We’ve written about the differences between investing and trading before – Difference Between Stock Market Investing and Trading – Don’t Mix Up the Strategies. These two strategies sound similar, but they have very different foundations and philosophies. Here, we will discuss two approaches to investing and trading: technical and fundamental analysis. The former tends to associate with trading, and the latter tends to associate with investing. They are not disparate, but the two approaches to the market arose from the strategies, largely remaining best-suited to the strategy for which it was designed.
The first difference, which correlates very closely to the investing and trading split, is the timeframe in which these approaches are applied. Technical analysis (TA) tends to be used on shorter timeframes. High frequency and algorithmic trading employs technical analysis. Day traders use TA to follow trends. Swing traders (a couple days to a few weeks) also use TA, though the longer-term swing traders may incorporate several fundamental analysis techniques.
Fundamental analysis (FA), on the other hand, tends to be employed by investors. Long-term investors might use some TA techniques, such as trend resistance and support, but because they move in and out of assets more slowly, they use indicators that have longer lag times. Fundamental indicators change less frequently than technical ones (quarterly versus hourly/daily/weekly), so FA is best suited for investors with longer market horizons.
With these timeframes in mind, let’s take a closer look at what constitutes FA and TA.
The shorter timeframe approach uses frequently or even continuously shifting indicators. TA relies on market psychology and trends heavily. Charting, the concept of using visual charts as a basis for decisions, forms the foundation of TA. Often indicators are decoupled from the company’s mission, goals, management, and other traditional investment indicators. TA cares only about the current price, historical prices, and what these two datasets may predict about future price movements.
The most powerful TA indicators use momentum and price comparisons to determine the future price. This future price may be predicted for only a few minutes into the future (in the case of day trading) or a few days or weeks (for swing traders). What is momentum?
Momentum comes directly from the physics definition: an object moving with a certain velocity (speed and direction) tends to continue that velocity until acted upon by an outside force. Furthermore, the acting force must be powerful enough to overcome the current velocity to change the direction or speed of the object. And so is the philosophy of technical analysts. If a stock is “trending” upward, it will likely continue to trend upward unless acted upon by another force (those forces are numerous).
Some commonly used indicators
Volume: A surge in volume implies interest in a stock, which in turn means a likelihood of increasing or decreasing prices in the future. Once the volume starts to fade, the velocity of the stock will probably start changing, too.
Moving Averages (MAs): These are rolling, continuously calculated averages over a period of time. The main idea? When a “faster” moving average (say, the average of the last 10 days) crosses a “slower” moving average (say 30 days), a signal is triggered. If the faster average crosses ABOVE the slower one, this means the more recent prices have experienced upward momentum – after all, the short MA is more affected by the recent data than the longer MA, as the latter has so many more prices to consider. Using a good mixture of faster and slower MAs, technical analysts claim they can predict when to buy and sell for maximum profits. A good spread is key: too wide and you get rapid, useless signals (i.e., noise); too narrow, and you rarely have signals because the MAs move almost in lockstep.
Exponential Moving Averages (EMAs): These are just like moving averages, but they place more weight on recent prices. This means recent trends are not muted by past price action, but past price action is not ignored.
Moving Average Convergence/Divergence (MACD): This indicator obviously uses MAs, but there is an added layer. This indicator calculates the difference between two EMAs, then uses the EMA of the difference as the “signal line”. When the difference crosses the EMA of the difference, a signal is generated. When the former crosses ABOVE the latter, there is a buy signal, as recent momentum is increasing in the price movement. When the MACD crosses zero, or the centerline, (i.e., when one EMA crosses the other EMA), a signal indicating increased momentum is generated. A signal that the price momentum is weakening is when the MACD diverges from the price action – this implies prices conflict with the recently prevailing trend.
Relative Strength Index (RSA): This indicator tracks ticks and their direction. It divides the average gain of upticks by the average loss of downticks over a period of time. This is termed “relative strength”. Then, this relative strength is fed into another formula, generating a number between 0 and 100. If the output is above 70, the stock is seen as overbought (i.e., you should start selling, because too many people bought recently and the stock is bound for a correction). Below 30 is a buy signal, as the stock is seen as oversold.
Stochastic Oscillator: This one comes from the perception that, in bullish markets, prices close near highs, and, of course, the opposite for bearish markets. It doesn’t have to be the daily price closings, just the closing of a period (for one hour charts, periods may be only single minutes). This indicator is also “range bound”, like the RSA, and can only be between 0 and 100. A similar rule applies, but 80 for overbought and 20 for oversold.
There are tens or even hundreds of other indicators. Many of the published indicators have a sort of self-fulfilling prophecy attribute to them. Because so many traders use them, their signals can actually cause price action. On the other hand, there are likely many proprietary indicators that traders use. With the advent of easy data analysis tools at home, individuals can find new indicators uniquely suited to their trading strategies and preferences. Of course, large companies with Big Data capabilities probably also have some accurate, proprietary indicators.
These indicators also fail. The idea is to have more or bigger gains than failures, and on average, make money. Unfortunately, many people choose poor timeframes or allow emotions to rule their trading. This negatively impacts profits and losses.
Furthermore, technical analysis solely focuses on price action. There is little in the way of news, management, or product analysis. As mentioned, Big Data and AI might somehow quantify news and customer perception, but for the average individual trader, these are out of reach. This means TA is decoupled from the underlying asset in a way. For those who invest because they believe in a product or company, TA may even seem soulless. Moreover, decoupling from the asset can be dangerous. News, upcoming earnings, and other fundamentals that hold considerable influence cannot be ignored. Few people engage solely in charting and TA.
While TA is concerned singly with price action, fundamental analysis takes into account many other factors. There are certainly quantitative ratios, especially regarding the financial health of a company, and they are absolutely important to FA. However, FA tends to incorporate other factors as well and focuses far less on the observable trends on a chart derived from the dataset of historical prices. Furthermore, because FA ratios are slower moving (once a quarter or year for many that require financial statements), FA tends to focus on the long term rather than the short term.
Metrics and Financial Ratios
Finance is inherently a quantitative field. It is not advisable to entirely neglect financial ratios and metrics for any sort of investing. Money is really just numbers and perception, and finance is a numbers game. Hence, there are plenty of ratios and indicators that fundamental analysts use to gauge the investment-worthiness of an asset. Reading the financial statements is an integral part of FA, and gauging those ratios is certainly a core task for any fundamental analyst. While TA requires no accounting knowledge, FA requires quite a bit.
Earnings ratios: these give an idea of how much profit the company generates compared to some important factors.
- Price to Earnings (P/E): This multiple shows how expensive each share is compared to the profit generated for each share
- Earnings Per Share (EPS): This is simply the profit divided by the number of shares outstanding. It gives an indication of how divided the company’s equity is, but its more important purpose is to serve as the denominator in the Price to Earnings (per share) ratio (P/E)
Market Capitalization: This one shows how large a company or overarching asset is (e.g. Bitcoin’s market cap). Large companies tend to be more resistant to price swings due to daily trading, since it takes more money to affect the whole market. Bad news, of course, will drop a stock regardless of market cap.
Debt and Equity Ratios: These measure how much a company owes to debtors and how much investors have in the company. There are plenty of ratios, but usually lower debt and higher equity numbers are preferable. Of course, one must compare these to the industry, as some industries may routinely carry significant debt. A very low current ratio (current assets / current debt) may spell trouble for solvency, and soon. If the interest coverage ratio is also low, the problem is compounded. On the other hand, if the company has an envious interest rate, there may be a low current ratio but high interest coverage ratio.
Cash Flow Ratios: Cash flows are indicative of solvency, profitability, and managerial skills. Poor performance here indicates precarious debt situations or poor management. If a business cannot move inventory fast enough to pay current debt expenses, solvency becomes an issue, and perhaps management’s strategy is to blame.
Inventory Ratios: For retailers and other businesses holding large amounts of inventory, these ratios cannot be ignored. A high inventory turnover rate demonstrates a company can effectively manage its inventory levels and is actually able to sell what it purchases.
I will write it again: finance is a numbers game, and FA certainly acknowledges that. However, some other, non-quantitative factors influence FA decisions. These probably could be quantified to an extent, but many people do not attempt it.
A major influence on the decision to buy or sell a company for fundamentalists is who is part of management. A serial entrepreneur on the Board could bode well for the company. A good fundamentalist will dig into management’s background, and if someone making influential decisions has suffered a series of failures, the fundamentalist will be cautious. Fundamentalists may be hesitant to purchase shares even with a wildly successful member if the venture is the member’s first foray into the industry.
An uncommunicative management is anathema to fundamentalists. Even armed with financial statements, it is essential in FA to know management’s plans. TA doesn’t care about the plan for the next quarter or decade because the timeframe is short and the corporate strategy irrelevant. But fundamental analysts tend to be focused on the long-term, so vague visions of the company’s future are a reason to avoid an investment.
Perceptions and Principles
For some people engaged in FA, the company’s image and mission are important. While many companies exist to make money and fulfill some sort of need for society, others may be viewed by the general public in a negative light. For some investors, this can be a dealbreaker. In fact, there is a subset of investors termed “activist investors” who invest in companies on principle. Perhaps a company is even struggling, but the person believes in the company’s mission and believes public sentiment is such that the future will be profitable for that company.
Regarding perception, a stellar marketing campaign can differentiate the thriving from the dying. An investor who expects an upcoming marketing campaign to be groundbreaking or to immediately go viral may invest, even with poor financial ratios. And for some people, owning the stock “before anyone else” holds its own appeal.
Belief in the Product
One final reason people may invest is a deep belief in a product or service. Angel investors, late-stage investors who often save companies from bankruptcy, certainly expect to make a tidy profit from a struggling company. But before an angel investor injects cash, s/he must believe the company is capable of conquering its ailments. This belief often stems from a belief in the product to be useful and valuable to society and mankind.
One question many non-investors ask is “what do they do?” in regards to the company. A common reply for those involved in TA is “Who cares?”. For many employing FA, though, the reply may be a substantial speech about the merits and benefits of the companies they choose. Some people simply enjoy the thought that their investment contributes positively to the world.
This is by no means a full analysis of FA and TA. It is a (very) brief overview of the approaches to the market. The most important differences – timeframes, focus (charts VS financial statements), and some personal philosophies (make money or support a company) – are only slightly described above. Many individuals and certainly institutions mix the two. Someone might use FA for some industries and companies but TA for others. The different approaches may also be applied with different profitability to different companies: a stable stock paying dividends may be better viewed as a long-term investment and thus using FA, but a highly volatile asset may be more profitably traded with TA.
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