Tommy R
11-19-2002, 11:00 AM
I wrote this article ages ago and thought someone might be interested. It kind of explains technical and fundamental analysis and explains the pros and cons of each.
Technical Analysis (TA) V’s Fundamental Analysis (FA)
This article outlines the principles of both TA and FA, analysing the plausibility of each methodology in obtaining excess returns under the efficient market hypothesis (EMH).
Fundament Analysis
FA uses earnings and dividend prospects of a the firm, expectation of future interest rates, and risk evaluation of the firm to determine proper stock prices. To do this analysts examine firm specific past financial statements, industry specific conditions, make forecasts of macroeconomic activity and evaluate a series of financial ratios. The hope is to attain insight into future performance that is not yet recognised by the market. Presumable, under this methodology analysts can obtain excess returns by buying into stocks that are relatively “under valued” and selling those stocks that are relatively “over valued”, as stock price adjust to the estimated intrinsic value in the long run.
Technical Analysis
An alternative approach to forecasting the behaviour of prices in any market where there are a number of buyers and sellers is TA. This approach seeks to explain and forecast share price movements on the basis of the past behaviour of prices. The key underlying assumption of TA is that markets are dominated at certain times by a mass psychology, and that, over time, regular patterns in share price movement can be discerned. As partial pattern emerges it is assumed that the historic patter will emerge in full – that is, the pattern will unfold this time, as it did in the past. This phenomenon has become known as behavioral economics, where patterns emerge in markets because traders behave in groups. It is thought that early recognition of such patterns gives an insight into the direction of prices movements, such that excess profits can be obtained.
Fundamental Analysis V Technical Analysis
Traditionally, the plausibility of each methodology in obtaining excess returns, is examined under the EMH framework. Three degrees of information efficiency are usually tested for. The “weak-form” of market efficiency states that prices already reflect all information that can be derived from examining past prices. The “semi-strong” form states that all publicly available information is reflected in prices. Finally, the “strong-form” states that all public and private information is contained in prices. If the “weak-form” of the EMH holds then there is no scope for TA, while if the “semi-strong form” holds there is no scope for TA or FA to obtain excess returns. If the “strong-form” is true then under the EMH even those with inside information can not obtain excess returns. There is a great debate in academia as to the level of market efficiency. Recently, strong evidence [Jegedeesh and Titman 1993[1]], [Cheng, Wagner, Hua Lin 1996[2]] has surfaced showing that markets, in general, do not pass the test for weak efficiency. This is inline with behavioral economists expectations and provides validity for TA as a feasible methodology.
This is an appealing result since TA offers many advantages over FA. Using TA a chartist can gain a strong indication of the direction of price movement from a simple glance at a chart, whilst FA requires extensive data collection and analysing to obtain such forecasts. Furthermore, assumptions and guess work is required, under FA, to forecast cash flows and macroeconomic conditions. Forecasts under this method are only as good as the assumptions made. In addition, it is easy to learn TA. Given the right resources any individual can be trading to a high level in a short period of time. Finally, capital can be tied up for a long period before prices adjust to their intrinsic value and any return is realised under FA.
A superior trading methodology often adopted is to use a combination of TA and FA. FA is used to determine companies that are “under priced”, while TA is used for market timing purposes, so capital is not tied up for an unreasonable time without return.
Personally, I prefer using TA for the advantages mentioned above. While well adverse in all TA techniques, I am a strong believer in trading on support and resistance and place a high importance on volume in evaluating directional movement. In addition I regularly trade on tends and other pattern formations such as head and shoulder tops/bottoms and double tops/bottoms. I have been keenly involved in researching the Fibonacci Series and hope to publish my results soon.
[1] N Jedadeesh, S Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”, Journal of Finance 48 (March 1993).
[2] Cheng, Wagner and Hau-Lin, “Forecasting the 30-year U.S Treasury Bond with a System of Neural Networks, NeuroVe$t Journal Jan/Feb 1996
Technical Analysis (TA) V’s Fundamental Analysis (FA)
This article outlines the principles of both TA and FA, analysing the plausibility of each methodology in obtaining excess returns under the efficient market hypothesis (EMH).
Fundament Analysis
FA uses earnings and dividend prospects of a the firm, expectation of future interest rates, and risk evaluation of the firm to determine proper stock prices. To do this analysts examine firm specific past financial statements, industry specific conditions, make forecasts of macroeconomic activity and evaluate a series of financial ratios. The hope is to attain insight into future performance that is not yet recognised by the market. Presumable, under this methodology analysts can obtain excess returns by buying into stocks that are relatively “under valued” and selling those stocks that are relatively “over valued”, as stock price adjust to the estimated intrinsic value in the long run.
Technical Analysis
An alternative approach to forecasting the behaviour of prices in any market where there are a number of buyers and sellers is TA. This approach seeks to explain and forecast share price movements on the basis of the past behaviour of prices. The key underlying assumption of TA is that markets are dominated at certain times by a mass psychology, and that, over time, regular patterns in share price movement can be discerned. As partial pattern emerges it is assumed that the historic patter will emerge in full – that is, the pattern will unfold this time, as it did in the past. This phenomenon has become known as behavioral economics, where patterns emerge in markets because traders behave in groups. It is thought that early recognition of such patterns gives an insight into the direction of prices movements, such that excess profits can be obtained.
Fundamental Analysis V Technical Analysis
Traditionally, the plausibility of each methodology in obtaining excess returns, is examined under the EMH framework. Three degrees of information efficiency are usually tested for. The “weak-form” of market efficiency states that prices already reflect all information that can be derived from examining past prices. The “semi-strong” form states that all publicly available information is reflected in prices. Finally, the “strong-form” states that all public and private information is contained in prices. If the “weak-form” of the EMH holds then there is no scope for TA, while if the “semi-strong form” holds there is no scope for TA or FA to obtain excess returns. If the “strong-form” is true then under the EMH even those with inside information can not obtain excess returns. There is a great debate in academia as to the level of market efficiency. Recently, strong evidence [Jegedeesh and Titman 1993[1]], [Cheng, Wagner, Hua Lin 1996[2]] has surfaced showing that markets, in general, do not pass the test for weak efficiency. This is inline with behavioral economists expectations and provides validity for TA as a feasible methodology.
This is an appealing result since TA offers many advantages over FA. Using TA a chartist can gain a strong indication of the direction of price movement from a simple glance at a chart, whilst FA requires extensive data collection and analysing to obtain such forecasts. Furthermore, assumptions and guess work is required, under FA, to forecast cash flows and macroeconomic conditions. Forecasts under this method are only as good as the assumptions made. In addition, it is easy to learn TA. Given the right resources any individual can be trading to a high level in a short period of time. Finally, capital can be tied up for a long period before prices adjust to their intrinsic value and any return is realised under FA.
A superior trading methodology often adopted is to use a combination of TA and FA. FA is used to determine companies that are “under priced”, while TA is used for market timing purposes, so capital is not tied up for an unreasonable time without return.
Personally, I prefer using TA for the advantages mentioned above. While well adverse in all TA techniques, I am a strong believer in trading on support and resistance and place a high importance on volume in evaluating directional movement. In addition I regularly trade on tends and other pattern formations such as head and shoulder tops/bottoms and double tops/bottoms. I have been keenly involved in researching the Fibonacci Series and hope to publish my results soon.
[1] N Jedadeesh, S Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”, Journal of Finance 48 (March 1993).
[2] Cheng, Wagner and Hau-Lin, “Forecasting the 30-year U.S Treasury Bond with a System of Neural Networks, NeuroVe$t Journal Jan/Feb 1996