Technical and fundamental analysis are often considered binary opposites when it comes to investing in stocks, however a clever combination of both can potentially enhance the timing of your buy and sell decisions, especially within the current highly volatile market. While stock-pickers traditionally like to sit on just one side of the technical/fundamental divide, by marshalling the benefits of both, you can receive a more complete picture of a company and what’s happening on the share market.
Fundamentals first
Until you know what a company is worth, it’s impossible to apply a ‘value investor’ mentality to stock selection. This is where fundamental analysis – if used properly – can be well worth the effort. By analysing historical financial data, along with forecast earnings and profit projections, you’re simply in a better position to predict future company performance and growth.
Remember, if you’re investing in the share market based on fundamentals and not just speculating or gambling on share price momentum, you’re actually buying a piece of a company. That’s why it’s critical that you understand the underlying business you’ve bought into.
If you make no attempt to understand a company’s underlying business, by default you’ve relegated the share market to a form of gambling.
By drawing on financial ratios – like return on equity (ROE) and net debt to equity, plus key qualitative indicators like management capability, earnings sustainability and a company’s competitive advantage – you can determine the all important value of a company.
Only once you have an idea of the company’s true value are you in a position to determine whether the current share price makes for an attractive entry point, relative to future projections.
Avoid paying a premium for shares
Contrary to popular opinion, what you actually pay for a company’s shares is the single most important determinant of future returns.
Simply buying a quality company at any old price, parking it in the bottom drawer and relying on share market momentum to do the rest – the way investors’ did during the 20 year bull market run – is fraught with danger.
It’s equally dangerous buying ‘falling daggers’ within a down market on the pretext that price and value are mutually exclusive. They’re not, and the direction within which a share price is heading is often a good determinant of whether it’s a ‘value-play’ or a ‘value-trap’.
Enter technical analysis (aka charting) as a highly useful accompaniment
As a value investor, your primary goal is to buy quality stocks trading at a discount to their true value. That’s because over the long term, share prices typically reflect the value of the underlying business.
Value investors who are patient enough will sooner or later be presented with opportunities to capitalise on negative announcements or unfavourable macroeconomic data, which can and do trigger share market corrections.
Recent deliberations over the US Federal Reserve’s (The Fed’s) decision to finally raise interest rates when its meets 15 December is a classic example.
Seasoned value investors refer to is as ‘buying on the dips’ and within the highly volatile trading environment, it’s not unusual for the share market to move well over 200 basis points (pbs) – aka 2% – in any trading week and on occasion on any single day.
Technical analysis can help time trading decisions
While even the highest quality stocks can get caught up in negative market sentiment, the mispricing this throws up can represent some tantalising buying opportunities.
To the uninitiated, technical indicators – which focus on volume and price – try to gauge the direction in which share prices might be heading. This technique can help you time your entry into top quality stocks when they’re most likely to be cheaper.
Admittedly, technical analysis by itself won’t help you identify the best stocks to buy. However, it will let you draw conclusions from trading patterns, company charts, graphs and trend lines to help you pick the best time to act on a stock.
What’s unique to technical analysis?
So what exactly can technical analysis add to your stock research that fundamental analysis can’t?
Fundamental analysis can’t tell you what the market thinks of a stock you want to buy. That’s where the ‘technical stuff’ like volume indicators can help.
Notable spikes in traded volumes typically suggest that a stock has attracted abnormally high attention from the trading community and that its shares are under either an ‘accumulation or distribution’ phase.
Volume indicators can help confirm whether other investors agree with your fundamental outlook on a stock. They can also help gauge whether a stock is gaining or losing momentum – if it’s the latter then a reversal could be around the corner.
This serves to remind you that a stock’s inclusion in or out of an index will have a material impact on the market’s interest in it, and can directly impact share price momentum. The same can be said for a share buy-back program.
Useful technical charts
If you like the look of a stock based on what the fundamentals are telling you and seek to time a trade or solidify a favourable entry (or exit) point, the following technical charts can be extremely useful:
Intraday chart:
Let traders watch for spikes in volume, which often correspond with block trades. Intraday charts can be extremely helpful in deciphering exactly when large institutions are trading.
Short-term movements:
While most fundamental investors tend to focus on longer time frames, they still want to obtain a favourable buy-in price and/or a favourable selling price upon liquidating a position.
That’s why it’s important to pay particular attention to when a stock pushes through what called its 15- and/or 21-day moving average, as this typically indicates what’s expected to follow in the coming term.
Similarly, you can also use 50- and 200- day moving averages to determine longer-term breakout patterns.
Reactions over time
By looking at a chart of a specific stock, industry, index or market, you can determine how that entity has performed over time when certain types of news have been released. Remember these patterns tend to repeat over time.
How fundamental and technical analysis adds value
Fundamental Analysis:
- Select stocks to include in your investing universe or ‘watch list’
- Determine whether a stock is overvalued or undervalued relative to its intrinsic value.
- Avoid overvalued stocks or high debt companies to lessen risk.
Technical analysis
- Time the entry into an already filtered fundamentally sound stock.
- Manage the investment execution.
- Time an exit for the investment.
