| How often do you hear that the best time to buy stocks is when they are at or below their normal values? This type of thinking hails from fundamental analysis, one of the two primary schools of financial analysis. The other school is technical analysis, which uses terms like overbought/oversold, gaps, and breakouts, to name only a few. What makes these two schools so different? Let's take a look at each approach. TECHNICAL ANALYSIS - Technical analysis is the art of examining charts of past price movements to forecast future movements. Technicians those who follow technical analysis do not look at income statements, balance sheets, or other fundamental information about the company.
- Technicians' stated belief is that the current market price is the reflection of all the information available, whether or not it's known by all market participants. Since the information is already reflected in the current price of the security, technicians are of the opinion the price represents fair value and should be the basis for analysis.
- Technicians agree that prices tend to trend. According to technicians, prices also go through periods of consolidation, trading in a relatively narrow band before an uptrend or downtrend is established. Technicians are of the opinion it is possible to spot a trend, and either invest in or trade strong trends. Trend strength is determined by trading volume.
- Technicians do not place any emphasis on the company they are trading. Often, they only know the ticker symbol of the security. Their interest lies in interpreting charts to determine whether it would be profitable to trade a specific stock.
- Technical analysis can be applied to either bull or bear markets. It can also be applied across markets to stocks, market indexes, or commodities. By looking at price action over an extended period of time, you can see the battle between supply and demand unfold. Generally speaking, higher prices reflect increased demand and lower prices reflect increased supply.
- Technicians use the open, high, low, and close of a security to forecast its next move. There are periods when a security will trade within what is referred to as a trading range. During a trading range, prices move within a confined area. For example, a stock could be trading between $48 and $50 for a while without clear direction. When prices finally move out of the trading range, it's because either supply or demand has taken hold. Again, supply and demand form the basis of stock price movements. If prices move above the upper portion of the trading range, it means demand is winning. Conversely, if prices move lower than the trading range, supply is winning.
- Technicians focus on price. The price is the market's analysis of the knowledge of all participants, and is the result of the forces of supply and demand. It reflects the price that all participants agree the security is worth at any given time. As they analyze price, technicians ask several questions: What is the price? Where has the price been? Where is the price headed?
DRAWBACKS - Technical analysis is open to interpretation. Two technicians can look at the same chart and interpret it in two different ways, even when they are both using standard analysis techniques.
- Technical indicators are often criticized for generating buy and sell signals too late, which is known as lagging.
FUNDAMENTAL ANALYSIS - Fundamental analysis focuses on evaluating a security's value based on forecasts. Fundamentalists examine a company's balance sheets, dividends, sales data, management, competition, and so on. All of these are taken into account before the stock price is evaluated.
- Fundamentalists usually begin their analysis by evaluating the overall economy. The first step is to look at interest rates and where they are headed. Many economists believe that interest rates give a good reading on where the economy is going. Once an opinion on the overall economy is formed, the fundamentalist can analyze a particular industry or group.
- In an expanding economy, some groups are likely to benefit more than others. A fundamentalist can narrow the list down to only those groups that are most likely to benefit from the current or projected future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and a fundamentalist might choose an aggressive, growth-oriented strategy. In an economy that is forecasted to contract, the same trader might use a more conservative strategy, one that would opt for stable, income-oriented companies. A defensive strategy might also involve the purchase of consumer staples such as utilities and energy-related stocks.
- To assess the investment potential of an industry group, fundamentalists look at the group's overall growth rate, market size, and importance to the economy. It is often more important to be in the right industry than the right stock. Fundamentalists are of the stated belief that when stocks move, they tend to move in groups.
- The next step for fundamentalists is to narrow the list of companies within the chosen industry group. A fundamentalist will look at the market share, competitive advantage, and product position of each company in the group. These can be determined by looking at each company's business plan, management, and underlying financials.
- Another factor that fundamentalists consider is the company's market leadership status. If a company is a market leader, will it sustain its present market advantage, or is there a strong possibility that competitors might take over?
- The company's management plays an important role in fundamental analysis. How much experience does management have? Sometimes inept management will force fundamentalists to look elsewhere.
DRAWBACKS - Fundamental analysis suffers from individual analysts' unique biases. Fair value determined by using fundamental analysis is subjective. This subjectivity begins as an analyst reads the economy; if he or she sees a weak economy, the rest of the analysis will be painted with that bias. The same goes for the analyst who forecasts an expanding economy.
- Fundamental analysis is far too dependent on forecasting. Because of this, fundamentalists tend to lose focus on their market analysis tools and concentrate too much on prediction, which can lead to inaccuracies.
SUMMARY Whether you decide to use technical or fundamental analysis is completely up to you. You can always incorporate both technical and fundamental analysis; this can help reduce your risks and improve your trading results. John Devcic is a freelance writer. He may be reached at glatko@aol.com. Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.
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