Fundamental Economic Analysis vs. Technical Analysis – What Method Provides the Best Profits?

Meir Barak |

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The long-standing debate between fundamental and technical analysis began when the first analyst drew a line between two points representing a stock’s price changes over the axis of time, thereby creating the very first price graph. 

The essence of the dispute is whether to buy a stock based on company and market performance, such as the company’s balance sheet, or based on the stock’s behavior, as illustrated by graph alone. Both methods attempt to predict price trends. As already noted, the fundamental economic investor examines the stock’s value relative to company performance and market performance, and concludes whether its price is above or below its true value. If, in the long-term investor’s opinion, the price is currently below its true value, he or she will buy, and vice versa. The technical trader does not ask “why,” but tries to predict price trends according to graphs, that is, results in the real-time field.

The Yin and Yang of Investment Research

At this point, I will cease being objective and say outright that I do not believe in the sole credibility of one or another method. I believe that their integration is the winning method. In reality, I choose to be 80% technical and 20% fundamental. Most technical analysts arrived at this preference through fundamental economic analysis. I can promise you that if you try to earn profits by reading financial reports in newspapers and watching them on television programs, you will discover sooner or later that you're wasting your time.

Why do most people believe in fundamental economic analysis? Because we’re educated to invest in the long term. Why is that? Very likely because someone has to make a living from teaching economics in universities, because funds must find legitimate justifications for erroneous purchases, because stock market colleges want to continue existing, because we as humans must peg everything into some kind of mathematical, organized framework, and because none of the educators are willing to admit that basically, they know just about nothing even when history indisputably proves that they’ve erred throughout the long term! Teaching methods and attitudes have not changed over decades, and sometimes even over centuries.

When Worlds Collide

Most of those involved in the stock market define themselves as purely fundamental or purely technical. In reality, there is no small amount of overlap between the two methods. The problem arises when the two methods oppose each other. History has proven that the technical method has always preceded the economic analysis. Most of the largest market trends occurring throughout history were ascribed no significant explanation according to economic data, yet most could be predicted based on technical conduct. Experienced technical traders learn over time to trust their own considerations, which will often stand in direct opposition to those proposed by fundamental economic analysts. Technical traders will be enjoying the benefits of changes when fundamental investors have long since missed the train. 

Would you like an example? Was it possible to profit from tech company stocks at the end of the 1990s? Of course, and abundantly! Could even one fundamental investor be found able to justify buying stocks in technology companies that have no income, only expenditures and dreams? Of course not! Technical traders knew where the public’s emotions would lead the market, whereas fundamental investors chose to ignore the expected change. 

At some point, they nonetheless found justification for joining. Remember the phrase “profit without advertising costs”? Several more illustrious economic concepts came into being along the duration of the tech bubble, meant to justify late-entry into a teeming market. Funds simply could not tell their clients they were not buying when all competitors presented astronomical profits, therefore they invented a financial justification, and happily bought in. Those who wasted their time with analyses of hi-tech companies’ financial reports prior to and during the rush, left opportunities wide open for technical analysts to enjoy alone. Those who continued justifying their erroneous fundamental holdings when the stock exchange changed direction and crashed, lost out.

Over time, once the market had absorbed these large shifts, the two methods caught up with each other and once again presented a united front. We ask: must some compromise be found between them? As a novice, I thought the answer was no. Now, with years of experience under my belt, I believe I was wrong. As noted, I'm currently operating on an 80% technical and 20% fundamental mix. I've moved a little to the other side because I found that when sticking with only one approach, the market seems in many cases to operate as though it has a mind of its own. I found that relying on technical data alone did not provide me the advantage I sought. By contrast, it’s completely clear to me that relying on economic data alone is nothing more than a gamble. If you’ve ever tried to watch how a stock behaves after its financial reports are publicized, whether good or bad, you'll understand exactly what I’m referring to.

Note that I used the very specific terms “fundamental investor” and “technical trader.” In the past, when the world was chiefly industrial, it was possible to rely on economic data for the long term. It wasn’t possible to change the rules of the game overnight. When a mega-corporation like General Motors Company ($GM) or IBM ($IBM) presented good balance sheets, it was clear that no competitor could surface overnight and take their top status from them. Therefore, these economic data points were reliable for the long term. To compete with GM or IBM, an unimaginable investment would be needed, therefore in the short term, no change could be expected that would endanger the investor too greatly. 

In today’s technological reality, every young entrepreneur living in student dorms can topple a conglomerate like IBM from the top of the pyramid. Remember when IBM preferred to develop hardware, and some young guy named Bill Gates developed DOS for them? Just check Microsoft’s market stock against IBM’s to understand how the world can change. And who used technological innovation to topple Microsoft Corporation ($MSFT) from its top position as the company with the largest market value? Apple, Inc. ($AAPL), which was dormant for years but reached new peaks with the iPhone and iPad, leaving Microsoft behind the curve. And what of Google Inc. ($GOOG), sprinting ahead? Will Facebook, Inc. ($FB), breathing hard down Google’s neck, take the lead?

In the current business world, any technological or biological innovation can change market structure overnight. The days when our parents would buy a stock such as IBM, place the paper deed (yes, once upon a time a written deed was issued to the stock owner) beneath their pillow and go to sleep knowing all would be fine, have long since disappeared. Nor have we yet begun to discuss the impact of wars and terror attacks…

The Death of the Long Term Investor and the Rise of Technical Analysis

I believe that long-term investment is dead, together with the world of absolute control and the fundamental economic analysis method. The short term is what to watch, which is why technical analysis is the current controlling method. 

We live in a time when we need to trade with fast changes and remain wary of dangerous long-term investments. The technical trader who buys stocks that unfortunately move in the wrong direction (yes, that can happen, too) realizes he or she has erred, sells them and moves on to the next stock. When fundamental investors buy a stock, they hold onto them until it can be proven that the fundamental economic data have altered. Such investors believe that the stock’s value is actually higher than its market value. Therefore, when it drops in price, it can actually increase their holdings. 

Yet, not so many years ago, the method did work. Remember the dot-com bubble that burst in 2000? That’s where the method stopped working. That’s where the technical trader profited from shorts and the fundamental investor crashed in a market which, to date, has yet to fully recover. It was the trader’s opportunity, not the gambler’s.

If you need further persuasion, let me present another question: is there any link between a company’s balance sheet and reality? Older readers may well recall Enron, one of the largest energy corporations in the world. Enron collapsed when its CEO chose to present the balance sheet in a "creative" manner, and made sure he found an accountant who would not stand in his way. Even if we allow that the balance was legitimate, it nonetheless reflected the company’s status in the previous quarter, which commenced just three months earlier. Who is interested in it today? I'm sure that most balance sheets presented to us are legitimate and correct, but should we gamble on them with our money?

As traders, we rely chiefly on clear technical data. In the past, we have come across a stock that rose multiple percentages in one trade day, and only the next day the economic data causing the rise become clarified. This does not imply we have no trust in economic data. We just feel that they are already incorporated into the stock’s chart.

As if all that is not enough, there’s another important difference. Technical analysis can be applied to every stock, sector, and market. Give me a yearly graph for Japan’s Nikkei index, and within seconds I can analyze the Japanese market. Show me the yearly graph for the DAX index and in the blink of an eye, I will analyze the German market. Can fundamental analysts, who need to read mountains of material before buying any stock, do that? No! They cannot specialize in every market, sector, and stock. They are limited to a specific sector and even a specific company in some cases, and will never review the entire market, but only a slim segment of it.

Why Do I Nevertheless Use Fundamental Economic Analysis?

First and foremost, because most of the public uses it. Whether there is any meaning to fundamental analysis or not is as pointless as asking whether there is meaning to technical analysis. As soon as a large enough number of people believe so, and operate on the basis of economic data with predictable outcomes, the experienced trader will know how to take advantage of the predicted movement and earn a livelihood from it.

Over the years, I have learned to appreciate the power of the fundamental herd and rein it in for my own purposes. I make no small number of technical decisions based on economic factors alone. For example: I focus a lot on stocks influenced by extreme economic analysis, such as an analyst’s upgrade, but then I choose a technical entry and exit point. Using fundamental economic analysis does not in any way indicate that I believe in that method, but I'm definitely a firm believer in the predictable behavioral outcomes of those who do use them. I have no need to deny any kind of prediction. Rather, I need to evaluate whether it will be self-fulfilling.

 

To learn more about the stock market and to begin your own journey toward financial independence, visit Meir Barak's site Tradenet and check out his book "The Market Whisperer."  

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 118.91 0.96 0.81 22,442,756
IBM International Business Machines Corp 165.36 0.57 0.35 3,266,436
AAPL Apple Inc. 112.12 1.09 0.98 27,068,316
GM General Motors Company 36.42 0.12 0.33 14,516,035
GOOG Alphabet Inc. 776.42 5.23 0.68 1,488,059
MSFT Microsoft Corporation 61.01 -0.36 -0.59 21,220,753

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