What should I use; fundamentals or technicals? This is a question that has plagued investors for a long time and there are still no clear answers. A lot of investors tend to look at fundamentals as a key to long term investing and technicals as a way to quick-fix trading. While the understanding is broadly on the right track, it misses out some key nuances about fundamental and technical analysis. A fundament al analyst does spend a lot of time looking for value. Are the cash flows healthy; are the margins healthy; how good is the management; is the product disruptive; these are some of the key questions that a fundamental analyst asks. The technical analyst, on the other hand, is more focused on charts. Technical chartists believe that almost everything is in the price and so it makes a lot more sense to study charts. Since traders are humans, it is the same emotions that will drive the markets. Consequently, the past charts can be used to extrapolate the future. Let us now look at how the fundamentals differ from technicals in input and in output.
The essential focus is different in both the cases
Fundamental Analysis looks to forecast cash flows of a company based on how the economy, industry and the company will perform. This is also known as the top-down or the EIC approach. Once the cash flows are projected, they are worked backward to a present value. This gives an idea of what a stock is actually worth. The idea here is to find value bargains. You buy underpriced stocks and sell overpriced stocks. Technical Analysis on the other hand, focuses on internal market data. The focus is more on identifying patterns and trends that will repeat and which the trader can capitalize on. The assumption is that since markets are driven by the same set of emotions, the chart patterns also will tend to repeat over time.
Technicals work better in the short run; fundamentals in the long haul
The basic difference is that Fundamental analysis seeks to predict the value of the stock. It basically tries to gauge what the stock is actually worth. The price is not a controllable factor but the price will eventually converge towards value. So if you buy a quality stock with a good margin of safety then you can make healthy profits over the longer run. The technical analyst is not overly worried about cash flows and valuations. They believe that the price reflects everything. As long as you can catch the trend and ride it long enough, you will make money in the stock market. Such trends are mostly fit for short term trades.
Both see value arising from a different source altogether
The fundamental analyst acknowledges that every stock has a company behind it. The stock will be as good or as bad as the company. Since the company has a certain value due to the cash flows it generates, the stock derives its value from the value of the company. To that extent the stock is a derivative on the underlying called the company. The technical analyst does not believe that the stock, per se, has any value. Stock prices are determined by the forces of demand and supply which in turn are governed by rational and irrational factors. Technicals believe that the market is omniscient and hence reflects all that is good or bad about a stock. For technicals, the value is not to be found but it is there in the market. You just use charts to pinpoint value.
How they differ on their approach to contrarian buying
Fundamental analysts strongly believe that if a stock has value then it even makes sense to go contrary to the market trend and buy or sell the stock. In fact, some of the best fundamental analysts have made money by going counter to the market. For a technical analyst, trend is the friend and it is trends and patterns that matter in the final analysis. Past trends will be repeated again and the current movements can be used for studying the future trend. Chartists believe that the market always gives a message through the charts and it is the job of a trader to read these hints, understand the trend and trade accordingly.
How they approach decision making?
Fundamental analysis is a fairly laborious job and requires the careful study of financial statements, demand forecasts, quality of management, earnings and growth. It is a mix of quantitative and qualitative factors. Finally, the intrinsic value is estimated and an investment decision is taken. Technical Analysis purely believes that decisions are taken by listening to what the market has to say. Of course technical analysis uses plethora of long standing theories like supports, resistances, oscillators, overbought/oversold zones, stochastic, break outs, Elliot Wave etc. But they do not focus on intrinsic value at all.
Finally, let us look at how to put them all together for stock picking. After all, that is the bottom line. The best of investors rely on a mix of both these approaches. Fundamental analysis tells you how undervalued the stock is. The gap is called the margin of safety and it forms the basis of long term investing. But even the best of investors try to get that extra bang by timing their entry and exit so that it adds to their alpha. That is where technical charts chip in! A successful approach is essentially eclectic!