Fundamental versus technical analysis

Buyers and sellers on a public market determine the market capitalization of a company through regular buying and selling. In contrast, a company’s intrinsic value is worked out using potentially complex and lengthy spreadsheets based on a plethora of data points.

The purpose of fundamental analysis is to calculate the intrinsic value of a stock by gathering economic and financial data.

If a stock’s intrinsic value is higher than its stock price, the market may be underestimating the company’s stock market valuation. Investors will typically buy stocks in this category under the assumption that other investors will recognize the stock’s discounted valuation and eventually bid up its price.

Technical analysis ignores all fundamental data in favour of a standard stock chart. Technical analysts will study a chart in an attempt to predict future direction based on past price patterns. As a very basic example, suppose a stock came close to trading above $20 per share on four separate occasions over the past two years. Each and every time it approached the $20 threshold, the stock sold off back to $19. This is a pattern that, according to technical analysts, cannot be overlooked and should be considered when making an investment decision.

Technical analysis extends above and beyond simply looking at a chart for identifiable patterns. Here are some of the commonly used technical analysis tools:

• Average Directional Index (ADX), which is a trend indicator that calculates the specific strength of an observable trend
• Moving Average Convergence Divergence (MACD), which is a trading indicator often used for entry and exit points
• Relative Strength Index (RSI), which suggests whether a stock is overbought or oversold

One of the criticisms of technical analysis is that some market participants may rely on it too much. Since all technical analysts are looking at the same chart and coming to the same conclusion, it can result in groupthink when large hedge funds or institutional investors simply encourage smaller investors to follow the trend.

Also, a common saying among detractors of technical analysis is “a pattern is real until it isn’t.” That is, a pattern could repeat itself without fault three times in a row only to behave erratically and unpredictably the fourth time.