The Difference Between Fundamental and Technical Analysis
Investors and analysts regularly utilize fundamental and technical analysis to research and anticipate securities’ price movements. While both are used to give insights into the markets and their prices, there is a significant difference between the two.
What is Fundamental Analysis?
In simple terms, the fundamental analysis evaluates securities by exploring their intrinsic value. When employing fundamental analysis, investors and analysts conduct thorough research of the overall economy and the industry they are interested in, as well as the financial health of individual companies.
To be more specific, the fundamental analysis covers all important metrics and indicators including profit, expenses, assets, debt, liabilities, and more.
What is Technical Analysis?
In contrast to fundamental analysis, technical analysis focuses on detecting market opportunities by analyzing statistical information, particularly the price and volume of a security. Technical analysts base their beliefs on the assumption that all fundamentals are already baked into the price so there’s no significant reason to look at them closely.
The Key Differences
The approach to evaluating stocks between fundamental and technical analysis is different from the very beginning. This is because technical analysts typically start off by studying price charts while fundamental analysts look at a company’s financial statements first.
More specifically, fundamental analysis focuses on evaluating a company’s intrinsic value by analyzing its balance sheet, and financial and cash flow statements. To do this, analysts and investors ignore the expected future cash flow values.
If a company’s stock trades below its determined intrinsic value, it is generally viewed as an appealing investment opportunity. On the other hand, if the stock’s price trades above its intrinsic value the stock is considered overpriced.
Apart from the differences in general approach, fundamental and technical analysis are also different in terms of the time horizon. Normally, fundamental analysis focuses more on identifying long-term investment opportunities, as opposed to technical analysis which adopts a short-term approach.
For example, technical analysts analyze price charts that can be displayed to show the price movements over a week, a single day, or even a few minutes, compared to fundamental analysis which covers data spanning multiple quarters or years.
Technical analysts also always pay attention to support and resistance, the two key price levels used for the analysis of future price trends.
Resistance represents the price level where the selling interest is strong enough to stop the security’s price from rising further. Conversely, support is the price zone where buying interest is increased so it stops declining security from dropping further in price, making it more likely to “bounce” and reverse the trend.
Additionally, investors utilizing fundamental analysis sometimes have to wait a long time before identifying a company’s intrinsic value in the market. These investors believe that the price of a security is mispriced over the short term, assuming it will see a correction in the future - a process that can last even several years.
The majority of information reviewed by fundamental analysts is the information that is disclosed quarterly or annually, such as financial statements and changes in earnings, compared to technical analysis which focuses on information that changes each day. This is one of the reasons why fundamental analysis uses a long-term time-frame as the data it uses to conduct the analysis is generated and released significantly slower.
Given all the differences between fundamental and technical analysis, the two also differ in terms of their ultimate goal. In other words, those who rely on technical analysis typically focus on detecting short and medium-term market opportunities to make a profit while investors using fundamental analysis make long-term moves, betting on the future of a company’s underlying business.
It is safe to say that technical analysis has been often criticized for its validity in the past. However, even though the majority of Wall Street analysts prefer using fundamental analysis, there are many firms that still hire technical analysts as well.
Those who are sceptical about technical analysis and its efficiency mainly base their criticism on the Efficient Market Hypothesis (EMH) which claims that most of the previous information is already priced in the stock.
Put differently, this hypothesis states that securities always trade at their true market value, meaning that the idea behind the intrinsic value and undervalued/overvalued stocks is irrelevant. As such, the EMH states that no one can outperform the broader market through market timing and undervalued stocks and that the only way to make substantial returns is to invest in riskier assets.
Using Them Together
While generally fundamental and technical analysis are viewed as exact opposites when analyzing securities, some investors prefer to use the two methods in conjunction to try to increase their investing success.
A common example of this is using fundamental analysis to detect an undervalued stock and then employing technical analysis to identify the best entry and exit point. This approach can bear fruit particularly when security is extremely oversold, though making the move too early could lead to significant losses.
Technical analysis can also be particularly successful to detect appealing entry points for growth stocks that are on the rise. Stocks with high growth rates and lucrative valuations tend to see large price corrections, and in this case, technical analysis can be used to detect oversold levels.
It is important to know that stocks can continue trending higher for a long time after they become overvalued. That’s why selling security just because it is overvalued can lead to missing out on a significant price rally and because of that, traders can analyze price and volume trends to hold the security until the momentum fades.
On the other hand, if a security is trading around its fair value, it wouldn’t be surprising to see the price consolidate or keep trading within its range. In that case, traders can rely on technical indicators to stay within that range, while the security’s fundamentals remain the same.
Additionally, sometimes traders that rely on technical analysis will analyze the security’s fundamentals to reinforce their decision-making process. For instance, a technical trader could be considering a breakout ahead of an earnings report and take a look at the stock’s fundamentals to learn whether the company is expected to top earnings estimates.
Fundamental and technical analysis are also often used together to give the investor a broader, clearer picture of the current market. In addition, some technical traders first look at price charts and then analyze the fundamentals to find out if there is enough supply and demand to boost the price through support or resistance levels.
The main objective of fundamental analysis is to determine a stock’s intrinsic value. Investors who rely on fundamental analysis search for securities that are undervalued and often focus on making long-term moves. As opposed to that, traders that employ technical analysis primarily look at the security’s price and volume, often ignoring its fundamentals.
However, some experts use the two methods together. A common example of this is using fundamental analysis to detect an undervalued stock and then analyzing the technical indicators to detect the best entry and exit points.