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Two ways to determine buy / sell decisions on stocks
Before making a stock investment call, one needs to analyze the stock for its worthiness as an investment. There are two primary ways of analyzing a stock: technical analysis and fundamental analysis. Here, we focus on technical analysis and how the concept of technical analysis differs from the concept of fundamental analysis.
Fundamental analysis attempts to determine fair value of a stock
Fundamental analysis as the name suggests, constitutes analyzing the fundamentals of the company in order to arrive at the fair value of the security. It basically involves analyzing the financial statements like balance sheet, income statement and cash flow statements of the firm. Fundamental analysis also involves analyzing various fundamental ratios to understand the financial strength of the company. A key aspect of fundamental analysis is an attempt to project the future profitability and growth prospects of a company, based on the analyst's understanding of the business and the sector in which the business operates in. The main goal of fundamental analysis is to arrive at a fair or intrinsic value of a company stock. If the current price of the stock is less than the fair value, it is underpriced and an investor using fundamental analysis for investment will buy that stock. We have discussed this in some detail in the article on DCF (Click Here)
Technical analysis attempts to determine near term trends in a stock's price
Technical analysis does not undertake to study the fundamentals of the company or to arrive at its fair price. It involves analyzing the stock price movements of the past and the volumes with which it has been traded, in order to discern trends which can help predict the possible future movements of a stock's price. Technical analysis is based on the premise that the future price movements are an extrapolation of the past price movements of the stock. Also, technical analysis considers that all the fundamentals of the company are already fully reflected in the current price of the stock and therefore excludes it from factoring it in the analysis. Thus, technical analysis does not involve finding out securities which are underpriced or overpriced.
Its all about supply and demand for the stock in the market
Technical analysis is an analysis of the supply and demand of the securities, at various price points. The support and resistance levels of a stock are dependent on the supply demand relationship. Support level is the price below which the sellers are not prepared to sell the security while resistance level is the price above which the buyers are not prepared to buy the security. Hence, technical analysis is governed by the demand and supply of securities and therefore the volume of securities traded are significant here. When a stock's price is moving up amidst high volumes, the upside is expected to continue as a strong buying trend is visible. If volumes are however very thin, the upside is not likely to be sustained, as buying interest is not evident, though the price is still in an upward trajectory. Likewise, selling on huge volumes is a sign that the downward trend is likely to continue for some more time whereas when prices fall amidst very thin volumes, it is usually a signal that selling pressure is now getting over - there are not too many sellers left at these prices - and therefore the downward trend in the share's price is unlikely to sustain for much longer.
The most important difference is the approach of the analyst
Probably the most important difference between fundamental and technical analysis is that fundamental analysis is conducted in order to formulate a view on the future price movement of a stock, on the basis of which the analyst will buy a stock, if he finds it undervalued vis-Ã -vis his own price projections. In technical analysis, a key principle is not to have a view of your own, but to simply analyse aggregate market behaviour in terms of demand and supply dynamics for a stock at different price levels, discern trends from this using popular technical tools and trade on this basis, by going along with the current trend, if it has sufficient strength. The moment the trend changes - or rather the moment his technical tools signal the likely exhaustion of a current trend, the technical analyst should discern this and switch his position to be on the right side of the new trend again. "The trend is your friend" - that's the mantra of a technical analyst. He doesn't try to figure out whether the stock's price ought to be going up or down - he just focusses on which way the trend is at the moment, and the strength of the trend and therefore makes a decision whether to participate in the current trend or not.
So, while a fundamental analyst is supposed to detect mis-pricing of stocks and often take a position against the market, based on his own convictions, the technical analyst is supposed to train himself not to have a view of his own, but be guided purely by demand and supply dynamics for that stock to trade successfully.
Short term trends vs long term price projections
Another difference between the fundamental analysis and the technical analysis is that while technical analysis leads to analyse the short term price movements, the fundamental analysis is aimed at longer run price prediction. In fundamental analysis, the underpriced security can take a long time to actually reach to its fair value; therefore it aims at long term investments. Technical analysis on the other hand considers the various price patterns, charts and trends to arrive at short run price expectations. Thus, we can say that technical analysis is more relevant to traders and fundamental analysis to investors.
Assumptions underlying technical analysis
Technical analysis is based on various assumptions. Firstly, the stock price is arrived at from the relationship between the demand and supply. Second assumption is that the stock price fully appreciates the fundamentals of the company and the general market and economic conditions. Also, there are trends which the stocks follow and which tend to be repetitive. A trend of past price performance is usually repeated in the future price trend. Not only are trends repeated, price patterns are also repeated giving an indication of future prices.
Various tools that are used for technical analysis are charts, turning points, price patterns, trend lines, moving averages and other advanced tools like oscillators. The most commonly used technical indicators include the Accumulation - Distribution Line (A/D Line), Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI).
How fund managers use fundamental and technical analysis
Many portfolio managers and fund managers use a combination of fundamental and technical analysis in managing equity portfolios. Fundamental analysis is typically used in shortlisting stocks that the fund manager intends buying. The timing of the buy decision is often influenced by technical analysis, which focusses more on near term trends in the price of a stock. Likewise, sell decisions may be made on a fundamental basis, but the timing of the sale could also be influenced by technical analysis.
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