Some view stock market investing like gambling, but experienced investors who do their homework usually profit by doing market analysis. Yet even experienced investors debate which type of analysis - fundamental or technical - provides higher returns. Do they result in the same picks? What does it mean when the two approaches contradict?
The Difference Between Fundamental and Technical Analysis
In a nutshell, fundamental analysis aims to determine intrinsic value by looking at the strength of the business, a financial analysis and the operating environment including macroeconomic events. Technical analysis analyzes past market performance by looking at the chart activity of price movements, volume, moving averages and the statistics of various outcomes. Fundamental analysis assumes the efficient market theory holds in the long run and attempts to take advantage of inefficiencies in the short run.
Technical analysis assumes fundamentals are already priced in and tries to find patterns that lead to outcomes with high probabilities of occurring. Technical analysis also captures the psychological aspects of the market in the review of past patterns, whereas fundamental analysis fails to factor in investor psychology but believes fundamentals will rule in the long term, so short-term psychological blips will correct themselves. In general, there are differences in the types of investors that gravitate toward a specific type of analysis. Technicians are usually more short-term traders by nature, contrasting with the long-term view fundamentalists generally take.
Relationship Between Technicals and Fundamentals
Do fundamentals drive technicals or the other way around? In the short run, strong fundamentals do not always indicate strong technical patterns or vice versa. Often, technicals can continue to follow a strong or weak pattern when fundamentals are at turning points, which may lead them to be out of sync. Additionally, technicals can be out of sync with fundamentals when there is a shock to a stock, either positive or negative. Stocks tend to follow technicals in the short run unless there is an unforeseen shock. For example, there are times when stocks start moving before a new, material disclosure becomes public. Absent insider trading or improper disclosures by not following Regulation D, technical analysts say you can respond real time to a stock and not have to wait for the next reporting date or news disclosure, because the charts already interpret market sentiment, so following the charts will lead to higher profits. Technical analysts believe that stocks move even without disclosures because suppliers, competitors and employees, and all their family and friends, invest in companies and without needing inside information, get a sense of how the company is faring. These buying and selling activities define the stock chart and pattern, and reflect the real-time stock behavior.
At times when the market is surprised by a new disclosure the charts may fail, at least initially, and reviewing the fundamentals may lead to long-run profits by taking advantage of short-term mispricing when a surprise causes the markets to overreact. News is temporary and may positively or negatively impact the stock’s fundamentals, so following the fundamentals after a shock may be more prudent. Then using technical analysis may provide the opportunity to take advantage of a correction or rebound after the news is absorbed. Therefore, even if the two have been out of sync in the short run, technicals and fundamentals should be in sync in the long run. That's because in the long run, fundamentals should win and drive the technicals.
Investment time horizon often dictates when technical or fundamental analysis makes sense. Since at points of inflection it appears that technicals and fundamentals are often out of sync, investment time horizon often comes into play. It is generally believed that short-term investors follow technicals while long-term investors are willing to withstand the day-to-day “blips” and follow fundamentals. For example, if you believe that genetically modified seeds will be the seed of the future for farmers, than you will probably invest in a relevant company, Monsanto (NYSE:MON) for example, and are willing to stay the course despite any short-term noise the stock may experience.
Critics argue that fundamental analysis can lead to improper valuations and thus improper investment decisions, because the information is for the most part backward-looking. Financial statement analysis, 10Q and 10K commentaries and macroeconomic environments focus on what already happened. Investors use this information to model expected future results. The problem is that forecasting is very subjective, relies on the company management team’s expectations and disclosures, and can be in some ways a self-fulfilling prophecy. "Garbage in, garbage out" is a term often used in conjunction with the modeling associated with fundamental analysis' intrinsic value determination.
On the other hand, critics of technical analysis think that chart patterns work until they fail, and the failure of the pattern may not always be predictable from following the past pattern, especially if there is an unforeseen shock. One way to curtail the shortcomings of the two methods is to use them together to capture the best aspects of both. Fundamental analysis should be used to determine which stocks or sectors are most likely to perform well based on a strong macroeconomic environment and company or sector-specific operations. Technical analysis can then be used to decide when to buy or sell by giving entry and exit points based on moving averages, volume and price trends. By employing both strategies together, positions can be taken in fundamentally strong companies while avoiding buying into stocks that have already run up and are overvalued. Technical analysis can help you avoid buying high or selling low, a phenomenon which often occurs when psychology starts to rule trading.
Fundamental and technical analysis do not have to be contrary or held within bounds. At times there may be a single indicator that provides information for both the technician and fundamentalist. For example, price volatility is an important technical indicator of risk - the greater the volatility, the greater the risk. This may be a leading indicator that the fundamentals are changing. As a result, both would agree on the buy/sell decision.
The Bottom Line
Sometimes investors like to pigeon-hole themselves into one type of investment style, but being open to combining styles may provide the best opportunity to make the most profit. Technical and fundamental analyses do not have to be used alone, but can be used together to draw a complete investment picture. Fundamentals may be used to identify appropriate targets, while technicals can be used to make the trading decisions. Together, these methods can generate a confluence of information that should provide a better investment opportunity than either used alone.