There are two primary methods used to analyze stocks and make investment decisions: fundamental analysis and technical analysis.
Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements.
Technical analysis may appear complicated on the surface, but it boils down to an analysis of supply and demand in the market to determine where the price trend is headed. In other words, technical analysis attempts to understand the market sentiment behind price trends rather than analyzing a security’s fundamental attributes. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor over the long-term.
This article is based on the information obtained from Investopedia. You will be introduced to technical analysis and develop the foundation needed to understand more advanced concepts down the road.
Assumptions of technical analysis
Technical analysis is based on three assumptions:
1. The market discounts everything
Many experts criticize technical analysis because it only considers price movements and ignores fundamental factors. The counterargument is based on the efficient market hypothesis, which states that a stock’s price already reflects everything that has or could affect a company – including fundamental factors.
Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology is already priced into the stock. This removes the need to consider the factors separately before making an investment decision. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
2. Price moves in trends
Technical analysts believe that prices move in short-, medium-, and long-term trends. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
3. History tends to repeat itself
Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many form of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
Fundamental Vs. technical analysis
Technical analysts typically begin their analysis with charts, while fundamental analysts start with a company’s financial statements. Fundamental analysts try to determine a company’s value by looking at its income statement, balance sheet, and cash flow statement. In financial terms, the analyst tries to measure a company’s intrinsic value by discounting the value of future projected cash flows to a net present value. A stock price that trades below a company’s intrinsic value is considered a good investment opportunity and vice versa.
Technical analysts believe that there’s no reason to analyze a company’s financial statements since the stock price already includes all relevant information. Instead, the analyst focuses on analyzing the stock chart itself for hints into where the price may be headed.
Fundamental analysis takes a long-term approach to investing compared to the short-term approach taken by technical analysis. While stock charts can be delimited in weeks, days, or even minutes, fundamental analysis often looks at data over multiple quarters or years.
Fundamentally-focused investors often wait a long time before a company’s intrinsic value is reflected in the market. For example, value investors assume that the market is mispricing a security over the short-term, but that the price of the stock will correct itself over the long run. This ‘long run’ can represent a timeframe as long as several years, in some cases.
Technical analysis and fundamental analysis have different goals in mind. Technical analysts try to identify many short- to medium-term trades where they can flip a stock, while fundamental analysts try to make long-term investments in a stock’s underlying business. A good way to conceptualize the difference is to compare it to someone buying a home to flip versus someone that’s buying a home to live in for years to come.
Many critics view technical analysis as unproven at best or wishful thinking at worst. Don’t be surprised to hear these critics question the validity of the discipline to the point where they mock supporters.
Much of the criticism of technical analysis is focused on the efficient market hypothesis, which states that any past trading information is already reflected in the price of the stock. Taken to the extreme, the ‘strong form efficiency’ hypothesis states that both technical and fundamental analysis is useless because all information in the market is accounted for in a stock’s price. This thinking is explained in detail in books like a random walk down Wall Street, which states that an investor is better of guessing than stock picking.
The reality is that the EMH is still just that – a hypothesis. It’s up to investors to decide who is correct and determine their own philosophy.
Can they co-exist?
Technical analysis and fundamental analysis are often seen as opposing approaches to analyzing securities, but many investors have experienced success by combining the two techniques. For example, an investor may use fundamental analysis to identify an undervalued stock and use technical analysis to find a specific entry and exit point for the position. Often times, this combination works best when a security is severely oversold and entering the position too early could prove costly.
Alternatively, some primarily technical traders will look at fundamentals to support their trade. For example, a trader may be eyeing a breakout near an earnings report and look at the fundamentals to get an idea of whether the stock is likely to beat earnings.
The idea of mixing technical and fundamental analysis isn’t always well-received by the most devoted groups in each school, but there are certainly benefits to at least understanding both schools of thought.