Sunday, July 02, 2006

Fundamental vs Technical Analysis

Before looking at fundamental and technical analysis, I want to highlight a couple of the most popular market theories - efficient market hypothesis and the random walk theory.

Efficient Market Hypothesis (EMH)

EMH is a theory that states it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant known information. This means that stocks always trade at their fair market value, and therefore, it is impossible to either purchase undervalued stocks or sell stocks for inflated prices. According to this theory it is impossible to outperform the indexes by use of either fundamental or technical analysis to expertly pick stocks or to time the markets.

Although there is much academic evidence to support EMH, there are also many who depose the theory. For instance, according to EMH it would be impossible for investors and traders such as Warren Buffett and Dan Zanger to successfully beat the indexes year after year. As we know, they and many others have done just that. I don't think it is either just lucky or random that they have achieved such success.

Stock prices can also deviate from their fair values by considerate amounts, as seen during market crashes such as October 19, 1987, where the DJIA fell by 22% in one day. According to EMH, this is not normal or possible. EMH does not take into account the investor emotions that drive share prices such as fear, greed, hope and panic.

Random Walk Theory

The Random Walk theory is that stock price changes have the same distribution and are independent of each other. Past price movements or trend of the stock price cannot be used to predict its future, and that they act in a random and unpredictable manner.

According to random walk, monkeys throwing darts at stock lists can perform just as well as most mutual fund managers.

I personally do not subscribe to either EMH or Random Walk, and believe that through a mixture of fundamental and technical analysis, stocks can be picked and timed correctly to outperform the indexes.

Fundamental Analysis

Fundamental analysis involves analyzing the characteristics of a company in order to estimate it's value. Followers of fundamental analysis want as much data as they can find on revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight to a company's future performance. This doesn't mean that they ignore the company's stock price; they just avoid focusing on it exclusively.

Technical Analysis

Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market.

Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components.

Time and time again patterns occur in charts of stocks and these patterns can be used to predict the future direction of a stock’s price. Thomas Bulkowski’s ‘Encyclopedia of Chart Patternsprovides a detailed explanation and evidence of this theory.

Which Do I Use?

There is much argument between the fundamental and technical theorists as to whose method of analysis is better. Until I read William O’Neil’s book ‘How to Make Money in Stocks, and discovered , I used to focus solely on technical analysis. I did not have the time to interpret all the many financial figures of each and every company in the markets. A company is also sometimes able to manipulate these figures to give the impression it is financially superior, when in fact, it is not; Enron being the case in point here.

O’Neil’s system uses his proprietary CANSLIM method to analyze the fundamentals of a company but then also uses technical analysis to time the purchases and sales. More about that in the CANSLIM article here.

I use CANSLIM to come up with a watchlist of stocks which are possible buy candidates. I then use technical analysis to time the buy purchases by chart pattern breakouts, and then stop losses and price targets as exit strategies.

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