Pros and Cons of Technical and Fundamental Analysis: an Investment Management School of Thought

Introduction

Activities in the economic in modern nations, capitalist plus socialist ones alike, stay driven principally via choices being made on maximizing the utility of the features of productions – at micro and macro levels. Most countries have economic structures that ensures that much of this choice is made by the entrepreneur – who seeks to earn profit by utilizing capital - including tools, technologies and buildings humans created and use - to produce goods and services.

While capital is a broad concept with specific characteristics, the most economically relevant form is financial capital which is the currency, credit, and other forms of financial assets that the entrepreneur (either as an individual or a firm) uses to build wealth or acquire products and provide services. Such activity is often done within the framework of financial system that consists of financial markets, (a geographic or virtual location where buyers and sellers trade assets such as equities, bonds, currencies and derivatives), regulators (who monitor and regulate market trading to assure fair pricing and practices) and institutions (who intermediate and decide the flow/allocation of assets).

The Concept of Investment Management

Participation in the financial market requires allocating assets in a trade, with the expectation of gaining a return within a time frame; this allocation is called investment. Decisions on investments are made by market institutions which include banks, non-bank financial companies, institutional investors, business firms, households and even individual investors. Making these asset allocation decisions relies on a complex mix of understanding an investor’s needs, constraints, risk tolerance and knowing how to gauge future performance of financial securities with the right information. Investment management which is the study of these financial instruments, their properties and the risk and return faced by them, becomes useful in helping stakeholders conduct robust predictive analyses in the financial markets to decide what investments would be useful to them over time. There are two main schools of thoughts on the approaches that are most useful for analysing securities. These are the school that advocates Fundamental Analysis and Technical Analysis.

Fundamental Analyses

This refers to an approach to making investment decisions by a comprehensive evaluation of the economic, financial and other qualitative and quantitative factors that may affect the value of an asset in order to determine the asset’s intrinsic value.

Fundamental analysis is based on two key assumptions – that financial markets are efficient and that the value of an asset rises from the fiscal health of the company owning it (in the case of stocks) or price directions of nationally-relevant asset markets (in the case of currency trading). Fundamental analysis has the assumption that a stock price may not necessarily reflect the value of the stock at present and making an investment decision to buy or sell would be based on understanding the true value of the stock. As such, Fundamental analysis looks at factors at macroeconomic, sectorial and institutional/company levels that not only affect current price but may affect future price in estimating the objective value of an asset and in predicting its future price movement.

In conducting fundamental analyses, evaluations begin at assessing macroeconomic factors. The metrics used in conducting such evaluations include a nation’s Gross Domestic Product (GDP), interest rates, inflation, forex reserves, national productivity, Consumer Price Index and their impacts on the company’s financial health.

The sector or industry level analysis evaluates metrics such as market size over time (sometimes as a contribution to GDP), demand and supply analysis, value of existing competition and industry risk factors.

At company level, fundamental analysis assesses parameters that provide information on the current and projected financial health of the company. These parameters include the firm’s earnings per share, valuation analysis (Return on Equity, Price-to-Earnings, Price-to-Book, Price-to-Sales), ratio analysis (operating efficiency, operating profitability and solvency ratio) quality of management, debt and interest obligations, and revenue. In addition, a financial model that requires major assumptions on the company’s financial performance would be required, to forecast future valuation. This type of analysis is often done by non-high frequency investors and those who have a longer time horizon to work with.

The approach is a tad different for currency trading markets since what is traded here is not company stocks. What is evaluated are macroeconomic indices, a country’s asset markets and it’s political scene. This analysis is a comparative one between nations which guides trades on one currency as against the other. The macroeconomic metrics analysed are largely the same as for stocks while the asset market indices speak to the health of a country’s real estate and securities markets. Political events would also help investors decide the fiscal stability and investment confidence.

Beyond application, the theoretical basis for this school of thought is the decision making theory. This theory asserts that in making a choice of what to do, the rational decision would be that made from a systematic thought process that identifies the best one among several alternatives that can be used. In simple words, this theory encourages using rigorous evidence in making decisions.

Fundamental analysis presents several advantages one of which one that investors are able to build sufficient business acumen to spot companies with strong corporate and financial governance. Due to its industry level analyses, fundamental analysis can help investors identify value drivers; such value positions could be high-risk as the tech sector with its booms and bursts, low-risk such as utilities with fairly stable financial status over a long period of time, seasonal/cyclic as the transportation sector which has diurnal rush hours and seasonal patterns or non-cyclical as in food staples that remain in demand all year long.

Technical Analyses

A prominent investor in the US markets once said that “One way to end up with $1 million is to start with $2 million and use technical analysis” to show the disdain technical analysis previously enjoyed. In fact, many critics see technical analysis as an untested approach. However, as it became widely used, technical analysis has proved particularly useful for determining when to buy or sell assets.

Technical analysis begins with the major assumptions that the intrinsic value and any past trading information of an asset is already reflected in the market price, and that what needs to be known is the changes in the price trends of an asset over time due to shifts in demand and supply. Essentially, technical analysis applies indicators that are not dependent on the financial health of the asset. Price trends are useful in predicting future asset price based on the assumptions that, changes in prices are directional (upwards or downwards) and such observable patterns, like market behaviour and history, often recurs in non-random time frames (daily, weekly, monthly). Technical analysis focuses on using past market data in studying technical details of the market, including the psychology and emotions of market stakeholders to chart future trends in the price of assets.

Trends are useful not just because they are assumed to reoccur and continue, but that each trend is also believed to be influenced by proximate trends (the previous long trend, the next short one etc.) and all trends behave similarly. However, such similar behaviour, while not fully random is also not automatic –they have many components about them that are still random (Fidelity Investments, 2017). The primary tool for technical analysis is the chart – which summarises the movement of asset prices within specific time intervals to highlight trends and patterns. As such technical analysis provides critical and easily used tools for quick identification of trends, market volatility, trading volume and a fuller array of trading information within short time periods.

Among technical analysts, trade volume of an asset, moving averages, and technical indicators such as Stochastics and Moving Average Convergence-Divergence (MACD) are the metrics used with charts to predict market and price trends .

Importantly, technical analysis and non-dependence on information about the financial health of companies is based on the efficient market theory (Utami and Nugroho, 2017). This hypothesis states that efficient markets are able to aggregate (through the forces of demand and supply) the value of an asset and reflect it fully in the asset’s price.

The third school of thought

While it is classically accepted that there are two schools of thoughts on investment management, the last few years has seen the attribution of a third school of thought known as the Quantitative Analysis. In many ways, it represents both a blend of the two classic school of thoughts and the logical end point of the high-level computing that gave rise to technical analysis. Quantitative analysis refers to advanced statistical modelling using technical indicators to analyse excess return forecasting and fundamental indicators such as earnings and financial health of stocks.

Merit and Demerit

There are several merits and demerits of fundamental and technical school of thought. In explaining this, I will focus on this two only by first stating the merits and demerits of fundamental school of thought and later state the that of technical school of thoughts.

There are currently three known merits of fundamental school of thought:

Stock prices are determined by companies’ performance and their ability to make money

Shares are good investment choice when its market value is lower than its true intrinsic value

Fundamental analysis is that it examines real economic and market factors

The demerits can be stated as the following:

Fundamental analysis is considered as time consuming by investors as it takes time to identify the information needed to decide.

The value of stock prices is open knowledge as it is available to everyone

In the case of technical analysis, the merits

The relationship between technical and fundamental analyses

Complementarity

Historically, fundamental analysis was seen as the only useful school of thought but complex computing and innovative trade methods such as algorithmic trading has made technical analysis far more relevant. In today’s market an effective approach to investment management would not rely on one method alone. The bigger goals of investment management which is to utilise a rational and disciplined approach in preventing asset loss while making & keeping profits, within an acceptable range of risks would require both a complimentary application of both analyses approaches based on an understanding of their strengths and weaknesses.

It is accepted wisdom that the key contrast between both approaches is their central application. This is that fundamental analysis serves to guide in deciding long-term investment in an asset based on an assessment that the essential valuation of the asset, while not currently reflected in the assets’ current price, would be in its future price; Whereas technical analyses is for short-term trading to pick up an asset and flip it. Or as a prominent American investor explained “Fundamental analysis really drives the decision of which securities we want to own. But the timing of purchase and sale decisions is split pretty evenly between technical and fundamental”. Mishra further makes this point in her study that presents several academic literatures that show that with within short time frames, technical analysis outperforms fundamental ones in choosing profitable trades.

These applications are however not necessarily contradictory, despite the assertions of purists from both schools of thought. Such complementarity is referred to as ‘rational analysis’. Therefore, an investor who relies on fundamental analysis primarily, can decide to conduct that analysis to identify an asset whose price is currently undervalued and then borrow from the tools of technical analysis to decide when to buy such asset at a low price (entry), then sell at a higher price (exit). This combination is most useful when an asset is thoroughly oversold and entering the position too early could result in profit loss. Further, a technical analysis investor can decide that the price trend of an asset would change at a particular point in time, then apply fundamental analysis to measure the margin of profit he would expect to gain from that change.

Despite this complimentary utility, understanding the differences also matter.

Differences

The differences in the two analysis are broad, and range from key assumptions to information analyses, time frame of application and directional perspectives. A few pivotal ones are outlined below

a. Perspectives of market efficiency: While both accept that the market is efficient, the meaning of such efficiency differs. In fundamental analysis, the efficiency of the market is seen as the assumption of the market being able to eventually correct the valuation of an asset over time. This allows for holding an asset long term while waiting for the market to catch up with the investor’s assessment of the real value of the asset (i.e. Undervalued assets bought at lower prices can be sold later at higher prices). For technical analysis, market efficiency is evident in the assumption that the market is able to consider all

b. Data basis of analysis: Fundamental analysis is based on specific metrics that aim to principally assess return on equity & return on assets over time. Technical analysis however focuses on using historical price data and Dow theory to make judgements on investment. Also, while both approaches use trends in analysis, the parameter differs. Technical analysis looks at market price trends while fundamental analysis focuses on economic, demographic, technologic and consumer trends in developing a robust information base for determining an asset’s intrinsic value.

c. Integration of non-rational factors: Fundamental analysis prides itself on its rigorous information analysis and forecast future asset prices based on hard financial facts. Technical theory however undergirded by the Dow theory which asserts that the price changes of assets is largely behavioural (90%) and just 10% logical. As such the emotions & behaviours of investors traders is integrated into technical analysis. This presents a valid reason for the short-term outlook of technical analysis and its preference by high frequency traders. Further, the integration of psychological components to technical analysis relies on the predictability of crowd behaviour, which makes price trends possible to forecast.

d. Weaknesses: Fundamental analysis requires a lot of context information that it becomes very time consuming to perform, and much of this context is based on assumptions particularly about the future. Technical analysis doesn’t require as much information as it focuses almost exclusively on price data. While this makes it less time consuming to conduct, it means the level of analysis would be overly complex and tedious.

Conclusion

Investment management aims to maximise profit earned from trading on the value of an asset. Overall, both schools meet this goal sufficiently using different approaches. They are best used in a complementary sense. Therefore, the choice on what approach to use in managing investments is based on the time-based interest of the investor or as a study summarised it that selection of approach was based on investors’ length of experience and their time horizon.