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Learn what makes both approaches to financial analysis so unique and which one might be the right for you in this brief guide.
What images does the phrase “financial analysis” evoke in your mind? If it’s a series of complex chart patterns and technical indicators, then you would be glimpsing into the daily life of a technical analyst. And if you picture heaps of earnings reports stacked next to a thick book titled “The complete history of the stock markets”, then you’ll be roleplaying as a fundamental analyst.
Despite the heated arguments between both camps on which of both method is actually worth everyone’s time, the truth is that both have their place in the world of global economy. With that said, let’s have a look at what makes fundamental and technical analysis so fundamentally different (pun intended) from one another and which one might better suit your financial goals.
Technical analysis: the short-term approach
In the world of macroeconomics, technical analysis is widely used to predict future price fluctuations of shares, indices, futures, and other financial assets based on their past performance.
Since the main emphasis of this approach falls on market price movements, it is naturally more popular with traders who have short-term buy/sell strategies in mind. Each technical analysis report is a combination of 4 core concepts:
- Market trends
- Support and resistance
- Technical indicators
- Chart patterns
Market trends
Price movements lie at the heart of technical analysis. For instance, an asset that is expected to have a short-term downtrend, followed by a price increase will be much easier for analysts to recommend than an underperforming asset with a low chance of recovery.
Trading volume is another key metric here – the more an asset is being traded on the market, the more it’s price will likely increase and vice-versa.
Support and resistance
Another integral part to this type of analysis are the so-called “resistance” and “support” levels. The first level represents a price point above which the asset will struggle to “break through” and represents supply. The second level indicates the price point below which the asset won’t typically fall and represents demand.
Of course, support and resistance are very dependent on the current market conditions and will continuously shift to meet the industries’ evolving needs.
Technical indicators
Today, both traders and analysts can choose between a vast range of technical indicators. Some of them indicate if an asset is being overbought or oversold, while others calculate the average price of a given asset over a set period of time. Commonly used tools include:
- Commodity Channel Index (CCI): helps identify price reversals, price extremes, and market trend strength;
- Moving Average Convergence Divergence (MACD): used to monitor the relationship between two moving averages of an asset’s price;
- Relative Strength Index (RSI): a metric used to gauge the speed and change of market price movements.
Chart patterns
As with technical analysis tools, there is a wide variety of chart patterns, all of which represent certain variations in an asset’s price movement. One popular pattern is called “head and shoulders” and indicates that the asset will likely move against the previously established trend.
“Double tops and bottoms” is another commonly used chart pattern that suggests an upcoming trend reversal, while the presence of a “cup and handle” pattern will usually mean that an upward market trend will be briefly put on hold.
Fundamental analysis: the long-term approach
While technical analysts predominantly rely on charts to predict market movements, fundamental analysts attempt to take a step back and look at the “big economic picture” by calculating an asset’s value based on several economic factors, known as “fundamentals”.
With this branch of financial analysis, data is gathered from multiple sources over extended periods of time (usually spanning several years), making this method a preferred choice for long-term investors who rely on this data to buy assets that are likely to rise in value over time.
But let’s get back to the “fundamentals” that we’ve mentioned earlier. These consist of the following 3 stages: economic analysis, industry analysis, and company analysis.
Economic analysis
To perform this analysis, experts look at extensive financial statements that could include balance sheets, cash flow and income statements, or other vital information needed to determine an economy’s health. During this research phase, analysts will also consider the current economic cycle, as well as if the markets are affected by a recession or a boom.
Company analysis
This stage can be broken down into two main categories: sales revenue and earnings per share.
- Sales revenue. The income of each company is reported on a quarterly and annual basis. When reading these reports, fundamental analysts look at the main direction at which the revenues are headed. If profits are set to rise higher, they will meticulously study the events that led to the company’s success and vice-versa.
- Earnings per share. While rising sales is obviously a positive indicator, earnings per share (EPS) is a metric that will show whether the company can sustain its growth. If, in the midst of higher profits, the company also lavishly expends money due to poor resource management or hefty fines, this could potentially signal a trend reversal in the near future.
Industry analysis
Even if a company does everything by the book, outside factors can still make or break its earnings report. This is where the so called price to earnings ratio (P/E ratio) comes into play. A company’s P/E ratio is calculated by dividing its current stock price by its annual EPS.
The result you’ll end up getting is what fundamental analysts often refer to a as the company’s valuation. This information can then be used to predict how a given sector will behave under certain market conditions.
For instance, companies in the technological sector typically have higher P/E ratios during times of economic prosperity than companies in “defensive” sectors, such as manufacturers of bathroom accessories, for instance.
However, defensive industries will shine during an economic slowdown, while growth in the technological, transportational, and financial sectors will typically be rather sluggish.
The final verdict
For a long time, fundamental analysis was regarded as the only “true” way to analyse the markets. However, the recent technological revolution and the introduction of algorithms necessitated the development of a new financial field – that of technical analysis.
And while it’s true that an increasing number of financial institutions is relying on computer algorithms to make sound trading decisions, this doesn’t necessarily mean that fundamental analysts are becoming obsolete. In fact, many believe that the key to a successful financial career lies in the marriage between both seemingly opposing concepts.
Combining the intricate foresight of fundamental analysis with good understanding of charts and technical indicators will help you decide not just what to buy, but also when to buy it. But at the end of the day, it will be your personal trading and/or investing style and attitude that will ultimately determine which approach you’ll end up liking the most.
Used sources:
- https://www.moneycrashers.com/the-best-way-to-invest-fundamental-or-technical-analysis/
- https://www.cfainstitute.org/-/media/documents/article/cfa-magazine/2003/cfm-v14-n1-2789.ashx
- https://www.diffen.com/difference/Fundamental_Analysis_vs_Technical_Analysis
- https://www.suretrader.com/guide-to-analysis-fundamental-vs-technical/?mkwid=s_dc&pcrid=86950229783&pkw=&pmt=b&plc=&gclid=CjwKCAjwvuzkBRAhEiwA9E3FUrjb1YQxpC_Js2lqDp9hNSMATjySKivAEsoEGOpQET9I2_LAMD7XvxoCS2IQAvD_BwE
