This is by far the most requested post I’ve had from friends.
As a person who has been exposed to both sides, people are curious on what my opinion is. I’ll start from the absolute basics and build up. I want to reiterate, this is my own personal opinion and nothing more, so feel free to disagree completely with me. As I’ll try to give as much context for the basis of my opinion as I can, if you are to read this post, please read it in its entirety. This post is not intended to teach technicals or fundamentals, if that’s what you are after, you are at the wrong place. It’s main goal is to simply juxtapose the two schools of thought.
What are Fundamental and Technical Analysis?
Fundamentals analysis is the part of financial analysis area that deals with reading financial statements, such as Income Statements, Balance Sheets, Cash Flow Statements and others. These statements are reported by public companies in most cases on quarterly basis depending on listing and regulatory requirements. After numerical adjustments for window dressing and comparability, these numbers then end up in numerous Free Cash Flow and Discounting models. This is what mostly analysts in large institutional investor institutions do, day in, day out. Based on this data and gathered sector and economic statistics, they try to predict future growth and opportunities for a company, so as to arrive at a valuation using either a Top-down, Bottom-up or a Relative valuation approaches. Based on their valuation and seeing the current company price, they provide recommendations to clients and other departments weather to buy or sell a stock. The main metrics, people care about are Earnings, and ratios such as EPS (Earnings per Share), BPS (Book Value per Share), ROE (Return on Equity) and many others. As this is not a financial course, I’ll stop it here. The main point is, their input data is fundamentals information, output is price estimate, usually up to 12-18 months forward, which is continually revised.
On the other hand you have technical analysis, which is part of the quantitative field, which is quite broad and not clearly defined. It includes algo-traders, actuaries, derivatives pricers and exotics traders, essentially anything that involves a bit of mathematics. Technical analysis, in its essence, is the study of supply and demand of assets reflected by price and volume. Its main input data is prices and volume and output is a price range estimate for different periodicities depending on the analysed timeframe.
The first clarification here is, technical analysis is not looking at a price chart and saying in 10 seconds buy or sell. Technical analysis takes just as much time as fundamentals does. Multiple time periods are covered, different chart types – Candlestick charts, Point & Figure, Equivolume and others. The complexity of mathematics involved varies enormously. Second clarification, technical analysts are not traders. Some traders do technical analysis and use it for day-to-day trading, but trading is not technical analysis. TA people, just like FA, do a recommendation and give basis for their estimates, but are not the people executing the trades most of the time. They provide views and opinions, just like fundamentals guys, they are analysts.
A more interactive short version is offered by Investopedia HERE.
What’s the basis for the two schools of thought?
It’s the fundamentals view that when you buy into a company, you buy its core earnings power and ability to generate cash, which can be shown only in the financial statements. That’s why earnings is the main market mover. Further supplemented by fact-based research for the sector and global economy, to create estimates. Using Technicals and trying to predict future price movements based on historical patterns is nonsense, as what has happened in the past is not reflective of the future. As an example, Apple releasing an iPhone 5S and how the market reacted to it back then, is not comparable to Apple releasing now iPhone 8 and how people react to it now, as competition is different, market forces are different and so on. The belief is that financial markets are rational over the long-term. Trying to time the market, brings little benefit. It’s all about the right stock pick.
Technicals view is that fundamentals people, don’t get it right all the time. It’s all about supply and demand. The people making the trading decisions are not rational at all times and thus markets are inefficient. Simple trading strategies can be used to predict market movements and profit from these. Markets are still primarily traded by humans, who are susceptible to biases and emotions, which lead to irrational behavioural and to reduced risk opportunities. Timing the market is what it’s all about. Trading on different time-frames. All the information you need is what you already have – price and volume. Price contains more data than the fundamentals and often reflects expectations and future events, not incorporated in the analyst research.
Why the opposite philosophies?
It has to do with Behavioural Finance vs Efficient Market Hypothesis (EMH for short). EMH is still the predominant theory taught in universities, as it’s the most convenient way to rationalize markets. Behavioural Finance, is just starting to gain ground and explaining why markets are not efficient. I’ve noticed a few universities in the US that now teach Behavioural Finance, rather than EMH. I’m quite curious to see how this trend develops.
The three pillars of Technical Analysis are:
1) Price discounts everything
2) History repeats itself
3) Prices move in trends
Price discounts everything. It’s something well covered in EMH. It means, all publicly available information for the company is already priced in the price you are seeing on your screen. People have already traded on the latest market news and a new fair price has been achieved. Interesting point to make here is that analyst earnings estimates and recommendations based on research are considered public information, so that information is already incorporated in the price, thus trading on technicals means, you are actually building on top of already robust fundamentals research, by just looking at the price and volume action.
History repeats itself is the idea that patterns that have occurred in the past would appear again. The main misconception I’ve seen here is that people understand this, as in the price movement would be identical, in days, price changes, etc. However, it doesn’t work this way. Markets expand and contract. The pattern might be the same, but it will span over different length and different amplitude to reflect the market condition at that point in time, but in it’s essence the same market movement and behavioural trading patterns will emerge from the same forces of fear and greed. There’s a very apt quote by Warren Buffet, which I like – “Be fearful when everyone else is greedy and be greedy when everyone else is fearful”.
Prices move in trends. According to EMH, price movements are random and cannot be predicted. Technical analysis has a different view – patterns. The observed price movement is such for a reason, to conceptualize the idea a patterns jargon exists – reversal and continuation type patterns, which break down into flags, pennants, double top, head and shoulders and many others. To do a simple illustration, two popular “patterns” are support and resistance levels. The way they are usually drawn are by connecting 3 troughs or 3 peaks and extending the line, the more points connected to arrive at the line the more significance it has. The question here is – Why should future price movement follow the line. In short, it doesn’t have to, and these lines get constantly redrawn. Nonetheless, you now have a reference level, built on points, where demand overwhelmed supply (for support), that can be used as a validation level of your expectations or as an exit point.
On the other hand, EMH does recognize different levels of market efficiency – weak, semi-strong, strong.
Weak – Historically repeatable patterns and money can be made by using technicals.
Semi-strong – The only way to make money is via insider information, as all public information is already discounted.
Strong – Nobody can make money, as even insider information is priced in.
In reality, different markets have different coverage, if one market is covered by 1 analyst, you have much greater chance of inefficiencies that can be exploited by technicals, compared to a stock like Apple, which the entire world looks at.
Behavioural finance is easiest to explain to people have traded at least a little. The same biases are always there – loss aversion, regret aversion, overconfidence, availability bias.
People react differently in different situations, if every market participant was the “Rational Economic Man” textbooks tell us about, majority of share price movements would be just a spike and a flat line after, until new news or earnings announcement arrives. As it’s a very interesting topic, I encourage you to read on it. Plenty of books on Amazon.
Which is better? My answer is not the usual one people expect. The two philosophies are not contradictory. They actually complement each other. The way I don’t think any rational person, would just trade purely looking at a chart for 5 mins (pretty sure nowadays that wouldn’t stand as a reason in front of MIFID regulation either), the same way if a stock recommendation is a strong buy, the share price might be at a peak, relative to history, why blindly jump in when one can wait a little and improve the purchase price.
Fundamentals analysis is definitely the way to go, when you decide you are interested in a company. Understanding the business, management, operations, risks is what makes or breaks the business. After you’ve done your models, valued the equity, checked the debt levels and done your due diligence. Technicals kick in to confirm, does entry in this company right now makes sense, what’s the market picture, is the company overbought or oversold purely because of external market forces, which are expected to revert back to the mean. Is the price high, due to liquidity issues or a short-ban on the exchange. Is the price deceptively low, as there is no easy exit because of the currency, despite the company being a strong pick.
I’ve always believed that analysing a company is like solving a puzzle where you don’t get all the pieces, you can only assemble a chunk here and there of the entire picture, but it’s
enough to understand what the entire composition would look like. Combining Technicals and Fundamentals, gives you more pieces of the same picture. Technicals is just another tool in your analysis toolbox, the more tools you have, the more you know when to you use which. Rather than being in the situation – “If all you have is a hammer, everything starts to look like a nail”. My view of “complementarism” if you wish, has started to gain traction, as more people nowadays are very quantitative they are less dismissive of the Technicals side. A lot of fundamentals people would look at Technical indicators as to time their market recommendations and so forth. This is indeed the way to go in my opinion.
The long-term vs the short-term & Data Processing Differences
Fundamentals is often long-term focused, when people value a company, there’s this false assumption one would hold the stock for say more than 8-9 years. In real life though,
rarely is this the case, sector rotation, hedging and client account liquidation might force early sell/buy of the stock makes doing so harder than in theory. For short-term TA is better, as fundamentals targets and expectations take some time to be achieved if correct. For the long-term, if the fundamentals you saw originally, don’t hold up, the TA side won’t hold either. You cannot predict the future, nobody can, but by using statistics, you can stack the odds at least a little bit in your favour. That’s what Technical Indicators are all about, they are more reactive to unexpected (tail) events. If the limitations of each indicator used are well understood. The tools offered are only of help.
Fundamentals waits for quarterly reports to update the estimates, by the time you get them, usually 20 days after the fiscal quarter end. The people would have traded off the stock and long forgotten the news events. TA reacts on news events straight-away, by the time the FA guys take the market news into account, update the model inputs, revaluate the assumptions, correct the research, get compliance approval, redistribute the pdf, the TA guys have already accounted for the price movement and traders have traded off the news event already. As the way markets work is on surprise level vs current expectations. TA is better positioned to react to large tail events, that’s why tools such as trailing stop orders, support levels and many others exist.
With Technicals you cannot tell when it’s luck versus actual skill. It’s self-fulling prophecy that makes money.
The idea of the self-fulling prophecy is that if a lot of people look at exactly the same indicator and trade at exactly the same time, they would bid up the price and essentially, you become a winner (as long as you are not the last one) as everyone is doing the same thing. I do agree, there is some level of this phenomenon existing for the most popular indicators like Moving Averages, RSI and MACD on very popular stocks. I also think with the heavier involvement of algo-trading based on the same trading conditions, it’s logical that this “phenomenon” will become more prominent, if this will be the case I don’t know. Usually, here the conversation goes into High-frequency trading (HFT), where my domain of knowledge is based mostly on reading books, rather than experience, so I’m not the right person to discuss it.
The same criticism also applies to fundamentals and stock picking, you need a really long strong track record, to show passing a H(null) significance test and prove it’s more than luck. The other problem is the timeframe, many people are right on how events will unfold, but they get the timing wrong by a few years. However, the game is such that you need to be right 51% of the time to be on the winning side, irrespective of the school of thought.
Observing XYZ chart pattern is too arbitrary.
That one is probably true in the beginning, after a while, you start to filter things a bit better, in the beginning a lot of mistakes are made, but one learns and less incorrect observations are done. Usually, this is where technical indicators come into play, that help to validate which patterns to keep and which to remove. This is one of the area, experience comes into play heavily.
Doing TA is a post-factum analysis.
The blame here is that patterns are observed only after they’ve already occurred and by the time you realize it, it’s too late to take advantage of it. In order to build expectations, you look at the past behaviour, just like fundamentals people will base their growth expectations on historical growth to a certain degree, the same applies here. Doesn’t mean the analysis ends there.
In conclusion, there are many more fine details that could be used to criticize both sides. Each right in its own way. It’s only by acknowledging the advantages of each and combining them, that provides the edge in solving the puzzle of analysing a company. I want to reemphasize again, this is just an opinion piece. I hope even if you disagree with it, it has enriched your view on the topic at least a little bit.
Thanks for reading!