A lot of traders believe in either technical or fundamental analysis. The adherents of the former state that the market is a perfect validating machine and all factors (that can affect the asset price and are widely known) are by default reflected in the price chart. It can, therefore, be used on its own in the decision-making process. Those who believe in fundamental analysis pay more attention to the intrinsic value of the asset, which, according to them, is not always taken into account by the market. In today’s article we will take a closer look at both types of analysis and decide which one to choose — if there is at all the need to pick one.
Fundamental analysis is a method of an asset assessment based on the concept of intrinsic value. The latter is the ‘true’ value of an underlying asset, that is not always reflected in its market price. Indeed, when we say that a stock is trading at a premium/with a discount, we mean that its market price is not identical to its intrinsic value. Economic, financial and political factors are taken into account when evaluating a security from a fundamental viewpoint. The end goal of this type of analysis is to come up with a target price, that can then be compared to the market price. Should the intrinsic price be lower than the current price, it is wise to consider selling the asset. Should the opposite hold true, it is wise to buy it.
Although this method is usually applied to stocks, it can actually be used for almost any asset. In order to evaluate a currency pair (traded on the Forex market), the trader may want to look at the key interest rate, the rate of inflation and the GDP growth rate. All of the above can heavily influence the exchange rate. For stocks, earnings, revenue and their derivatives play the most noticeable role. Warren Buffett, dubbed the Oracle of Omaha, is an adherent of this exact approach.
Here is an example of fundamental analysis and how it works. When Facebook released one of the earnings report back in the days, the market was expecting a 43% increase in earnings, but the company demonstrated only a 42% increase. That and decelerating user growth have resulted in a 20% price decrease of its stock price. Quite a hit! It is worth saying that a suchlike price plunge could have hardly been predicted with the help of technical analysis.
Don’t forget that as not all fundamental factors are quantitative, there can be two opposing interpretations of the same set of readings.
Technical analysis, in turn, is based on the use of historical market data, namely trading volume and price. This type of analysis is not particularly interested in intrinsic value and its practical applications. Technical analysts believe that the past performance of the asset, displayed on the price chart, is a better indication of its future behavior than the intrinsic value. This school of thought postulates that patterns can be observed in the behavior of any asset and, most importantly, they tend to repeat themselves over time. Technical analysts, therefore, try to predict the said patterns and capitalize on them.
Since all the important information is openly available on the market (anything else would qualify as insider trading, which is illegal), the price is believed to always reflect “the sum total knowledge of all market participants.”
Every asset, traded on the market, is subject to the basic laws of supply and demand. Low supply and high demand push the asset price higher. Conversely, high supply and low demand push it lower. Technical analysts track the discrepancies between the two in order to predict the future performance of the asset. Over the years, a huge variety of technical analysis indicators were created. Some of them help determine the prevailing trend. The other excel at pinpointing reversals. There is no single best indicator. Each of them has unique features and helps to solve a particular problem.
It can be said that while fundamental analysis pays off on longer time frames, technical analysis is predominantly used by day traders and traders working on shorter time frames.
What to choose?
You may believe that there is one type of analysis that will better suit your trading style, and you may be right. However, as there is no one-size-fits-all technical indicators, there is no right or wrong method to predict future price fluctuations. Better think of technical and fundamental analysis techniques as two sides of the same coin that perfectly complement each other. According to Michael Marcus, an iconic trader who has multiplied his account 2,500-fold over the course of ten years, fundamental and technical analysis should both confirm your prediction for a deal to close in the green. It doesn’t mean that this combination will never fail. Still, the chances for a positive outcome are much higher this way.
*Information regarding past performance is not a reliable indicator of future performance.