Technical analysis: everything is in the price
Technical analysis assumes that everything that can affect a share's performance, company fundamentals, economic factors and market sentiment, is already reflected in the stock price. It does not try to value the business. It tries to forecast the direction of prices by studying patterns in historical market data, meaning price and volume. Technicians, sometimes called chartists, believe market activity generates indicators in price trends that can forecast both the direction and the magnitude of future price movements.
One, the history of past prices indicates the underlying trend and its direction. Two, the volume of trading that accompanies price movements shows the underlying strength of the trend. Three, the time span over which price and volume carry the impact of long-term factors that influence prices over a period. Technical analysis folds the three into price charts, support and resistance points and price trends.
Trends can be upward, downward or sideways, and the technician's aim is to trade in line with the trend. Support is a level with a lot of buying interest; resistance, one with a lot of selling interest. A holder watching the price approach an established resistance can book profits, since prices tend to retract near resistance. If a support or resistance breaks on strong volume, the trend has accelerated and the supply and demand picture has changed. Volume is the confirming signal throughout: an upward or downward trend should come with strong volumes, and a trend without volume is a weak one.
Price and volume are turned into charts (the line chart, the bar chart and the candlestick chart among them), and the patterns in the charts identify trends, reversals and triggers for buying or selling. Chartists typically use a moving average of the price to reduce the impact of day-to-day fluctuations that can hide the trend.
Short-term investors and traders lean on technical signals because business fundamentals seldom change drastically in the short run. Over the long run fundamentals do change, so past price trends become unreliable guides to later prices. Technical analysis is therefore less suitable for long-term investing. An option pairing technical analysis with multi-year investing is wrong.
Fundamental analysis: value follows the business
Fundamental analysis is focused on long-term investing. Its premise is simple: an equity share is part ownership of a company, so in the long term its value should be driven by the profits and cash flows the company generates on its investments. When short-term price movements pull the price far from fair value, that gap is the profit opportunity.
The method follows. First gauge the fair price of the equity from the expected performance of the business. If the market price is below intrinsic value, the share is an attractive investment. If it is above, sell or avoid. Profits come from two things together: identifying a good investment and making it at the right price.
The EMH holds that share prices incorporate and reflect all relevant information. If that were fully true, there would be no persistent gap between price and value to exploit. Fundamental analysis proceeds on the view that such gaps exist, which the syllabus describes as a contradiction of the EMH.
The questions a fundamental analyst asks of a company:
- 1Is the overall cyclical and secular macroeconomic trend likely to help the industry grow or decline?
- 2How intense is competition within the industry, and can existing players thrive?
- 3How is the company positioned against its competitors, and will it do better or worse than them?
- 4What is the company's cost structure, and how will it affect profit in different business environments?
- 5How strong is its financial position: strong enough to fund growth or withstand a crisis?
- 6Can the management identify and execute the right strategies to exploit growth and defend against adversity?
- 7Does the governance structure make the board and management act in the shareholders' best interest?
All of these fall into three baskets: economic analysis, industry analysis and company analysis, which are chapters 5, 6, 7 and 8.
Quantitative research: the numbers without the judgement
Fundamental research mixes quantitative and qualitative study, but some analysts work purely quantitatively, and the quantitative approach fits both technical and fundamental analysis. Applied to technical analysis, the analyst studies the underlying data rather than reading charts: the relationship between up moves and down moves, volume and other parameters, to gauge direction. Applied to fundamentals, the analyst looks for financial and operational metrics of the company that, alone or together, might act as leading indicators of its performance.
At the simplest level, time series analysis and regression on historical data can extrapolate future earnings; quantitative analysts may refine that with more sophisticated econometric approaches. Alongside the statistics they use financial statement analysis to project future financials and growth rates, then sensitivity analysis and simulations to see how changes in assumptions move their valuations.
The syllabus's sample question asks for the limitation, and the answer is comparable information. Frequent changes in accounting standards and business models make past data less useful for comparison with present conditions. The wrong options claim quant cannot analyse the economy, or that investing is intuition with little room for numbers; neither is the syllabus position. The conclusion is only that pure quantitative research is not often employed in fundamental analysis.
The behavioural approach: fear and greed
Investment decisions ought to rest on analysis of the available information, so that they reflect the expected performance and risks of the investment. Very often they are instead shaped by the behavioural biases of the person deciding, which produces less than optimal choices. Proponents of the behavioural approach assume that security prices move away from fair value, upward or downward, because of the fear and greed of market participants. The well-documented biases themselves are covered in the risk and return chapter later in the course (the workbook cross-references it as its chapter on biases).
| Technical | Fundamental | |
|---|---|---|
| What it studies | Historical price and volume patterns | The business: profits, cash flows, position, management, governance |
| Core assumption | Everything is already in the price; patterns forecast direction and magnitude | Long-term value follows cash flows; price can diverge from value |
| Horizon | Short term | Long term |
| Relationship to EMH | Compatible with prices reflecting information, but reads the patterns | Contradicts it: exploitable gaps exist |
- Technical analysis assumes fundamentals, economic factors and sentiment are all already in the price, and forecasts direction from patterns in historical price and volume. Three elements: past prices show the trend and its direction, volume shows the trend's strength, the time span carries long-term factors. Suits short horizons; unreliable for long-term investing because fundamentals change.
- Fundamental analysis is for long-term investing: value follows profits and cash flows, buy below intrinsic value, sell or avoid above it. Profit needs a good business and the right price, which contradicts the Efficient Market Hypothesis. Its questions fall into economic, industry and company analysis.
- Quantitative research works with data rather than charts or judgement: time series, regression, econometrics, projections, sensitivity analysis, simulations. Limited by comparable data, since accounting standards and business models keep changing, so pure quantitative research is rarely used in fundamental analysis.
- The behavioural approach holds that fear and greed push prices away from fair value in both directions because decisions are shaped by behavioural biases.