Chapter 3-3 Technical Analysis vs. Fundamental Analysis
Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. Technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals. Let’s get into the details of how these two approaches differ.
The Differences: Charts vs. Financial Statements
At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements. By looking at the balance sheet, cash flow statement and income statement, a fundamental analyst tries to determine a company’s value. In financial terms, an analyst attempts to measure a company’s intrinsic value. In this approach, investment decisions are fairly easy to make – if the price of a stock trades below its intrinsic value, it’s a good investment. Although this is an oversimplification (fundamental analysis goes beyond just the financial statements) for the purposes of this tutorial, this simple tenet holds true. Technical traders, on the other hand, believe there is no reason to analyze a company’s fundamentals because these are all accounted for in the stock’s price. Technicians believe that all the information they need about a stock can be found in its charts.
Fundamental analysis takes a relatively long-term approach to analyzing the market compared to technical analysis. While technical analysis can be used on a timeframe of weeks, days or even minutes, fundamental analysis often looks at data over a number of years.
The different timeframes that these two approaches use is a result of the nature of the investing style to which they each adhere. It can take a long time for a company’s value to be reflected in the market, so when a fundamental analyst estimates intrinsic value, a gain is not realized until the stock’s market price rises to its “correct” value. This type of investing is called value investing and assumes that the short-term market is wrong, but that the price of a particular stock will correct itself over the long run. This “long run” can represent a timeframe of as long as several years, in some cases.
Furthermore, the numbers that a fundamentalist analyzes are only released over long periods of time. Financial statements are filed quarterly and changes in earnings per share don’t emerge on a daily basis like price and volume information. Also remember that fundamentals are the actual characteristics of a business. New management can’t implement sweeping changes overnight and it takes time to create new products, marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use a long-term timeframe, therefore, is because the data they use to analyze a stock is generated much more slowly than the price and volume data used by technical analysts.
Trading Versus Investing
Not only is technical analysis more short term in nature that fundamental analysis, but the goals of a purchase (or sale) of a stock are usually different for each approach. In general, technical analysis is used for a trade, whereas fundamental analysis is used to make an investment. Investors buy assets they believe can increase in value, while traders buy assets they believe they can sell to somebody else at a greater price. The line between a trade and an investment can be blurry, but it does characterize a difference between the two schools.
One of the major premises of technical analysis is that history repeats itself. For the technician the recurrence of identifiable patterns and formations that have preceded important movements of the market in the past provide important clues as to the probable direction of price movement in the future. Chart patterns are formations that appear on the charts which provide you with forecasting tools of impending price movement. Some patterns are more reliable than others for price forecasting. . None of the chart patterns are infallible. They have a high probability of success but are not guaranteed to work all of the time. Technicians must always be on the alert for chart signs that prove their analysis to be incorrect. After trend lines, support and resistance lines have been drawn on a chart, one of the most important and most difficult decisions you will have to make is determining the timing of entering and exiting the market as well as determining when a major top in a rising market or a major bottom in a declining market has occurred.
There are two types of patterns that develop on charts, the reversal pattern and the continuation pattern. Reversal patterns indicate that an important reversal in trend is taking place. Knowing where certain patterns are most likely to occur within the prevailing trend is one of the key factors in being able to recognize a chart pattern. Some of the most common reversal patterns include; the head and shoulders top and bottom, double tops and bottoms, triple tops and bottoms, key reversals, island reversals, rounding bottoms and tops, “V” formations or spike bottoms and tops. There are a few important points to be considered which are common to all of these reversal patterns.
- The existence of a prior major trend is an important prerequisite for any reversal pattern – If a price pattern has not been preceded by an existing trend, there is nothing to reverse and the pattern would therefore be suspect. Knowing where chart patterns are most likely to occur within a price trend is one of the key factors in identifying price patterns.
- The first signal of an impending trend reversal is often the breaking of an important trend line – The breaking of a major trendline signals a change in trend, not necessarily a trend reversal. The breaking of an uptrend line might signal the beginning of a sideways trend which may later form either a reversal or continuation pattern.
- The larger the pattern the greater is the price movement potential – The height of the pattern measures the volatility, the width of the pattern measures the amount of time required to build and complete the pattern. The
greater the height of the pattern (the volatility) and the longer it takes to build, the more important the pattern becomes and the greater the potential for the ensuing price move.
- Topping patterns are usually shorter in duration and more volatile than bottoms – Price swings at major tops are wider and more violent. Tops usually take less time to form than bottoms. For this reason it is usually less risky to identify and trade bottoms than tops however the time spent in establishing a top is generally shorter than the time spent establishing a market bottom. Therefore, a market manager can generally do better by trading the downside of the market rather than the upside of the market. This has important implications for farm managers, due to the fact that the natural tendency is to trade the former rather than the latter.
- Volume is usually more important on the upside – Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. The completion of each pattern should be accompanied by a noticeable increase in volume, particularly at market bottoms. Market tops tend to fall on their own weight once a trend reversal is underway. At a market bottom, if the volume pattern does not show a significant increase following the upside breakout, the entire price pattern should be questioned. The second type of chart pattern is the continuation pattern. Continuation patterns suggest that market is only pausing for a while before the prevailing trend will resume. Another difference between reversal and continuation patterns is their time duration. Reversal patterns usually take much longer to form on the chart and represent major changes in trend. Continuation patterns, on the other hand, are usually shorter-term in duration and are often classified as intermediate term chart patterns. Some of the most common continuation patterns include; flags, ascending and descending triangles, symmetrical triangles, pennants, gaps, and rectangles
Technical indicators are additional tools used by the technician in order to develop commodity price forecasts. In this section you will examine a few of the more popular technical indicators used to supplement the basic analytical tools of support, resistance and trendlines. These include: moving averages and oscillators.
The moving average is a trend following indicator which is easy to construct and one of the most widely used mechanical trend following systems used. A moving average, as the name suggests, represents an average of a certain body of data that moves through time. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is subtracted. The new total is then divided by the total number of days (10) and the resultant average computed.
The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it much easier to view the underlying trend. The decision as to what time period to include (10 day, 30 day, 40 day) as well as the type of chart (daily, weekly, or monthly) is a subjective one that you will have to make for yourself. If a shorter time period is used (i.e. 10 day moving average), the resultant trend line will exhibit a greater degree of trend variation than a longer term moving average, such that the underlying trend may be more difficult to determine. If a longer term moving average is employed (i.e. 40 day
moving average) the time lag between the transformation from an uptrend to a downtrend will be delayed long after the change of price trend is underway. In some markets, it is more advantageous to use a shorter term moving average, and in others, a longer term average proves to be more useful.
Generally the closing price is used to compute the moving average, however opening, high, low and mid point of the trading range values can also be selected. Several types of moving averages can be calculated. Some analysts believe that a heavier weighting should be given to the most recent data and in an attempt to correct this problem, construct other types of moving avenges such as the linearly weighted and exponentially smoothed moving average. The most common application is the simple moving average as discussed above.
In a simple moving average each day’s price receives equal weight. The moving average is plotted on the bar chart on top of the appropriate trading day and along with that day’s price action. When the daily closing price moves above the moving avenge a buy signal is generated. When the daily closing price moves below the moving average a sell signal is generated.
If a very short term moving average is employed, numerous crossovers will occur such that the trader may be exposed to many false signals and higher commission costs of trading. If a longer term moving average is used the trader may be too slow in responding to a change in trend, forsaking much of the profit potential. A shorter term moving avenge works best in a sideways trending market, allowing the trader to capture more of the shorter swings. A longer moving avenge works best in trending markets, allowing the trader to stay with the trend and minimizing the chance of
getting caught in short term corrections. The correct approach is to use a shorter average during non-trending periods and a longer average during trending periods.
Moving averages are trend following systems which do not have forecasting capabilities. They are used only to help in identifying the underlying trend and as an aid in entering and exiting the market. One of the greatest advantages in using a moving average is that by nature it follow the trend and by selecting a suitable time period, allows profits to run and losses to be cut short. This system works best when markets are trending. During choppy or sideways markets a non trending method such as an oscillator will yield better results.
An oscillator is an extremely useful tool that provides the technical trader with the ability to trade non-trending markets where prices fluctuate in horizontal bands of support and resistance. In this situation, trend following systems such as the moving average do not perform satisfactorily, as many false signals are generated. The oscillator can also be used to provide the technician with an advance warning of short term market extremes, commonly referred to as overbought and oversold conditions. Oscillators provide a warning that a trend is losing momentum before the situation becomes apparent in the price action which is referred to as divergence. As is the case with other types of technical tools there are times when oscillators are more useful than others and they are not infallible.
The concept of momentum is the most basic application of oscillator analysis. Momentum measures the rate of change of prices by continually taking price differences for a fixed time interval.
The formula for momentum is: M= C-Cx
Where C is today’s market close and Cx is the close “x” days prior. To construct a 10 day momentum line, today’s closing price is subtracted from the closing price 10 days ago. If the most recent closing price is lower than the closing price 10 days prior, a negative number will be generated. Conversely if today’s closing price is higher than the closing price 10 days ago a positive number will be generated. These values are then plotted on the top or bottom of the bar chart with a horizontal zero line in the middle. As with the moving avenge, the number of days chosen to compute the oscillator can vary, with shorter term oscillators (5 day) producing a more sensitive line with more pronounced oscillations. A longer term oscillator (20 days) produces a smoother line in which the oscillator swings are less pronounced.
By plotting price differences over a fixed period of time, the technician is studying rates of change in price trends. If prices are rising and the momentum line is above zero and rising, an accelerating uptrend would be in place. If the momentum line begins to flatten out, the rate of as cent indicates that the uptrend has leveled off and provides the technician with a lead indication that the uptrend may be coming to an end. Because of the nature of its construction, the momentum line will always lead the price action. It will lead the advance or decline of prices by a few days, and then will level off while the current price trend is still in effect, before moving in the opposite direction as prices begin to level off
The most widely followed momentum oscillator in technical analysis is Welles Wilder’s Relative Strength Index (RSI).
The formula for the RSI is as follows:
The RSI is plotted on a graph with a vertical scale from zero to one hundred, with highlighted horizontal lines drawn at scaled values of 30 and 70. The horizontal axis corresponds to the time line on the bar chart.
Interpretation of the RSI is twofold. First the areas on the chart above seventy and below thirty are critical areas for the technician. When the indicator is in the area above 70, the market is said to be overbought. When the indicator is in the area below 30, the market is said to be oversold. These terms refer to a market condition where prices have moved too far too quickly, such that the technician can expect a correction to take place before the market resumes its trend.
One of the most valuable ways to utilize an oscillator is to watch for a divergence. A divergence describes a situation when the trend of the oscillator moves in a different direction from the prevailing price trend. In an uptrend divergence occurs when prices continue to rise, but the oscillator fails to confirm the price move into new highs. This often provides an early warning of a possible price decline and is called bearish or negative divergence. In a downtrend, if the oscillator fails to confirm a new low in the price trend, a positive or bullish divergence exists, which warns of a potential price advance. An important requirement for divergence analysis is that the divergence should take place near the oscillator extremes of 70 and 30 respectively.
Various chart patterns show up on the RSI indicator as well as support and resistance levels. Trend line analysis can then be employed to detect changes in the trend of RSI. The process of updating the RSI on a daily basis is greatly facilitated by accessing technical analysis software programs on a personal computer to perform the calculations and plot the indicator on the bar chart.
The price at which a commodity changes hands is established by the interaction of the supply of the item and demand for it. The fundamental analyst focuses on two facts about this transaction. First, that, other things being equal, a current higher price results in a larger supply at some future time (this is the law of supply). And, second, though no less important, a higher price will, at some point in the future, impede the sale of the item (this is the law of demand). Of course, both of these propositions are assumed to be reciprocal with regard to lower prices.
Fundamental and technical traders disagree about techniques for forecasting the future and perhaps even about when the “future” really is. For the trader who relies principally on fundamental tools, the future may be the next crop year or the next month or even the next week. Rarely is it the next day, hour, or minute, as is so often the case for the technician. The “fundamentalist” assumes that, within limits, enough information is available to predict the direction of prices for some period of time. Consequently, the fundamental view incorporates the idea that the market is not perfect. In a perfect market, all traders would have equal knowledge and the ability to apply that knowledge, and no one would be able to gain from it consistently. In fact, as Holbrook Working has noted, difference of opinion is the source of much trading. According to Working, differences of opinion arise because “the amount of pertinent information potentially available to traders in most modern markets is far beyond what anyone trader can both acquire and use to good effect,” Thus, traders are selective about the information they use, or circumstances dictate that they have access to only a limited range of information. Either way, differences of opinion and consequent transactions occur.
The fundamentalist also diverges from the technician in emphasizing the importance of underlying economic forces in establishing price-in “knowing” why price changes happen. Although some technicians may view the attempt to explain price movement with supply and demand balances, carryover stocks, and reports of economic activity as hopelessly naive, in fact few successful technical traders operate purely on the signals emanating from the charts.
At its base, fundamental analysis is nothing more than trying to figure out whether the forces of supply and demand will result in a price level higher or lower than the one prevailing at the time of analysis. In that sense, looking at the fundamentals is always a relative proposition. The analyst asks: “Will supplies be tighter or demand less intense a year from now? A month from now? Tomorrow?”
Analysts, regardless of their level of sophistication, rely on a model of the market. This may be as complex as multiple equations running on high-speed computers or as basic as an estimate of production and consumption derived from a cursory reading of the newspaper. Good fundamental analysis requires good information, however, and the first prerequisite for obtaining it is the judgment necessary to sort the meaningless from the meaningful in a blizzard of information.
Computer models play an increasing role in fundamental price forecasting. Elaborate equations describing the reaction of the market to changes in supply and demand of both the commodity itself and competing or complementary
items can be devised to forecast prices. Some models are extremely successful, but even the best must be adjusted frequently to take into account changing market structures. The cost and complexity of econometric models generally places them out of the reach of the average trader. Many are developed and run by firms with sizable research staffs and direct access to information on physical trades.
Even so, it is possible for the layman to collect sufficient data to develop an informed view of the market. The success of the individual analyst depends largely on the intensity of study, but a healthy dose of inspiration is often helpful. It is hard to be a successful generalist. For the novice, after reviewing a range of commodities for potential, the wisest course should be to focus on one or two and to get to know the factors that are most likely to-drive prices up or down from current levels. At this point, the serious trader regularly follows the data that will move the market. A loose-leaf notebook divided into sections for each of the factors to be followed is enough, if it is kept religiously.
The sad truth of fundamental analysis is that you can be right about the direction of the market and still miss the move. How many fundamental analysts have moaned, “I was right on the fundamentals, but my timing was off.” In too early. Stopped out. Chasing a market you “knew” was going to take off. It happens. But worse and far more dangerous than missing the move is becoming so wrapped up in supply and demand numbers that “unarguable” fundamentals fuel a speculative fever. That is precisely the time when the prudent trader turns to basic risk/reward and technical analysis for guidance.
Finally, we need to realize what fundamental analysis is not. It is not a premature peek at a sensitive government report that makes possible a killing on the floor of the exchange. The film Trading Places is a fundamentalist fantasy in which audacious junior traders outwit crooked Big Money and triumph in one incredible hour of frenetic activity in the orange juice pit. Reality puts the good fundamental trader in the market after studying weather conditions, reviewing private forecasts, talking to knowledgeable growers, and so forth.
Why Do It?
Why look at the fundamentals? The short answer is to avoid being surprised by the market. If we accept the basic laws of economics, in any given year the balance between supply and demand will shape prices. Therefore, having some idea of how these factors are aligned, or are likely to be aligned, should be a valuable trading tool. There are also times when the fundamentals allow one to get a jump on a major move. Correctly anticipating the impact of news on the market is one aspect of fundamental trading.
However, as noted earlier, being buried alive in carryover stocks or nourished only with an alphabet soup of PPIs, CPIs, Ms and GNPs can easily put the fundamentalist out of touch with market perceptions or expectations. In those all-too-frequent cases, the fundamentalist can wake up far behind or well in front of the forecast move.
Fundamental analysis is all about discovering the primary factors involved in establishing supply and demand and determining the influences those forces will have on the price of a commodity. It is obvious that no analyst can know
everything about even one market. Moreover, there is virtue in keeping things simple. More than one analyst has discovered that. Every variable added to the equation introduces the opportunity for error. Timeliness is important, too, but it is possible to overemphasize the advantage gained by being among the first to possess a particular nugget of information. Markets, particularly modern futures markets, are efficient discount mechanisms. As information that has a price impact percolates through a market, it is quickly incorporated into the price. Irwin Shishko, co-author with Stanley Kroll of The Commodity Futures Market Guide, has noted that “the central problem of attempting to base trading decisions on an analysis of changing fundamentals… [is that] it is difficult or impossible to gauge prices better than the collective wisdom of all traders, a wisdom that is already pretty accurately reflected in the market.”
Difficult, but not futile. Good fundamental analysis depends on selective use of available information and careful .interpretation of the data. The only way to develop the foundation is to read, listen and diligently study the forces shaping market prices. Although some general rules apply to all markets, success comes with an understanding of the unique features of individual markets. And, as we shall see in a detailed look at the sugar market later in this chapter, one often overlooked element of the analysis is keeping an eye on the expectations of other traders. Taking a position on the basis of a detailed review of supply and demand numbers even when the analysis is correct can be costly rather than profitable if no one else believes it at the time. There is small satisfaction in being ultimately right, if it costs you money.
How the Fundamental Analyst Looks at Markets
Obviously, markets are affected by different forces. The good analyst is attuned to the most important general influences-such as interest rate fluctuations, leading economic indicators, and the general state of the economy. This is information available in the popular press and financial publications such as The Wall Street Journal, Barron’s, Business Week, and others. More specific information may come from brokerage house reports. In addition to primary data, government publications are also an excellent source of analysis. The USDA, the Federal Reserve, and the Departments of Commerce and Labor publish reports that are the basis of even the most sophisticated models, and this information is available at a relatively low cost and in a timely fashion. Government agencies also provide analysis of long-term trends, and although these reports tend not to focus on price effects, they can be useful in formulating a view of the market.
Another outstanding compendium of information on commodities traded on futures markets is the Commodity Yearbook, published by the Commodity Research Bureau. It contains hundreds of tables of relevant information on the full range of commodities and clearly written articles on individual markets that outline the basic elements of supply and demand, and the role each plays in establishing price levels. Finally, the Chicago Board of Trade publishes a Commodity Training Manual that briefly describes the fundamental factors for many important futures markets.
The trader who wishes to concentrate on an individual commodity may consider subscribing to a specialized service that reports on supply and demand developments or physical transactions in a given market. Unfortunately, such services are usually expensive, and can cost anywhere from a few hundred dollars to several thousand annually. Most employ a staff of analysts to assemble information on changing production and consumption expectations. They may also describe market sentiment and physical trading activity-knowledge difficult or impossible to obtain from the popular .
press. Information on the leading private reporting services is available from the research department of any major brokerage house.
We have touched on supply and demand, but what factors should we include in analyzing them? First, let’s look at demand. In general, demand is reflected in data on consumption, or “disappearance.” The main factors influencing demand are population growth, income levels, and economic cycles. On the supply side, we are nearly always interested in production of the commodity. Stocks or inventories are a crucial element of supply and are often quite difficult to estimate. In fact, inventory data for a broad range of commodities, particularly agricultural products, are less reliable than those for production or use because they are frequently calculated from production and consumption information. Thus, any error in supply or use figures gets included in stocks. Over time, the data can be distorted. However, inventory figures tend to be most accurate when stocks are lowest (i.e., during periods of high prices). Stocks at those times usually provide a good indication of the level of minimum “working” inventories. Imports and exports-trade flows-are an aspect of both supply and demand and should be watched carefully if the commodity is internationally traded.
The careful fundamental analyst recognizes that not all factors are equal, that all markets are affected by general economic conditions, and that different causal keys open the doors to understanding different markets. The most important factors at work in major markets. We call these the high-impact variables-those with the most immediate or serious effect on prices.