A super computer was once posed a question as to who are more reliable, fundamental analysts or technical analysts. To get a scientific answer, the computer was fed with mountains of data from an array of analysts from across the United States. Based on the data the super computer finally concluded that the technical analysts were more reliable. The logic was quite intuitive. Based on data the computer concluded that the fundamental analysts were occasionally right but the technical analysts were always wrong. This made technical analysts more reliable.
Most likely the above story is apocryphal and also a tad unfair to both fundamental and technical analysts. That still does not answer our basic question; should investors base their view on fundamentals or technicals. Here is a touchdown.
The power of fundamental analysis
Fundamental analysis is based on the premise that every asset has a value and a certain price and the two need not be the same. The big challenge in fundamental analysis is in arriving at this value. Fundamental analysts believe that the only way to predict markets is to predict stocks and for that you need to understand value. Value stems from future cash flows or what the business can generate in the future. Fundamental analysis does not bother about index levels and the trajectory of prices. It is based on the premise if you buy a good stock at a good price then eventually the price will converge towards its intrinsic value.
But there is a shortcoming in the fundamental approach. The problem they have is that this might well help to predict the direction of stock, commodity, bond and currency prices but it says little about timing of entry and exit. Also fundamental analysts does not throw light on short term price targets, long term price targets, breakouts etc. That is where technical analysis comes in handy.
When to use technical analysis
Technicals are based on the premise that past patterns will repeat. So the only way to play markets is to understand the past pattern, create a template and use it for the future. That is just the outline. There is a huge body of knowledge in technicals. There are supports, resistance levels, break outs, stochastic etc. For longer term technicals there is Dow Theory as well as Gann and Fibonacci fan lines to Bollinger bands and Elliott Wave.
The myth is that only intraday traders use technicals. In fact, the best of fundamental views are also ratified by the technical charts. That is what happens when you combine the best of fundamentals and technicals.
Can we call it an eclectic approach?
Most brokers and investors do combine the best of fundamentals and technicals. While fundamentals are key to ensure that you buy the right stock at the right price, technical charts help to identify the right entry and exit levels for finer pricing and enhancing ROI. Here are few things to know about this eclectic approach.
- There are occasions when the two approaches can give opposite answers. Fundamentals could say buy but technicals may say sell. This could be more because of the time frame of the allocation.
- Fundamental analysis is based on the premise that price of the stock will eventually move towards its value. Technicals purely look at chart patterns and do not make any such assumptions.
- Technicals are vulnerable to price performance. When a stock price moves strongly higher, technical analysts would probably suggest that the trend will continue and urge their customers to buy more. For fundamental analysts this may be counter intuitive.
- For most fundamental analysts it does seem quite unbelievable that everything you need to know is in the price.
- At the same time, fundamental analysis has little to say about trader psychology, fear or greed in the markets which is arguably an important market driver.
Both the approaches have their merits and their limitations. As a prudent investor, you need to understand the business of the company you are buying into. That is logical. Even if you are not a short term trader, there is a lot of intelligence and insights available in stock charts. You cannot afford to miss out on them.