People often ask if technical analysis can be used as an effective substitute for fundamental analysis. Although there is no definitive answer whether technical analysis can be used as a whole substitution for fundamental analysis, there is little doubt that combining the strengths of both strategies can help investors better understand the markets and gauge the direction in which their investments might be headed. In this article, we'll look at the pros and cons of technical analysis and the factors that investors should consider when incorporating both strategies into one market outlook.
The Best Of Both Worlds
Some technical analysis methods combine well with fundamental analysis to provide additional information to investors. These include:
1) Volume Trends
When an analyst or an investor is researching a stock, it's good to know what other investors think about it. After all, they might have some additional insight into the company or they might be creating a trend.
One of the most popular methods for gauging market sentiment is to take a look at the recently traded volume. Large spikes suggest that the stock has garnered much attention from the trading community and that the shares are under either accumulation or distribution.
Volume indicators are popular tools among traders because they can help confirm whether other investors agree with your perspective on a security. Traders generally watch for the volume to increase as an identified trend gains momentum. A sudden decrease in volume can suggest that traders are losing interest and that a reversal may be on its way. (To learn more, read Gauging The Market's Psychological State.)
Intraday charting is growing in popularity because it enables traders to watch for spikes in volume, which often correspond with block trades and can be extremely helpful in deciphering exactly when large institutions are trading. (For more on this subject, see Volume Oscillator Confirms Price Movements and The Pros And Cons Of Institutional Ownership.)
2) Tracking Short-Term Movements
While many fundamental investors tend to focus on the long haul, the odds are that they still want to obtain a favorable buy-in price and/or a favorable selling price upon liquidating a position. Technical analysis can be handy in these situations as well.
More specifically, when a stock punches through its 15- and/or 21-day moving average (either to the upside or the downside), it usually continues along that trend for a short period of time. In other words, it is largely an indicator of what to expect in the coming term. Incidentally, 50- and 200-day moving averages are often used by chartists and some fundamental investors to determine longer term breakout patterns. (To read more about how to interpret these indicators, see our Moving Averages tutorial.)
For those looking to time a trade or to solidify a favorable entry or exit price in a given stock, these types of charts and analyses are invaluable.
3) Tracking Reactions Over Time
Many fundamental analysts will look at a chart of a specific stock, industry, index or market to determine how that entity has performed over time when certain types of news (such as positive earnings or economic data) has been released.
Patterns have a tendency to repeat themselves, and the investors who were lured (or put off by) the news in question tend to react in a similar manner over time.
For example, if you take a look at the charts of various housing stocks, you'll often see that they react negatively when the Federal Reserve chooses to forgo a cut in interest rates. Or check out how home improvement stores tend to react when reports of new and existing home sales decline. The reactive move lower is pretty consistent each time.
In short, by analyzing historical trends, investors can ballpark the possible reaction to a future event. (For related reading, see Why do stock prices change following news reports?)
The Downside to Blending
Technical analysis may also provide an inaccurate or incomplete perspective on a stock because:
1) It's History!
While it is possible to decipher and anticipate certain movements based on patterns or when a particular stock crosses a major moving average, charts cannot usually predict future positive and/or negative fundamental data - instead they are heavily focused on the past.
However, if news leaks out that a company is about to release a good quarter (for example), investors might be able to take advantage of it and this good news will be apparent in the chart. A simple chart cannot provide the investor with crucial long-term fundamental information such as the future direction of cash flow or earnings per share.
2) The Crowd is Sometimes Wrong
As mentioned above, it's nice to buy into a stock that has upside momentum. However, it is important to note and understand that the crowd is sometimes wrong. In other words, it is possible that a stock that's being accumulated en masse this week may be under heavy distribution the next. Conversely, stocks that are being heavily sold this week may be under accumulation in the weeks to come.
A terrific example of the "crowd is wrong" mentality can be found in the large amount of money that went into technology shares at the turn of the millennium. In fact, money kept flowing into shares of companies such as CMGI or JDS Uniphase, as well as a number of other high-tech issues. When the bottom dropped out, the money flow into these stocks and the stock markets on which they traded dried up almost overnight. The charts did not indicate that such a harsh correction was coming. (For related reading, see The Madness Of Crowds.)
3) Charts Don't Typically or Consistently Forecast Macro Trends
Charts also are generally unable to accurately forecast macroeconomic trends. For example, it is nearly impossible to look at a major player in the oil and gas sector and decipher definitively whether OPEC intends to increase the amount of oil it pumps, or whether a fire that just started at a shipping facility in Venezuela will affect near-term supplies.
4) There is Subjectivity
When it comes to reading a chart, a certain amount of subjectivity comes into play. Some may see a chart and feel that a stock is basing, while another person might see it and conclude that there is still more downside to be had.
Who is right?
Again, there's no calculation that can be done to solve the argument, as might be the case with fundamental analysis. When it comes to charting, only time will tell which way the markets will actually go.
Technical analysis can be a very valuable tool, but it is important to realize the benefits as well as the limitations before diving in. There is no definite answer about whether technical analysis should be used as a substitute to fundamental analysis, but many agree that it has its merits when used as a compliment to other investing strategies.
To learn more about how to use technical analysis, read The Basics Of Technical Analysis.