In investing and trading, we often hear debates on the merits of fundamental versus technical analysis. Both aim to improve our probability of a profit. Both methods have their usefulness when correctly applied.
They are not the same by any stretch, so it’s not a debate over one “apple” versus another. It’s a comparison of two completely different approaches, and the comparison is more of the “apples vs. oranges” variety.
Trading Versus Investing
Before we get into the fundamental versus technical analysis, there are important distinctions to be made between investors and traders. Investors are more long-term growth-oriented, while traders focus on immediate income or aggressive account growth. Market participants tend to be focused on one approach or the other. But many are a mix of both.
Investing and trading are different worlds, and it can be challenging to master either domain, much less both. The key is to know what style is best for your timeframe, to what extent and why.
Technicals VersusFundamentals
The Technical Approach
Technicians are students of price patterns. Technical analysis looks at the price movement of a security and uses these data to predict future price movements. In general, the more liquid the product, the more reliable the price patterns on the chart. A high-volume index product like the SPDR® S&P 500 ETF (NYSE:SPY) will more reliably chart investor and trader sentiment than a thinly traded penny stock.
Technicians focus on chart price action, often supplemented by choosing among literally thousands of “indicators” and combinations thereof. I can’t tell you how often I’ve heard from hardcore nerd technicians something like, “This indicator (or set of indicators) works in all markets and all timeframes.”
Uh, no. I haven’t seen that yet in more than 30 years of trading. Beware of too much chasing of a holy grail set of indicators. That “forest” is vast, and you may never find your way out. A relatively small group of indicators and patterns can serve technicians well. The key is to know under which conditions to apply them and how.
The Fundamental Approach
The fundamental approach looks at economic and financial factors that influence a business over the longer term. Fundamentalists study financial statements, analysts’ reports and ratings, earnings reports and forecasts.
If a company has earnings “X” that are expected to grow at “Y%,” it is still up to market participants to decide what value to place on their assessment. And they can be a moody bunch.
Why I Lean Toward The Technicals
My opinion of a “correct” valuation is essentially meaningless. But as a technician, I care about what the big money thinks and how they move their capital. The price action from the chart is a reflection of what the big money thinks. That’s our edge as technicians. We’re following the money rather than our opinions on valuation.
Technicians are all about picking high-probability entries and exits. As a technical trader, do I even care about fundamentals? Perhaps not. The charts can tell me what I need to know about what the big money is doing.
Can technicians safely ignore fundamental analysis? There’s a case to be made based on the assumption that everything currently known about fundamentals is baked-in into price. Efficient market theory, as it were. Technicians can be quite successful by focusing just on price action. But chart patterns and indicators can and do unexpectedly fail. So good risk management is always a requirement.
A Hybrid Approach For Buy-And-Hold?
A herd mentality often drives markets. One of the classic texts about market behavior is “Extraordinary Popular Delusions and the Madness of Crowds,” written by Charles Mackay and initially published in 1841. It’s been commented on and analyzed ever since, and it seems not much has changed about human behavior. History rarely repeats precisely, but it does tend to rhyme.
If you’re a long-term investor of the “buy and hold” variety, you could dismiss technical analysis. But you’d be doing yourself a disservice. Why? Because the economy and markets are cyclical and there are times when it is best to move to the sidelines to avoid large drawdowns. Fundamentals can be far out of sync with price action when fear and greed take over. The market can be irrational for longer than you can be solvent.
Staying fully invested through major economic and price corrections can be costly to long-term results. At other times, technical analysis can help buy-and-hold investors to see when a security is oversold, bottomed out and may have a high-probability re-entry. Again, good risk management is essential to protect our capital.
Summary
Fundamental or technical analysis – which is better for you?
It depends not just on your time horizon but also on what suits your personality better. I doubt I can do fundamental analysis on a public company and gain some insight that few others see. That would make me a first-order participant with no edge versus an army of institutional professionals. As a technician, I’m a second-order participant. My goal is simply to assess the price action as accurately as I can and make decisions accordingly.