In Part 1, I took a look at a fundamental analysis of stocks and how it tries to get rid of some of the uncertainty that stock picking bears.
The trend is your friend
The second approach is referred to as technical analysis. The reason why I decided to talk about it is the fact that it could be seen as the outright opposite of fundamental analysis. Technical analysis solely focuses on the history of stock prices and tries to predict the future movements of the price. Three assumptions underlie the concept of technical analysis:
- The market already discounts all available information in the price. That is basically equivalent to market efficiency and eliminates the need to evaluate the value drivers separately. Thus, price movements are the key focus and assumed to be the product of supply meeting demand.
- Prices move in trends, which makes future movements more predictable.
- History repeats itself.
The first assumption seems to be the strongest and most controversial. There are plenty of papers that provide evidence against market efficiency and I’m not going to object inefficiency.
Assumption two appears to be plausible. A lot of tools on technical analysis aim to identify trends and try to predict a possible reversion of them.
I think that assumption three is a key point that justifies technical analysis. Historic prices reveal information about human behavior in certain situations. Identifying those “certain situations” and the resulting behavior of market participants makes predictions of future behavior feasible, as long as no changes in the investors’ behavior arise and the market’s situation is considered to be ‘normal’. That, in turn, asks for a definition of ‘normal’, which is probably rather a subjective matter than a general consensus. However, everyone would certainly agree that the recent crisis doesn’t count as ‘normal’ which suggests that during that time technical analysis would have most likely failed to predict future price movements.
Regardless of the discussion whether technical analysis works or not, I would like to present some basic ideas, tools and techniques technical analysts use.
Trends, Support and Resistance
As already mentioned trends play an important role in technical analysis. A large part of technical analysis is about identifying trends and their reversals, and ideally, do so before others do.
Probably most people have some sort of idea what a trend in general is and associate a trend in stock prices with stock prices tending to go either up or down over a certain period of time. However, technicians use a more refined definition of a trend: an upward trend is defined as a series of higher highs and higher lows whilst a downward trend is defined as a series of lower high and lower lows. To get the idea, imagine the up and down fluctuations of a price as peaks (highs) and troughs (lows). What you get over time is a series of peaks and troughs, a series of highs and lows. If the highs and lows increase over time, you have an upward trend; the highs and the lows are ‘higher’ than they were before, which means that you have higher highs and higher lows. The logic for a downward trend is similar.
Trends can be classified into different time horizons. A long term trend, e.g. over two years, may include different intermediate trends over a couple of months, which in turn might include some short term trends over a couple of weeks.
A key concept of technicians are trendlines. Trendlines, as the name says, simply are lines in the chart that represent the trend. A trendline that connects the lows is called the support line of the trend. When a peak has been reached and the price is on its way to the next trough, the support level tells the technician at which price level the next trough is going to occur, which is the level at which the price is going to increase again, according to the trend. The support of a stock can be seen as a lower bound that the price is unlikely to undershoot.
An equivalent concept to the support level is the resistance level. The resistance line connects the highs of a trend and therefore indicates when the next peak is reached and when the price is likely to decrease again. Thus, it can be interpreted as an upper bound that is hard to exceed.
In order to predict future trends and/or reversals of trends, different chart patterns can be used as indicators. The concept of patterns heavily relates to the third assumption, which states that history repeats itself. Relying on this assumption, identifying certain patterns in the chart allows to predict future price movements. Generally, the patterns can be categorized into continuation patterns, which indicate that the present trend is going to continue, and reverse patterns, that indicate a reversal of the trend.
A common continuation pattern the Triangle. A Triangle is present when the resistance line and the support line converge to each other. The technician steps in when one of the trendlines is broken: the price is expected to break out in the respective direction. The closer the break of the trendlines is to the point where the different lines meet each other, the more severe is the following break out of the price expected to be. Triangles can take three different forms: symmetric, ascending and descending. The symmetric triangle can appear in both upwards and downwards trending markets and is defined by the two trendlines moving symmetrically to the point of convergence. The price breakout is expected to be in the direction of the overall trend.
An ascending triangle can be found in upwards trending markets and is represented by an upwards sloping support line and a horizontal resistance line. Technicians expect the upward trend to continue. The descending triangle is the counterpart for descending markets and consists of a horizontal support line and a descending resistance line.
A common reverse pattern is the head and shoulders pattern. As the name says the pattern consists of two shoulders and a head in the middle. In an upward trend the each shoulder and head are represented by highs, with the head exceeding the shoulders. The pattern itself has a support line (in a bullish market) which can be compared to some sort of neckline for the head. The lows (between the head and the two shoulders) lie on this neckline. In a bearish market, the pattern has the inverse structure of the bullish market. After the second shoulder the previous trend is expected to reverse.
These are only two of many patterns. However, there are no concrete rules where to start drawing the trendlines and it can be quite hard to indentify the pattern before the price already broke out.
There is an economic intuition behind a lot of patterns that is based on the interaction between supply and demand that drives the prices and for the interested reader there is a lot of material that can be found online.
Moving Averages and Oscillators
A moving average simply is the average over a fixed period of time. Despite their simplicity, moving averages are useful tools for technical analysts.
There are several ways to use moving averages, some of the most important are: identifying a trend by smoothing out some of the fluctuations, predict trend reversals when the price crosses the average, using the average as a proxy for support and resistance levels and calculate momentum oscillators. Those momentum oscillators are measurements of whether a stock is overbought or oversold. The former is the case the case when a price moved up too far and too fast and the opposite logic applies for the case of overselling. In that sense the momentum oscillators measure possible overreactions that might get corrected by the market. That could lead the investor to go short in a bullish market and go long in a bearish market, which goes against the usual intuition.
So…how do I finally get rich: with fundamental or technical analysis?
First of all, it needs to be mentioned that technical analysis often focuses on a shorter period of time and is therefore often referred to as speculating, which finds some justification in the fact that technicians try to exploit fluctuations of the price and are not interested in any fundamentals.
Despite that distinction, there are successful investors in both camps and comparing them in order to select a winner is hard.
But there is no reason why both approaches should only be used separately. For example, a brief technical analysis could be used as a first screening tool to identify attractive stocks that are worth the effort of a thorough analysis of the fundamentals.
Another thinkable way to combine both methods is to perform them both and compare the results. In order to limit the workload, multiples could be used for a first screening. Ideally both approaches come to the same conclusion, underscoring each other’s result.
If they come to opposing conclusion, deeper analysis needs to be undertaken in order to explain the differences in the perception of the stock. Extreme cases are bubbles: the market’s irrationality drives the price further up (technical analysis suggests to go long) even though the fundamentals don’t support the upward trend (the stock is overvalued and should be shorted).
It could also be the case that fundamental analysis concludes that the stock is priced fairly while the technical analysis suggests to entry a new position. In that situation, the reasons why the market is collectively bullish (or bearish) should be investigated. Trying to exploit the mispricing can be dangerous since the perception of the market can simply be wrong and an analyst should look for technical signs that predict a reversal of the (wrong) trend.
The situation where no trend is apparent but the fundamental analysis suggests that the stock is overvalued or undervalued is ideal to combine both approaches: price movements are the results of trades on the markets; no trades, no change in prices. This makes the plain knowledge of a stock being over- or undervalued not really satisfying, since the market still needs to react. Technical analysis helps to time the entry into new positions (breaking the resistance or support line). That means the fundamental analysis spots the potential investment and the technical analysis times the entry.
No chicken for free
In the end, neither fundamental analysis nor technical analysis can guarantee success. Both have their advantages and disadvantages and which approach is more promising depends on numerous factors, an important one being the time horizon of the investment. Technical analysis appears to be quite hard to implement successfully to me and seems to require a lot of experience. The clearer, quite straightforward and intuitive methodology makes fundamental analysis probably more approachable for many people. From a perspective of responsible and sustainable investing, fundamental analysis is certainly ahead.