The debate over the relative merits of fundamental analysis and technical analysis is a contentious one. Investors and traders alike often miss out when they choose one over the other. Actually, both can be combined effectively.
In this article we explain the differences and highlight the strengths and weaknesses of each type of analysis. We also list a few methods the two approaches can be combined, and what the future holds for the different forms of investment analysis.
What is fundamental analysis?
Fundamental analysis in the stock or cryptocurrency market is a way of evaluating a company or a coin and determining the intrinsic value. Companies and firms are valued as though they were unlisted, with no regard for their market prices. Buy and sell decisions are made based on whether a stock is trading at a discount or a premium to its fair value.
Although a crypto/stock’s value is ultimately an opinion, relatively undervalued companies are able to outperform over the long term. Fundamental analysis can also be applied to other markets like 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 on stock price or volume data. The objective is not to forecast 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 so how they might act in the future.
Technical analysts use chart patterns and trends, support levels and resistance levels, and price and volume behavior to identify trading opportunities with positive expectancy. Technical analysis does not use the underlying business, or the economics that affect the value of a company.
Understanding the difference
The difference between the two methods comes down to what determines a stock’s value and price. Fundamental analysis considers the value of the company. This depends on the value of its assets and the profits it can make. 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 momentum, which gives clues as to the stock’s supply and demand dynamics – which is what determines the stock price. Patterns often repeat themselves as investors often behave in the same way in the same condition. Technical analysis is concerned with price and volume data alone.
Tools used for fundamental and technical analysis
Fundamental analysts use a company’s financial positions and performance, the market in which it operates, competitors and the economy. The major 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 such statements can be used to calculate ratios and metrics that reflect the company’s performance, health and growth rates. Industry data and economic factors, such as interest rates and retail spending, are also used to estimate future growth rates. Ultimately, a fair value is arrived at after comparing models and ratios.
Technical analysis is a lot broader than many people think. All chartists use price charts – usually either line charts, bar charts or candlestick charts. Apart from price charts, the tools used can vary extremely. Some analysts use indicators such as moving averages and oscillators calculated from stock prices. Others use price patterns, and complex analysis frameworks such as Elliott Waves and Market Profile. Trend followers use other tools to identify price trends and measure moves.
Fundamental vs. technical analysis: Which one is better?
The debate over fundamental and technical analysis is contentious. Proponents of either type of analysis often write the alternative off but misunderstand that they can have their place combined. Fundamental analysis is most useful for long term investments, while technical analysis can be used mostly 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 normally 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 when determining whether a stock is under or overvalued and what its value may be years into the future. Charts reflect what has taken place in the past, and their value diminishes the longer the time horizon.
Advantages and disadvantages of fundamental analysis
Analysis based on a company’s financial and competitive position has lots of 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 really worth. This is invaluable for long term investing. Investing during market bubbles can be rewarding – but it’s still important to understand when the market is actually in a bubble.
Portfolio risk can be managed by calculating the premium to fair value at which stocks are trading. Asset allocation decisions can be made to reduce the potential downside of a portfolio. The best profits are usually made by the investors that are correct when the rest of the market is wrong. This can be achieved with fundamental analysis. Also, decisions based on fundamental analysis usually have a higher probability of being correct, especially over the long term.
There are also many drawbacks to fundamental analysis. It’s important to be realistic about the limitations. Fundamental analysis is time consuming – because each company must be studied independently and exactly. Most of the information used in fundamental analysis is widely available. To gain an edge with fundamentals, you have to find unique datasets that aren’t available to other investors.
Fundamental analysis clarifies very little about what might happen in the near term. Short term price actions and volatility cannot be estimated by looking at financial statements. Fundamental analysis is a lot less exact than often perceived. Valuation models such as the discounted cash flow model are based on many 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 two years into the future.
Advantages and disadvantages of technical analysis
One of the most important advantages of technical analysis is that stocks can be analyzed fast. Also, some tasks can be automated which saves time, so 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 enable traders to make investment strategies with clearly defined risk and reward profiles.
In the near term, price action is affected by many 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 notice whether a stock price is in a trading range or a trend. Some technical strategies can be back tested. This means that 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 disadvantages. First amongst these is that while some technical methods 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 mostly 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 methods. Charts often seem 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 big 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 usually less than 60%. To trade setups like this profitably needs a large number of trades.
Using fundamental and technical analysis together
There are many ways in which technical and fundamental analysis can be used effectively together. The following are a few of the methods you can combine two types:
- Simply looking at a price chart can give you an idea of the direction of a momentum. This can 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 fast if a stock is widely owned and the fundamentals change.
- You can make a watchlist of stocks you are prepared to own based on fundamental analysis, and then use technical analysis to decide if or when to purchase them.
- Quantitative studies have found that a combination of value and momentum can be an effective way 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 or cryptocurrencies 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 chances investors will ever get to buy growth stocks.
- Stocks or cryptos 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 asset 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 types to trade within the range.
- Fundamental research can sometimes be used to determine which parts of a business cycle are most profitable. Technical analysis can then be used to confirm anticipated trends.
The future of investment analysis
In the future it is possible that the different 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 enables different types of analysis to be effectively combined, and tested. Increasingly, behavioral finance and market sentiment are being incorporated in algorithmic trading strategies. And, new technologies such as 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 the best trades. We can expect the lines between fundamental analysis and technical analysis to be blurred more and more as the investment industry evolves.