Price movements in stocks are generally governed by demand and supply. In turn demand and supply are determined by factors that can be categorized into three large categories namely sentiment, fundamentals and technicals. Let’s go through each of these briefly to understand how they influence stock prices.
Usually sentiment can change faster than anything else, so we consider tracking sentiment for short term trading most appropriate, while fundamentals change slower and create lasting changes which makes tracking them ideal for long term trading. In the middle between sentiment and fundamentals lies technical analysis that is the missing link between the two.
Beginning with sentiment, we generally include in this category everything that can cause a change from positive to negative or neutral and the opposite. The usual suspects are the story behind the stock, positive and negative earnings surprises, rumors and news.
The story is what people say about a company’s stock and the management of the company. Taking into consideration Tesla, we now understand in hindsight that the vision of its CEO Elon Musk and its investors was one of the most important factors for the phenomenal performance of its stock even before the company was able to produce enough cars to break-even.
Earnings surprises, either positive or negative, can stir strong sentiments changes or embolden current sentiment. Usually the most bullish scenario is for a company to report EPS (earnings per share) and revenues well above what the analysts estimate and anticipate. The opposite scenario of reporting far below what was expected creates a strong negative sentiment and the expected reaction to the price of the stock.
However, news and rumors are among the top factors moving a stock because not only do they affect sentiment, they have the potential to impact fundamentals. For example if a company like Tesla announces or there are rumors that it is planning to open two additional car manufacturing plans due to strong demand, this a piece of news or rumor that is expected to reflect onto the financial statements of the company as well. It creates expectations of higher volume sales in the future and growth for the company. So the critical filter for news, whether the information is real, will result in higher growth for the company in the near future or not.
Fundamentals evolve around the financial performance of the company, the valuation of the company, meaning how much its stock is worth and financial SWOT (strengths, weakness, opportunities, threats) analysis. Anything that affects the financial performance of the company like the growth estimate in revenues and profits is considered a strong fundamental factor.
High growth rates in revenues and EPS are considered very bullish for a stock, while negative growth causes bearish sentiment around a stock. News and earnings surprises can be categorized as fundamentals factors too as they relate to the growth prospects of the company whose stock is under consideration.
Additional fundamentals include debt ratios, profitability ratios and valuation ratios like the P/E (price to earnings) ratio. A higher P/E ratio can signal a growth stock or an expensive one. If revenues and EPS are growing then it’s the first. A lower P/E ratio is either showing a lack of growth or a stock that is neglected by investors.
Technicals involve trading patterns like triangles, wedges, head and shoulders patterns and more (click here for the top patterns to trade). Support and resistance levels and volume are also key technicals to watch in stocks, especially round number levels that play a key psychological role for investors. Lastly, there is a huge variety of indicators like Ichimoku (click here for the Ichimoku strategy), moving averages and more.
Below is an example of support and resistance levels on Apple stock. Price often respects these levels and then it passes through, creating new ones that in turn are respected in future price swings.
Combining sentiment, fundamentals and technicals
The critical factor in selecting stocks for trading is how the investor combines all these factor categories into a strategy, depending on the preferred investment period. Technicals and fundamentals apply to day trading and long term buy and hold while sentiment is considered more short term.
Here is a hypothetical trading example combining all factors in the stock of Nike Inc.
Before earning results, the sentiment has been positive for Nike as analysts expected strong EPS and revenue results for fiscal Q3 2021. Moreover, the two previous earnings results had beaten analysts’ estimates both on EPS and revenues. So the sentiment has been overall positive.
On the technical side of things, the stock price was near all time highs although price failed to go through multiple times. So it seemed only fit that if EPS was a smash hit as analyst expected, this could be the much needed catalyst to push the price above this resistance barrier and possibly create a new bullish trend, making technical analysis neutral at the time.
In terms of fundamentals, the company posted strong financials in the previous two quarters and growth seemed to be intact despite a tough year due to the Covid-19 pandemic, making fundamental analysis bullish for the stock. So the missing part for everything to turn bullish and start a new bullish trend was a strong positive earnings surprise on EPS and revenues alike.
Fast forward to results, Nike did post strong EPS results but missed revenue estimates due to the supply chain issues caused by the pandemic. This caused analysts and investors to re-adjust their growth estimates used in valuation models for Nike. As a result, fundamentals and the valuation for Nike stock changed instantly and the price needed to re-adjust by correcting lower, which it did shortly on the next day market open.
So for a successful stock pick for buying or even selling, sentiment analysis, technical analysis and fundamentals need to agree. This is critical for identifying stocks that have potential to move in large and persistent trends. It is extremely important for medium trend trading, whereas sentiment analysis and fundamentals overlap and technical analysis can be used to time an entry.
In Nike’s example before the earnings result, technical analysis showed a neutral situation and that price could go higher if earnings would have been a positive surprise or the trigger (catalyst). Fundamentals were already positive and strong and analysts were bullish causing sentiment to be bullish before earnings. But the earnings announcement proved sentiment wrong and caused fundamentals analysis to re-adjust to a more conservative basis as revenue estimates had to change according to reality. This in turn caused technical analysis to be interpreted as bearish (meaning resistance will hold once more) and price corrected sharply lower after all factors turned bearish.