I. Technical Analysis vs. Fundamental Analysis?
Have a question? Just
The study of the stock market has become divided into two schools of thought: fundamental analysis; and, technical analysis.
Fundamental analysis focuses on the economic forces of supply and demand that cause prices to move higher, lower or stay the same. The fundamental approach examines all the relevant factors affecting the price of a market in order to determine the intrinsic value of that market. The intrinsic value is what fundamentalists indicate something is actually worth based on the law of supply and demand. If this intrinsic value is under the current market price, then the market is overpriced and should be sold. If market price is below the intrinsic value, then the market is undervalued and should be bought.
On the other hand, Technical Analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. The term "market action" includes the two principal sources of information available to the technician - price and volume.
There are three premises on which the technical approach is based:
1. Market action discounts everything - The technician believes that anything that can possibly affect the price - fundamentally, politically, psychologically, or otherwise - is already reflected in the price of that market. It follows, therefore, that a study of price action is all that is required.
2. Prices move in trends - The whole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends.
3. History repeats itself - The key to understanding the future lies in a study of the past, or that the future is just a repetition of the past. Patterns in the market are based on human psychology, which tends not to change.
Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move. They just approach the problem from different directions. The fundamentalist studies the cause of market movement, while the technician studies the effect. The problem is that the charts and fundamentalists are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most. Usually they come back in sync at some point, but often too late for the trader to act. One explanation for these seeming discrepancies is that market price tends to lead the known fundamentals. While the know fundamentals have already been discounted and are already "in the market", prices are now reacting to the unknown fundamentals. Some of the most dramatic bull and bear markets in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway.
In accepting the premises of technical analysis, one can see why technicians believe their approach is superior to the fundamentalists. If a trader had to choose only one of the two approaches to use, the choice would logically have to be the technical. Because, by definition, the technical approach includes the fundamental. If the fundamentals are reflected in market price, then the study of fundamentals becomes unnecessary. Chart reading becomes a shortcut form of fundamental analysis. The reverse, however, is not true. Fundamental analysis does not include a study of price action. It is possible to trade financial market using just the technical approach. It is doubtful that anyone could trade off the fundamentals alone with no consideration of the technical side of the market.