one over the other. In fact, both can be combined effectively.
In this post we explain the differences and highlight the strengths and weaknesses of each. We also list a few ways the two approaches can be combined, and what the future holds for the various forms of investment analysis.
- What is fundamental analysis?
- What is technical analysis?
- Understanding the difference
- Tools used for fundamental and technical analysis
- Fundamental vs. technical analysis: Which is better?
- Pros and cons of fundamental analysis
- Pros and cons of technical analysis
- Using fundamental and technical analysis together
- The future of investment analysis
What is fundamental analysis?
Fundamental analysis in the stock market is a method of evaluating a company and determining the intrinsic value of its stock. Companies are valued as though they were unlisted, with no regard for their market prices. Buy and sell decisions are then made based on whether a stock is trading at a discount or a premium to its fair value.
Although a stock’s value is ultimately an opinion, relatively undervalued companies can outperform over the long term. Fundamental analysis can also be applied to other markets including currencies and commodities. In that case any factors that affect the value of the asset are considered.
What is technical analysis?
Technical analysis is based only on stock price or volume data. The objective is not to predict the future, but to identify the most likely scenarios. Price action is used as an indication of how market participants have acted in the past and how they may act in the future.
Technical analysts use chart patterns and trends, support and resistance levels, and price and volume behavior to identify trading opportunities with positive expectancy. Technical analysis does not consider the underlying business, or the economics that affect the value of a company.
Understanding the difference
The difference between the two approaches comes down to what determines a stock’s value and price. Fundamental analysis considers the value of the company. This ultimately depends on the value of its assets and the profits it can generate. Fundamental analysts are concerned with the difference between a stock’s value, and the price at which it is trading.
Technical analysis is concerned with price action, which gives clues as to the stock’s supply and demand dynamics – which is what ultimately determines the stock price. Patterns often repeat themselves because investors often behave in the same way in the same situation. Technical analysis is concerned with price and volume data alone.
Tools used for fundamental and technical analysis
Fundamental analysts consider a company’s financial positions and performance, the market in which it operates, competitors and the economy. The most important source of data for fundamental analysis is the company’s financial statements. These include the income statement, balance sheet and cash flow statements.
Data from these statements can be used to calculate ratios and metrics that reflect the company’s performance, health and growth rates. Industry data and economic factors, like interest rates and retail spending, are also used to forecast future growth rates. Ultimately, a fair value is arrived at after comparing several models and ratios.
Technical analysis is a lot broader than many people realize. All chartists use price charts – usually either line charts, bar charts or candlestick charts. Apart from price charts, the tools used can vary widely. Some analysts use indicators like moving averages and oscillators calculated from stock prices. Others use price patterns, and complex analysis frameworks like Elliott Waves and Market Profile. Trend followers use other tools to identify price trends and measure momentum.
Fundamental vs. technical analysis: Which is better?
The debate over fundamental and technical analysis is contentious. Proponents of either form of analysis often write the alternative off but misunderstand that they can both have their place. Fundamental analysis is most useful for long term investments, while technical analysis is more useful for short term trading and market timing. Both can also be combined to plan and execute investments over the medium and long term.
Short term price movements are determined by supply and demand, which are in turn affected by a lot more than what typically goes into fundamental analysis. Market sentiment and the effect of emotion on market activity can only be analyzed by using price and volume data. On the other hand, charts cannot be used to determine whether a stock is under or overvalued and what its value may be years into the future. Charts reflect what has happened in the past, and their value diminishes the longer the time horizon.
Pros and cons of fundamental analysis
Analysis based on a company’s financial and competitive position has several advantages. Analyzing the environment in which it operates is also of value. Focusing only on the business, rather than on the stock price, gives investors an idea of what the company is actually worth. This is invaluable for long term investing. Investing during market bubbles can be rewarding – but it’s still important to know when the market is in a bubble.
Portfolio risk can be managed by calculating the premium to fair value at which stocks are trading. Asset allocation decisions can then be made to reduce the potential downside of a portfolio. The biggest profits are usually made by the investors that are correct when the rest of the market is wrong. This can only be achieved with fundamental analysis. Also, decisions based on fundamental analysis typically have a higher probability of being correct, particularly over the long term.
There are also several drawbacks to fundamental analysis. It’s important to be realistic about its limitations. Fundamental analysis is time consuming – each company must be studied independently and in detail. Most of the information used in fundamental analysis is widely available. To gain an edge with fundamentals, you need to find unique datasets that aren’t available to most investors.
Fundamental analysis tells you very little about what might happen in the short term. Short term price movements and volatility cannot be forecast by looking at financial statements. Fundamental analysis is a lot less precise than often perceived. Valuation models like the discounted cash flow model are based on numerous assumptions which are seldom very accurate. Target valuations can be useful on a relative basis but are limited when it comes to valuing a company more than one or two years into the future.
Pros and cons of technical analysis
One of the major advantages of technical analysis is that stocks can be analyzed quickly. Also, some tasks can be automated which saves time. This means a technical analyst can cover more stocks and draw ideas from a larger universe. Technical analysis can also be used to identify price targets, and levels at which an idea is obviously wrong. This allows traders to create investment strategies with clearly defined risk and reward profiles.
In the short term, price action is affected by several factors that fundamental analysis cannot pick up. The effects of market sentiment, market psychology, and supply and demand can all be observed by looking at a chart. Technical analysis can be used to improve timing, and to trade strategies appropriate to market conditions.
It can improve hedging strategies by improving your timing when short selling or buying options. By looking at a chart you can quickly see whether a stock price is in a trading range or a trend. Some technical strategies can be back tested. This means they can be scientifically tested and applied. Strategies that can be back tested form the basis of many algorithmic trading strategies.
Technical analysis does of course have its drawbacks. First amongst these is that while some technical approaches can be back tested, many cannot. Pattern trading, Elliott Wave analysis and other forms of technical analysis are subjective and rely on judgement. Using charts is often regarded as more of an art than a science.
Technical analysis frequently results in ambiguity. Two technical analysts can come to very different conclusions about the same stock by using different approaches. Charts often appear very different on different time frames. And, with the large number of analysis methods, indicators and time frames available, forming a single view can be a challenge. This happens often and is known as analysis paralysis.
Technical trading setups have a relatively low win rate. While a pattern or setup may have an edge, the win rate is often less than 60%. To trade setups like this profitably requires a large number of trades.
Using fundamental and technical analysis together
There are several ways in which technical and fundamental analysis can be used effectively together. The following are a few of the ways you can combine the two methods:
- Simply looking at a price chart can give you an idea of the direction of a trend. This will give you an idea of whether the market agrees with your valuation or not. You should have stronger conviction when going against the crowd and also be prepared to exit quickly if a stock is widely owned and the fundamentals change.
- You can build a watchlist of stocks you are prepared to own based on fundamental analysis, and then use technical analysis to decide if or when to buy them.
- Quantitative studies have found that a combination of value and momentum can be an effective method of stock picking. In essence, stocks trading on low valuations but with strong momentum tend to outperform.
- Technical analysis can be used to find favorable entry levels for growth stocks that are in an uptrend. Companies that have high growth rates and trade on high valuations often experience large corrections. In such cases, technical analysis can be used to identify oversold levels. These are often the best opportunities investors will ever get to buy growth stocks.
- Stocks can continue trading higher long after they become overvalued. Selling a stock just because it is expensive often means missing out on a large percentage of a rally. By using price and volume trends you can continue to hold the stock until the momentum is exhausted.
- If a stock is trading close to its fair value, it makes sense for the price to consolidate or trade in its range. While the fundamental picture remains the same, you can use technical methods to trade within the range.
- Fundamental research can sometimes be used to determine which parts of a business cycle are most profitable for a company. Technical analysis can then be used to confirm anticipated trends.
The future of investment analysis
In the future it is likely that the various forms of analysis will increasingly be combined. The field of quantitative investing has rapidly gained recognition in the asset management industry due to its more scientific approach. Technology now allows fundamental, technical and quantitative analysis to be effectively combined, and tested. Increasingly, behavioral finance and market sentiment are being incorporated in algorithmic trading strategies. And, new technologies like artificial intelligence and big data can also enhance all three forms of analysis.
New sources of big data, in particular, can be used to find unique insights. Catana Capital is a leader in the field of combining systematic trading, artificial intelligence and big data. In the case of Catana’s Data Intelligence Fund, trading strategies employ user generated data combined with market data. This gives the fund an edge by measuring market sentiment in real time and identifying profitable trades. We can expect the lines between fundamental analysis and technical analysis to be blurred further as the investment industry evolves.
If you invest in an unlisted company, fundamental analysis is all you have available to work with. But, when it comes to listed stocks, there is a lot that can be learnt from their trading history. The price of tradeable securities is also affected by a lot more than the underlying fundamentals. For these reasons, technical analysis does have value.
However, for long term investors, it’s important to have an idea of the value of a company. This is important when picking stocks to hold for the long term, to manage portfolio risk, and to know when to exit extended price moves. In the future, the debate over the two styles of analysis may become immaterial as multiple approaches are combined with quantitative and systematic approaches to investing.