“The fundamentalist studies the cause of the market movements while the technicians studies the effect” – John Murphy
Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. As mentioned earlier, technical analysis looks at the price movement of a security and used this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals. Let’s get into the details of how these two approaches differ, the criticism against technical analysis and how technical and fundamental analysis can be used together to analyze securities.
Charts vs. Financial Statements
At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements.
By looking at the balance sheet, cash flow statements and income statement, a fundamental analyst tries to determine a company’s value. In future terms, an analyst attempts to measure a company’s intrinsic value. In this approach, investment decisions are fairly easy to make – if the price of a stock trades below its intrinsic value, it’s a good investment.
Technical traders, on the other hand, believe there is no reason to analyze a company’s fundamentals because there are all accounted for in the stock’s price. Technicians believe that all the information they need about a stock can be found in its charts.
Fundamental analysis takes a relatively long-term approach in analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years.
The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company’s value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock’s market price rises to its “correct” value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This “long run” can represent a timeframe of as long as several years, in some cases.
Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share do not emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management cannot implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. 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 Versus Investing
Not only is technical analysis more short term in nature than fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for trading, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools.