Technical Analysis vs Fundamental Analysis
Technical analysis and fundamental analysis are the two primary methods that investors utilize to pick investments and identify the best buy and sell points for stocks and other financial securities.
While the ultimate aim of both methods of investment analysis is the same, technical and fundamental research methods to investing are radically different.
This article defines technical and fundamental analysis, reveals the tools that technical analysts and fundamental analysts use. It compares the two investing approaches and examines the relative advantages and disadvantages of technical and fundamental analysis.
What is Technical Analysis?
Technical analysis focuses on analyzing the price action, the up and down price changes, of a stock or other traded security.
Technical analysts look for identifiable patterns of price movement based on the belief that stock prices tend to move in frequently repeated patterns.
Thus, they examine the current price action of a stock and its historical price action (such as recent or all-time highs or lows) to determine probable future price movements.
When you get right down to it, technical analysts don’t reject the value of fundamental analysis. Rather, technical analysts believe that all the various fundamental factors that may affect a stock price are reflected in the current price action of the stock. Thus, they essentially consider technical analysis to be the most effective means of cutting through to the bottom line of predicting a stock’s future price movement.
What is Fundamental Analysis?
Fundamental analysis focuses on all the “real world” factors that may contribute to a company’s value and probable future growth and financial success.
Its aim is to determine:
- (A) if a company’s current stock price is undervalued or overvalued relative to the company’s intrinsic value, and
- (B) whether and by how much a company’s intrinsic value is likely to increase in the future, thus, logically, pushing its stock price higher. Fundamental investors are sometimes referred to as “value investors.”
While technical analysis relies on the underlying assumption that price action repeats, the underlying assumption of fundamental analysis is that a company’s stock price will accurately reflect the true, fair market value of the company, typically referred to as its intrinsic value or enterprise value.
It’s important to understand that when assessing a company’s intrinsic value, fundamental analysts aren’t looking solely at what a company is worth right now but also what it is likely to be worth in the future.
A common definition of “intrinsic value” is the current value of a company’s predicted future earnings. Thus, in the end:
Fundamental analysts are trying to accomplish the same goal as technical analysts: predict the most likely future price movement of a stock.
The Difference Between Fundamental and Technical Analysis
From their respective definitions, you can see that both technical and fundamental analysts have the same goal of predicting future stock prices.
The difference lies in their methodologies, specifically in the analytical tools that each uses to accomplish their goal.
However, one other common difference between technical and fundamental analysis is the investing strategy that the analysis is usually employed with.
Generally, fundamental analysis is more frequently used by long term investors, the kind of “buy and hold” investors that purchase a stock with the intention of staying invested in it for a year or even several years.
In contrast, technical analysis tends to be more commonly employed by more short term traders, such as day traders, or swing traders who usually buy and sell a stock within a matter of a few weeks or months.
Tools Used for Technical Analysis
The tools used for technical and fundamental analysis, respectively, are worlds apart.
The basic tools used in technical trading are price charts and various technical trading indicators applied to the charts.
The indicators commonly used by technical analysts include candlestick patterns, trendlines, moving averages, channels, volume, pivot points, and various measures of trend strength.
Technical analysis is essentially a two-step process. The first step is identifying potential support and resistance levels for a stock.
A support level is a price level that is likely to act as a foundation for a stock to move higher. Basically, a price level that technically analysts believe a stock is not likely to drop significantly below.
A resistance level is identified as a price level that a stock will likely have difficulty rising above. Various tools of technical analysis can be used to identify support and resistance.
The second part of technical analysis focuses on trying to gauge the strength of the existing trend in a stock’s price movement.
Its about obtaining an idea of how likely the trend is to continue and how much further it is likely to advance (uptrend), or drive down (downtrend), a stock’s price.
Trend strength analysis is primarily done by using what are known as momentum indicators. Among the most widely used momentum indicators are the relative strength index (RSI) and the moving average convergence-divergence indicator (MACD).
Tools used for Fundamental Analysis
The tools employed by fundamental market analysts include the following:
- Economic news and reports, which includes news information about the overall economy, the growth prospects for different market sectors, and news reports about specific companies
- General information about companies, such as a company’s management team and current and long term business strategy
- A wide range of financial metrics that are used to assess a company’s current value, how its current stock price compares to its current value, and the likelihood of the company’s intrinsic value either increasing or decreasing in the future (and by how much)
Among the many sources of information that fundamental analysts consider are basic economic reports that are periodically issued by the government on things such as employment, inflation, interest rates, manufacturing production, and foreign imports/exports.
They will also read financial newspapers and magazines in order to get information and clues regarding the future prospects for market sectors and specific companies within a market sector.
They also examine the various financial statements and reports that all publicly traded companies are required to periodically issue, such as their income statement, balance sheet, and cash flow statement.
Finally, when analyzing specific companies and their competitors, fundamental analysts will look at a variety of stock metrics that are used to evaluate the company’s intrinsic value and its value, both current and predicted future value, relative to the company’s current stock price.
In short, they’re looking to determine whether the stock is likely underpriced or overpriced relative to the company’s fair value and future prospects. There are dozens of such metrics to choose from.
The most widely used metrics include:
- profitability measures, such as profit margin;
- debt measures, such as the debt-to-equity ratio; and
- value measures, such as the price-to-book ratio.
Other popular metrics are the:
- price-earnings-growth ratio,
- earnings per share, and
- return on equity.
Fundamental analysts also ultimately rely on their personal opinions as to the likely future prospects for overall economic growth, different market sectors, and specific companies.
Pros and Cons of Technical Analysis
Technical and fundamental analysis come with relative advantages and disadvantages.
The primary advantages of using technical analysis are as follows:
- Patterns of price movement for a stock or other financial security do, indeed, tend to repeat over time. Therefore, being able to identify such patterns can certainly help investors make buy and sell decisions
- Technical analysis trading strategies can be tested using historical price action charts
- Technical analysis can be applied to any financial security, including securities with little fundamental information available, such as cryptocurrencies
- Technical analysis can be used with any trading timeframe, from a one-minute timeframe to a monthly timeframe, whereas fundamental analysis can usually only be employed to a long term investment outlook
The disadvantages that technical analysts have to deal with include the following:
- There are literally hundreds of technical indicators to choose from. Deciding which one(s) to use can be a daunting task
- Regardless of what trading strategy a technical trader employs, it usually takes quite some time to master actually implementing the strategy to deliver consistent profits
- Technical trading strategies can be wrecked in an instant by significant fundamental news. For example, a clear downtrend can change into a sharp uptrend in just seconds following a very favorable report release
Pros and Cons of Fundamental Analysis
Fundamental analysis has specific advantages and disadvantages.
Pros of fundamental analysis include:
- It’s based on solid, common sense reasoning. A company’s stock price is likely to move up or down based on legitimate increases or decreases in the company’s value.
- Fundamental analysis is helpful during sudden, severe market downturns. Technical analysts are likely to just bail out of a stock, fundamental analysts are more likely to consider whether a company has actually lost value or not
- Fundamental economic conditions and trends are drivers of long term growth (or lack thereof) for various market sectors and businesses
Primary cons of fundamental analysis are:
- It’s extremely time-consuming, as it requires continually reading and evaluating numerous economic news reports and articles. It includes looking at sector, industry, and company news and reports. Also, you have to keep up with various financial metrics, as well as learning how to accurately decipher financial statements and determine which economic factors are most important
- Correctly identifying whether a stock or other security is underpriced or overpriced is not an exact science, it’s ultimately a judgment call with each individual investor and may be right or wrong
- Just like there are hundreds of technical indicators for technical traders to choose from, there are dozens of financial metrics for fundamental investors to choose from, and it’s difficult to determine which are most important for a specific company
- Fundamental analysis usually can’t be applied to shorter trading timeframes. It’s typically only applicable to long term price forecasting
Technical vs. Fundamental Analysis: Which is Better?
The answer to that question is easy: There is no definitive “better” or “worse” between technical vs fundamental analysis. One or the other may produce more profitable investing results at different times.
What determines whether an individual chooses to rely on fundamental or technical analysis, as we said at the beginning, is mostly a matter of preference. Deciding which analytical approach an investor is most comfortable using, likes using, and believes in.
Using Technical and Fundamental Analysis Together
Technical and fundamental analysis aren’t necessarily exclusive of each other. You don’t have to look at them as strictly fundamental vs technical analysis. Many investors combine both methods of analysis. A typical combination of fundamental and technical analysis within an investor’s trading strategy involves:
- using fundamental analysis to identify solid value investments and
- using technical analysis to identify the most promising specific buy and sell price points.
Now you gained a solid overview of fundamental vs technical analysis, along with the relative pros and cons of each. There’s no definitive right or wrong in choosing to employ technical analysis or fundamental analysis.
It’s more just a matter of personal preference, which you feel more comfortable using, and more importantly, which analysis method you believe is most likely to help make you a successful investor.
Neither method of stock analysis is foolproof, guaranteed to provide profitable investments. Whichever analytical method you personally choose to employ, continuing study and learning more about how to evaluate investment opportunities will improve your chances of consistent and long term success as an investor.