This article is primarily intended to give an introduction to how technical analysis is used to make investment and stock market trading decisions. It will then compare the position of technical analysts to fundamental analysts in terms of what information and data each group uses in their quest for high returns.
I have sourced most of the information below from a copy of the 2007 CFA Level 1 course notes that I have been reading.
Technical analysis involves the examination of past market data, such as stock prices and the volume of
trading, to lead to an estimate of future price trends and subsequently an investment decision.
The assumptions underpinning the technical analysis model are as follows:
- The market value of any good or service is determined solely by the interaction of supply and demand.
- Supply and demand are governed by numerous factors (examples include people’s moods, guesses and opinions). The market weighs all these factors continuously and automatically.
- The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. That is, when new information enters the market, it leads to an adjustment of stock prices.
- Prevailing trends change in reaction to shifts in the supply and demand relationship. These shifts can be detected at some point in the action of the market itself.
The philosophy behind technical analysis is in sharp contrast to the efficient market hypothesis and fundamental analysis.
Fundamental Analysis Versus Technical Analysis
Fundamental Analysis involves making investment decisions based on the difference between the fundamental value of a company and the current price of that company’s stock.
Fundamental analysis involves an examination of the economy, a particular industry, and financial company data in order to lead to an estimate of value for that company. If this value is then compared to the current stock price, investment decisions can be made assuming that the market will correct and move towards the estimated value at some point in the future.
Although both fundamental and technical analysts agree that the price of a security is determined by the interaction of supply and demand, technical analysts and fundamental analysis have different opinions on the influence of irrational factors. A technical analyst might expect that an irrational influence may persist for some time, whereas other market analysts would expect only a short-run effect with rational beliefs prevailing over the long-run.
A bigger difference exists between the two regarding the speed of adjustments of stock prices to changes in supply and demand. Technical analysts believe that new information comes to the market over a period of time because of different sources of information or because certain investors receive the information or perceive fundamental changes earlier than others. Based on this belief they expect stock prices to move in trends that persist for long periods, and a gradual price adjustment to reflect the gradual flow of the information.
However, fundamental analysts believe that new information comes to the market very quickly and they expect stock prices to change abruptly as a result of this.
How do Technical and Fundamental Analysts make investment decisions?
- Technical analysts make investment decisions by examining past market data to estimate future price trends. They identify new trends and take appropriate actions to profit from the trends. Technical analysts use market data and non-quantifiable variables like psychological factors and claim that their method is not heavily dependent on company financial accounting statements.
- Fundamental analysts make investment decisions by examining the economy, the industry and the company to estimate the intrinsic value of the company’s stock. They then compare the intrinsic value to the prevailing market price and take appropriate actions. Fundamental analysts typically use economic data (including accounting data and information released by the company to the market).
Why Technical Analysts believe Technical Analysis is superior
According to technical analysts, it is important to recognise that the fundamental analysts can experience superior returns only if they obtain new information before other investors and process it correctly and quickly. Technical analysts do not beleive that most investors do so consistently.
Secondly, Technical analysts believe that it is too difficult for fundamental analysts to pinpoint a specific time to take investment actions even if they have identified the under-valued or over-valued securities.
Technical analysts need only quickly recognise a movement to a new equilibrium value for whatever reason (they need not know about an event and determine the effect of the event on the value of the firm and its stock). In addition, because they don’t invest until the move to the new equilibrium is under way, they contend that they are more likely to experience ideal timing compared to the method of fundamental analysts.
Finally, technical analysts believe that financial statement analysis is not sufficently accurate to depend on to make investment decisions and therefore consider it advantageous not to depend on such statements.
I will later write an article about the potential fundamental analysts’ responses to these points but more can be read about fundamental analysis and Warren Buffett’s concept of Value Investing in one of my previous articles (includes a video).
Click here for a look at Company Valuation methodologies like multiples and discounted cashflow analysis.