Fundamental v Technical Analysis - The Difference and can they Co-exist?

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A Brief Address to Technical v Fundamental Analysis

My primary focus as a trader involves technical analysis, for reasons I will explain shortly, however, unlike many technical analysts, I do believe that fundamental analysis has value. I believe it serves as a foundation to interpreting charts across longer time-frames, and aids in understanding what is possible and likely.

Conversely, some fundamental analysts seem to believe that projecting the market using price charts is some kind of "voodoo." I suppose this is understandable; most things we don't understand carry a certain mystique to them. It's important to realize that price charts, all by themselves, contain all the collective knowledge about a stock or index.

People act on what they know or believe, so it stands to reason that people buy or sell securities based on what they know and believe -- thus (and here's the critical point about technical analysis) everything known about a given security by all the shareholders collectively is reflected in a price chart. When an insider makes a trade, it influences the price of that security, and leaves a clue which can be read on the chart. When a huge hedge fund gains a piece of critical information (usually well ahead of the public) and starts buying or selling a specific stock or commodity, that action leaves its mark on the charts… and so on. Thus the charts point the way ahead.

The fundamental analyst and the technical analyst (one who studies charts) share the same goal: Both seek to project the future.

Their methods are also quite similar in many respects. For example, a fundamental analyst might look at Apple (AAPL) and try to project how many iPhones and iWidgets will be sold next quarter, and how that will influence profits, growth, etc. Then he takes all his research numbers and derives a projection of the company's outlook -- largely based on what's happened in the past. He then plugs that projection into a formula to arrive at a future share price target, which is also based on how things have performed in the past.

A technical analyst does the same thing, except he looks at the charts directly (which, as we just learned, contain all the knowledge of the collective) and cuts out the middle man. He seeks patterns which convey information: When price has moved up by x number of dollars, and then moved down by x percent to create a certain pattern? How has the market usually performed in the past?

Both forms of analysis are based on past performance and on future probability – they just get there by different means.

The weakness to fundamental analysis is that there are a great many variables which the analyst simply cannot foresee. Study what happened in 2007-2008 for an example. Many stocks looked great, and projected earnings looked great, and their futures looked so bright that everyone was wearing shades – but their share prices collapsed anyway, in a spectacular fashion. In September 2008, did anybody care about how many iWidgets any given company was projected to sell in the fourth quarter of that year?

Some fundamental analysts saw what was coming back then; others didn't. Likewise, some technical analysts saw what was coming (myself included) and others didn't. But the probability of a crash was all telegraphed well in advance on the price charts – one didn't even need to turn on the TV to see it coming ahead of time.

The big advantage to technical analysis: Technical analysts were able to arrive at actual price targets for the crash, in real time, while it unfolded.

Fundamental analysts knew it was "gonna be bad!" but that type of analysis doesn't help time the market with a large degree of accuracy. This is why the majority of fundamental analysts don't even try to time the market, except in broad strokes; their system is ill-suited to it.

by Jason Haver
In analyzing price action, market traders make use of two main kinds of analysis. Those who concentrate on price action, and ignore most other factors choose to direct their efforts at perfecting their skills at technical analysis, while traders who prefer to study the economic events that cause the market action mostly focus their efforts in studying fundamental analysis. In this article we’ll take a brief look at both of these concepts, before moving onto examine them in greater detail in further lessons in this notepad.

Many traders combine both types of analysis to generate trading signals. Others concentrate on one aspect of analysis and exclude the other from their calculations, and it is fair to say that either approach can be valid depending on the circumstances. Both of these traders would probably agree that emotional control and discipline are the most important aspects of a successful trading career.  Fundamental and technical analysis are not exactly the same thing and in the longer term the predictive power of fundamentals is maybe more accurate.  Nonetheless, these two are akin to two different languages describing the same phenomenon, and at least on hindsight, they always show the same direction, and reach the same conclusions.

What is Fundamental Analysis

We've already looked at what Technical Analysis is in An Introduction to Technical Analysis.  So to compare the two we must first look at what Fundamental Analysis is.  Fundamental analysis is the discipline that tries to make sense of price movements in light of economic data and news flow. In comparison to technical studies, fundamental analysis also has a large selection of indicators. While many traders choose to focus on the news releases and indicators that appear to determine the day-to-day movements in the financial markets, fundamental analysis in fact studies many other aspects of economics including politics, financial law, social attitudes, in addition to the many other aspects of human life.

Fundamental analysis aims to establish a cause and effect relationship between market movements and economic developments. In that sense, it is different from technical analysis which regards the price action as the beginning and end of trading. While technical analysts generally argue that the price action reflects all information available to the market, fundamental analysts seek to identify imbalances and “errors” in the market that may offer profit opportunities. Unlike the technical trader, the fundamental trader is always sceptical of the price action, and seeks alternative explanations to the “wisdom of the market” in evaluating price trends.

While this type of analysis has been proven to be efficient and reliable through the ages, there are a number of issues that we must keep in mind in order to avoid being too optimistic about the predictive powers of our approach. While fundamental analysis can and often does indeed warn us on possible errors in market attitudes to economic realities, there’s no indication that the correction will happen anytime soon. Similarly, bubbles and market extremes often cause analysts to rationalize the unhealthy positioning of the market, invalidating the healthy advantage of skepticism inherent in the fundamental approach.

Advantages of Fundamental Analysis

The greatest benefit derived from the study of fundamental analysis is the ability to understand the causes that drive the market action. By understanding market dynamics, we can be confident in maintaining a position as long as the cause that triggered the trade exists. A thorough grasp of fundamental analysis also ensures that we do not lose our composure in the face of market volatility.  Many of those who successfully made millions in this business were users of fundamental analysis; and there is no reason to doubt that if we use the same methods we can achieve successful results.

Conclusion

Both types of analysis are useful for examining market action. Your trading style, and attitude to trading will determine which kind of analysis you'll find most beneficial. But before making that decision, it is a good idea to study the subject of technical analysis in slightly more detail. In the next few modules, our subject will remain focused on Technical analysis.  In reality most Technical Analysts will have an understanding of The Fundamentals, especially if your trading style is over a longer time frame.  Even those trading intra-day (Day Traders & Scalpers) should understand fundamentals, as a knowledge on what economic releases are due within their trading horizon is important to their trading decisions.

The Two Methods of Trading & Investing

The broad investment strategy followed by all market investors is the same. Since the purpose of tapping the market is to generate better returns, they all buy scrips that are expected to rise in the future and sell the ones that are likely to fall or remain flat. However, the methods used to identify these stocks differ significantly for fundamental and technical analysts. Let us consider these two modes.

Fundamental analysis: This involves evaluating all economic factors, macro and micro, which can affect the stock price. Macro factors include the economic growth, growth rate of the sector to which the company belongs (compared with the GDP growth), inflation rate, interest rate structure, etc. Micro factors, on the other hand, are more stock-specific-sales, profitability, return on equity/assets, liabilities, cash, etc. The aim of analysing all these factors is to predict the firm's future trajectory.

Once the expected sale, profit, cash flow, dividend, etc are calculated, the next step is to arrive at the intrinsic value of the security. There are several methods, such as the dividend discount model and discounted cash flow, to arrive at this value.

The final step is to compare the intrinsic value with that of the current market price and decide whether the stock is underpriced (if the market price is lower than its intrinsic value), fairly priced or overpriced (if the price is higher than its intrinsic value). Fundamental analysts buy stocks when it is underpriced and sell when it is overpriced.

Technical analysis: This method restricts analysis to the data (price movements, volume, etc) generated by the market. Though technical analysis can be used in all markets-commodities, forex, stocks, bonds-we are confining it to the stock market for the sake of simplicity. Why is this method restricted to market data? Are the fundamental factors irrelevant and should be ignored? No. Technical analysis believes that the market price of a stock discounts these fundamental factors through the actions of buyers and sellers and, hence, there is no need to analyse them again. So the first rule of this method is that 'price captures everything'.

The next rule is that 'price moves in trends' as opposed to moving at random. These are uptrend, downtrend and sideways. Despite the best efforts of regulators, the price-sensitive information comes to the market slowly. First it comes to insiders, then to the circle close to them, then to analysts and big investors, before finally reaching the small investors.








Since the transmission of information takes time (few hours to several days), the price movement is also slow. By the time the news hits the market, the news may be fully priced in and explains the muted price action despite big news like fall in net profit, etc. If you can spot the emerging trend at the start, you can make money by participating in an uptrend or downtrend without knowing the fundamental reasons for it. So, a technical analyst is concerned with the direction of the market, not the reasons for its movement.








How do you know the stock is entering either of these trends? The best way to do this is to study the historical price patterns and compare it with the current ones. Since people usually react in a similar fashion when faced with similar situations, the price patterns generated in the past are repeated in the future. This, then, is the third rule: history tends to repeat itself.


Techno-funda analysis: Which is the best form of analysis? It is difficult to say because technical analysis works better for short-term trading and investing, while fundamental analysis is useful for long-term investing. Successful investors use both the methods - fundamental analysis to identify what to buy/sell and technical analysis to decide when to do so. In some cases, both may generate similar results.

So, if there is a sharp rise in stock price, both analysts will be cautious, but for different reasons. The fundamental analyst may say that you need to be cautious since the stock is overvalued. The technical analyst may warn you about the reason to be cautious since it is in an overbought zone and ready for a correction or trend reversal. Both the methods are useful, which explains why most big brokerages employ the two types of analysts.

by Narendra Nathan


=======

A Brief Address to Technical v Fundamental Analysis

My primary focus as a trader involves technical analysis, for reasons I will explain shortly, however, unlike many technical analysts, I do believe that fundamental analysis has value. I believe it serves as a foundation to interpreting charts across longer time-frames, and aids in understanding what is possible and likely.

Conversely, some fundamental analysts seem to believe that projecting the market using price charts is some kind of "voodoo." I suppose this is understandable; most things we don't understand carry a certain mystique to them. It's important to realize that price charts, all by themselves, contain all the collective knowledge about a stock or index.

People act on what they know or believe, so it stands to reason that people buy or sell securities based on what they know and believe -- thus (and here's the critical point about technical analysis) everything known about a given security by all the shareholders collectively is reflected in a price chart. When an insider makes a trade, it influences the price of that security, and leaves a clue which can be read on the chart. When a huge hedge fund gains a piece of critical information (usually well ahead of the public) and starts buying or selling a specific stock or commodity, that action leaves its mark on the charts… and so on. Thus the charts point the way ahead.

The fundamental analyst and the technical analyst (one who studies charts) share the same goal: Both seek to project the future.

Their methods are also quite similar in many respects. For example, a fundamental analyst might look at Apple (AAPL) and try to project how many iPhones and iWidgets will be sold next quarter, and how that will influence profits, growth, etc. Then he takes all his research numbers and derives a projection of the company's outlook -- largely based on what's happened in the past. He then plugs that projection into a formula to arrive at a future share price target, which is also based on how things have performed in the past.

A technical analyst does the same thing, except he looks at the charts directly (which, as we just learned, contain all the knowledge of the collective) and cuts out the middle man. He seeks patterns which convey information: When price has moved up by x number of dollars, and then moved down by x percent to create a certain pattern? How has the market usually performed in the past?

Both forms of analysis are based on past performance and on future probability – they just get there by different means.

The weakness to fundamental analysis is that there are a great many variables which the analyst simply cannot foresee. Study what happened in 2007-2008 for an example. Many stocks looked great, and projected earnings looked great, and their futures looked so bright that everyone was wearing shades – but their share prices collapsed anyway, in a spectacular fashion. In September 2008, did anybody care about how many iWidgets any given company was projected to sell in the fourth quarter of that year?

Some fundamental analysts saw what was coming back then; others didn't. Likewise, some technical analysts saw what was coming (myself included) and others didn't. But the probability of a crash was all telegraphed well in advance on the price charts – one didn't even need to turn on the TV to see it coming ahead of time.

The big advantage to technical analysis: Technical analysts were able to arrive at actual price targets for the crash, in real time, while it unfolded.

Fundamental analysts knew it was "gonna be bad!" but that type of analysis doesn't help time the market with a large degree of accuracy. This is why the majority of fundamental analysts don't even try to time the market, except in broad strokes; their system is ill-suited to it.

by Jason Haver
In analyzing price action, market traders make use of two main kinds of analysis. Those who concentrate on price action, and ignore most other factors choose to direct their efforts at perfecting their skills at technical analysis, while traders who prefer to study the economic events that cause the market action mostly focus their efforts in studying fundamental analysis. In this article we’ll take a brief look at both of these concepts, before moving onto examine them in greater detail in further lessons in this notepad.

Many traders combine both types of analysis to generate trading signals. Others concentrate on one aspect of analysis and exclude the other from their calculations, and it is fair to say that either approach can be valid depending on the circumstances. Both of these traders would probably agree that emotional control and discipline are the most important aspects of a successful trading career.  Fundamental and technical analysis are not exactly the same thing and in the longer term the predictive power of fundamentals is maybe more accurate.  Nonetheless, these two are akin to two different languages describing the same phenomenon, and at least on hindsight, they always show the same direction, and reach the same conclusions.

What is Fundamental Analysis

We've already looked at what Technical Analysis is in An Introduction to Technical Analysis.  So to compare the two we must first look at what Fundamental Analysis is.  Fundamental analysis is the discipline that tries to make sense of price movements in light of economic data and news flow. In comparison to technical studies, fundamental analysis also has a large selection of indicators. While many traders choose to focus on the news releases and indicators that appear to determine the day-to-day movements in the financial markets, fundamental analysis in fact studies many other aspects of economics including politics, financial law, social attitudes, in addition to the many other aspects of human life.

Fundamental analysis aims to establish a cause and effect relationship between market movements and economic developments. In that sense, it is different from technical analysis which regards the price action as the beginning and end of trading. While technical analysts generally argue that the price action reflects all information available to the market, fundamental analysts seek to identify imbalances and “errors” in the market that may offer profit opportunities. Unlike the technical trader, the fundamental trader is always sceptical of the price action, and seeks alternative explanations to the “wisdom of the market” in evaluating price trends.

While this type of analysis has been proven to be efficient and reliable through the ages, there are a number of issues that we must keep in mind in order to avoid being too optimistic about the predictive powers of our approach. While fundamental analysis can and often does indeed warn us on possible errors in market attitudes to economic realities, there’s no indication that the correction will happen anytime soon. Similarly, bubbles and market extremes often cause analysts to rationalize the unhealthy positioning of the market, invalidating the healthy advantage of skepticism inherent in the fundamental approach.

Advantages of Fundamental Analysis

The greatest benefit derived from the study of fundamental analysis is the ability to understand the causes that drive the market action. By understanding market dynamics, we can be confident in maintaining a position as long as the cause that triggered the trade exists. A thorough grasp of fundamental analysis also ensures that we do not lose our composure in the face of market volatility.  Many of those who successfully made millions in this business were users of fundamental analysis; and there is no reason to doubt that if we use the same methods we can achieve successful results.

Conclusion

Both types of analysis are useful for examining market action. Your trading style, and attitude to trading will determine which kind of analysis you'll find most beneficial. But before making that decision, it is a good idea to study the subject of technical analysis in slightly more detail. In the next few modules, our subject will remain focused on Technical analysis.  In reality most Technical Analysts will have an understanding of The Fundamentals, especially if your trading style is over a longer time frame.  Even those trading intra-day (Day Traders & Scalpers) should understand fundamentals, as a knowledge on what economic releases are due within their trading horizon is important to their trading decisions.

The Two Methods of Trading & Investing

The broad investment strategy followed by all market investors is the same. Since the purpose of tapping the market is to generate better returns, they all buy scrips that are expected to rise in the future and sell the ones that are likely to fall or remain flat. However, the methods used to identify these stocks differ significantly for fundamental and technical analysts. Let us consider these two modes.

Fundamental analysis: This involves evaluating all economic factors, macro and micro, which can affect the stock price. Macro factors include the economic growth, growth rate of the sector to which the company belongs (compared with the GDP growth), inflation rate, interest rate structure, etc. Micro factors, on the other hand, are more stock-specific-sales, profitability, return on equity/assets, liabilities, cash, etc. The aim of analysing all these factors is to predict the firm's future trajectory.

Once the expected sale, profit, cash flow, dividend, etc are calculated, the next step is to arrive at the intrinsic value of the security. There are several methods, such as the dividend discount model and discounted cash flow, to arrive at this value.

The final step is to compare the intrinsic value with that of the current market price and decide whether the stock is underpriced (if the market price is lower than its intrinsic value), fairly priced or overpriced (if the price is higher than its intrinsic value). Fundamental analysts buy stocks when it is underpriced and sell when it is overpriced.

Technical analysis: This method restricts analysis to the data (price movements, volume, etc) generated by the market. Though technical analysis can be used in all markets-commodities, forex, stocks, bonds-we are confining it to the stock market for the sake of simplicity. Why is this method restricted to market data? Are the fundamental factors irrelevant and should be ignored? No. Technical analysis believes that the market price of a stock discounts these fundamental factors through the actions of buyers and sellers and, hence, there is no need to analyse them again. So the first rule of this method is that 'price captures everything'.

The next rule is that 'price moves in trends' as opposed to moving at random. These are uptrend, downtrend and sideways. Despite the best efforts of regulators, the price-sensitive information comes to the market slowly. First it comes to insiders, then to the circle close to them, then to analysts and big investors, before finally reaching the small investors.








Since the transmission of information takes time (few hours to several days), the price movement is also slow. By the time the news hits the market, the news may be fully priced in and explains the muted price action despite big news like fall in net profit, etc. If you can spot the emerging trend at the start, you can make money by participating in an uptrend or downtrend without knowing the fundamental reasons for it. So, a technical analyst is concerned with the direction of the market, not the reasons for its movement.








How do you know the stock is entering either of these trends? The best way to do this is to study the historical price patterns and compare it with the current ones. Since people usually react in a similar fashion when faced with similar situations, the price patterns generated in the past are repeated in the future. This, then, is the third rule: history tends to repeat itself.


Techno-funda analysis: Which is the best form of analysis? It is difficult to say because technical analysis works better for short-term trading and investing, while fundamental analysis is useful for long-term investing. Successful investors use both the methods - fundamental analysis to identify what to buy/sell and technical analysis to decide when to do so. In some cases, both may generate similar results.

So, if there is a sharp rise in stock price, both analysts will be cautious, but for different reasons. The fundamental analyst may say that you need to be cautious since the stock is overvalued. The technical analyst may warn you about the reason to be cautious since it is in an overbought zone and ready for a correction or trend reversal. Both the methods are useful, which explains why most big brokerages employ the two types of analysts.

by Narendra Nathan


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