Fundamental or Technical Analysis

Firstly, and most importantly, Technical Analysis should not be seen as a sole generator for your investment or trade ideas. Technical analysis is often used by people completely unfamiliar with an asset to select an asset to trade, presuming they have a substantial amount about the underlying fundamentals simply from viewing price charts. Studying technical indicators of an asset without studying the underlying asset’s fundamentals or studying how the asset is affected by economic cycles is not recommended. Technical analysis is almost completely backward looking. The future impact of economic trends on underlying companies and firm fundamentals should determine what and how you trade, not simply a price chart alone.

Both Not Or

Technical and fundamental analysis are often seen as contrary, but this is untrue. Fundamentals are studied to reveal the intrinsic value of a company at a point and time, and the time period measured immediately before that time. After this time, those values become increasingly outdated, although they should be referenced for historical value until updated fundamentals are released. Additionally, released fundamentals affect the psychology of people purchasing and selling the asset, and encourages them to buy or sell. In short: Fundamentals show the company level impacts on supply and demand and thus price.

Technical analysis is the practice of using past pricing information on charts to predict future pricing trends. A chartist attempts to predict the future from an evidence-based viewpoint, taking positions based on signals suggesting a trend will continue or reverse in the future. These trends are driven by individual buyers and sellers quickly reacting in order to swiftly acquire profits and avoid losses.

Technicals Faster but Fundamentals Eventually Win

The result can be represented with a simple example: A manufacturing company releases a financial report showing the income from its operations. It reveals 5 million in revenue from 5,000 goods produced by two factories, with each one responsible for 2,500 goods. Two days after this report is released, one of those factories burns to the ground. This will appear on the technical level far faster than it will appear at the fundamental level. Investors will rapidly unload the company’s shares in order to avoid losses incurred by other people unloading the investment, resulting in a sharp price decline on the technical chart level. The financial statements will not show the impact until the next reports are released. Technical analysts will see the impact instantly, even if they have not seen the reason shares fell off a cliff.

When the next report is released, current fundamentals and future fundamental expectations will be released by the company, with the most important being earnings. The price of each share for the company will be impacted by these expectations, and the market price will quickly adjust to better align with fundamentals. Over the next quarter, the market price will positively or negatively stray from the actual fundamental values, until the next report reveals actual hard numbers.

The evidence of technicals eventually aligning with fundamentals is even stronger on a macro-economic level. Markets have often been bid up beyond reasonable levels, only to crash in the future when the fundamental underpinnings of the market are revealed to be less stable than estimated. Examples include the subprime mortgage crisis and the dot-com crash. Traders buying trends based on technicals bought into long term trends far above their realistic fundamental value, only to realize prices should have been far lower at a later date, and only after taking large losses.

Seek Alignment in Positions

We should always use a systematic approach, picking economic, fundamental, sentimental, and technically aligned positions. Technical Analysis should not be used without an and sentiment bias. The goal of Technical Analysis is to time investment entries and exits. Technical Analysis is a filtering and timing mechanism for trades that pass our fundamental and sentimental biases.

Is a trade idea is generated from our fundamental bias? Move it to the sentiment level. Does your trade pass sentiment level screens? Move it to the technical level. Does the trade pass the technical level? Move it to the risk management level. Can we take the trade while retaining our risk management requirements? Enter into the trade position and watch for a technical analysis exit. Never take a trade only because it looks good at the technical level.