Technical analysis and fundamental analysis are the two main schools of thought when it comes to analyzing the financial markets. As we’ve mentioned, technical analysis looks at the price movement of a security and uses this data to predict future price movements. Fundamental analysis instead looks at economic and financial factors that influence a business. Let’s dive deeper into the details of how these two approaches differ, the criticism against technical analysis, and how technical and fundamental analysis can be used together.
Tools of the Trade
Technical analysts typically begin their analysis with charts, while fundamental analysts start with a company’s financial statements. (For further reading, see Introduction To Fundamental Analysis and Advanced Financial Statement Analysis).
Fundamental analysts try to determine a company’s value by looking at its income statement, balance sheet, and cash flow statement. In financial terms, the analyst tries to measure a company’s intrinsic value by discounting the value of future projected cash flows to a net present value. A stock price that trades below a company’s intrinsic value is considered a good investment opportunity and vice versa.
Technical analysts believe that there’s no reason to analyze a company’s financial statements since the stock price already includes all relevant information. Instead, the analyst focuses on analyzing the stock chart itself for hints into where the price may be headed.
Fundamental analysis takes a long-term approach to investing compared to the short-term approach taken by technical analysis. While stock charts can be delimited in weeks, days, or even minutes, fundamental analysis often looks at data over multiple quarters or years.
Fundamentally-focused investors often wait a long time before a company’s intrinsic value is reflected in the market. For example, value investors assume that the market is mispricing a security over the short-term, but that the price of the stock will correct itself over the long run. This “long run” can represent a timeframe as long as several years, in some cases. (For more insight, read Warren Buffett: How He Does It and What Is Warren Buffett’s Investing Style?).
Fundamentally-focused investors also rely on financial statements that are filed quarterly, as well as changes in earnings per share that don’t emerge on a daily basis like price and volume information. After all, a company can’t implement sweeping changes overnight and it takes time to create new products, marketing campaigns, and other strategies to turn around or improve a business. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts.
Trading v. Investing
Technical analysis and fundamental analysis have different goals in mind. Technical analysts try to identify many short- to medium-term trades where they can flip a stock, while fundamental analysts try to make long-term investments in a stock’s underlying business. A good way to conceptualize the difference is to compare it to someone buying a home to flip versus someone that’s buying a home to live in for years to come.
Many critics view technical analysis as unproven at best or wishful thinking at worst. Don’t be surprised to hear these critics question the validity of the discipline to the point where they mock supporters. While most Wall Street analysts focus on the fundamentals, just about any major brokerage employs technical analysts. There are also professional certifications for technical analysts and some techniques are included in the CFA exam, among others.
Much of the criticism of technical analysis is focused on the Efficient Market Hypothesis, which states that any past trading information is already reflected in the price of the stock. Taken to the extreme, the ‘strong form efficiency’ hypothesis states that both technical and fundamental analysis are useless because all information in the market is accounted for in a stock’s price. This thinking is explained in detail in books like a Random Walk Down Wall Street, which states that an investor is better of guessing than stock picking. (For more insight, read What Is Market Efficiency? and Working Through The Efficient Market Hypothesis).
The reality is that the EMH is still just that – a hypothesis. It’s up to investors to decide who is correct and determine their own philosophy.
Can They Co-Exist?
Technical analysis and fundamental analysis are often seen as opposing approaches to analyzing securities, but many investors have experienced success by combining the two techniques. For example, an investor may use fundamental analysis to identify an undervalued stock and use technical analysis to find a specific entry and exit point for the position. Often times, this combination works best when a security is severely oversold and entering the position too early could prove costly.
Alternatively, some primarily technical traders will look at fundamentals to support their trade. For example, a trader may be eyeing a breakout near an earnings report and look at the fundamentals to get an idea of whether the stock is likely to beat earnings.
The idea of mixing technical and fundamental analysis isn’t always well-received by the most devoted groups in each school, but there are certainly benefits to at least understanding both schools of thought.
In the following sections, we’ll take a more detailed look at technical analysis.