Technical Analysis vs. Fundamental Analysis

Traders use a variety of methods to analyze markets and securities in search of potential buy or sell opportunities. While each market participant may rely on their own “secrets” to find these opportunities, almost all traders belong to one of two camps – fundamental analysis or technical analysis. In this article, we will introduce both approaches and explain the basic principles of each. Note also that while we will be covering these topics in terms of the currency market primarily, fundamental and technical analysis is also applicable to the evaluation of other securities such as equity stocks.

Fundamental Analysis

Fundamental analysis attempts to determine the appropriate value of a security by evaluating the economic conditions that could affect the price of the security. Traders are looking for a good buy candidate (i.e. an under-valued security that will appreciate in value) or a good short-sell opportunity. In the case of a specific corporate stock, fundamental analysts examine the underlying company’s artifacts such as P & L statements and outstanding orders; for a currency, fundamental analysts look at the economy of the country.

Interest rates in particular have a major impact on the value of a currency and investment opportunities can often be identified when a change in interest rates is likely. In order to understand when interest rates may change however, one must first have an understanding of a country’s current economic conditions and the overall monetary goals of the government – or central bank as appropriate – for the jurisdiction. For this information, fundamental analysts rely on a series of economic measurements often referred to collectively as economic or leading indicators.

Leading indicators provide feedback on the present state of the economy, and by extension, the strength of the country’s currency in relation to other currencies. Leading indicators are published by the government or other authorized institution and includes such common and well-known metrics as Gross Domestic Product (GDP), Consumer Price Index (CPI), Retail Sales, and the Trade Balance report to name just a few. For more information, see the article on leading indicators.

Most jurisdictions publish a calendar that lists when each indicator is due to be announced and speculation often intensifies in the time leading up to an announcement. This is particularly true in the case of some of the more influential indicators such as employment reports and interest rate announcements and many of the larger broker / dealers often put forward their predictions based on what “the street” expects.

You should pay close attention to the expected results put forward by the experts – when expected results match the actual results, market reaction will be somewhat less dramatic even if the results are not particularly positive for the economy. However, when the actual results differ from the expected, considerable volatility in the currency price often results. If followers of the U.S. dollar for example expect a rate cut of just 25 basis points in an upcoming interest rate announcement, the news will have little effect on the USD as the announcement merely confirms what is already expected.

On the other hand, if the street does not expect a cut to the Federal Funds target rate but the Fed goes ahead with a quarter-point cut, this will catch some investors off-guard and it is likely that there will be considerable trading action for the U.S. dollar soon after the announcement. In short, the market does not like uncertainty and anything falling outside the expected often leads to some short-term instability for the affected currency.

Technical Analysis

Technical analysis differs from fundamental analysis in that it does not seek to identify the appropriate price for a currency or security. Instead, technical analysts track historical prices and volumes in an attempt to identify trends. Technical analysts use charts and graphs to quantify historical performance to identify repeating patterns as a means to signify buy and sell opportunities – for this reason, technical analysts are sometimes referred to as chartists.

The field of technical analysis is based on three important assumptions:

1. The price of a security automatically factors economic conditions.

Technical analysts do not consider factors such as interest rates and other fundamental indicators when evaluating a security. They believe that any impact that economic conditions could have on a currency will automatically be factored into the price of the security through the natural actions of buyers and sellers within the market.

2. When it comes to pricing, history tends to repeat itself.

Technical analysts believe that prices move in trends and price movements generally follow established patterns. Some commentators attribute this partly to the phenomenon known as market psychology (or more euphemistically as herd mentality) which is based on the widely-held belief that participants in the markets – who for the most part have the same goals and objectives – react in a similar fashion when faced with similar situations.

In some instances, this may even be a unconscious aversion to breaking a certain price barrier such as the case in September of 2007 when the Canadian dollar reached parity with the U.S. dollar or when oil finally broke the $100 a barrel mark. Both events eclipsed long-standing price barriers and oil in particular saw the price see-saw back and forth several times before finally breaking through the $100 plateau in January of 2008.^[1]

3. Future price changes follow established trends.

As noted, technical analysts look for trends as a way to predict future prices and this is the strategy most commonly-used by technical analysts. Essentially, there are three self-explanatory trends:

• Uptrend
• Downtrend
• Sideways / horizontal

Chartists believe that future price movement is tied closely to the current trend and while trend reversals are inevitable, often times there is sufficient historical data available to identify potential reversal points.

Comparing the Two Approaches

Whether as a trader you subscribe to fundamental or technical analysis depends somewhat on your trading style. Technical analysts point to the unavoidable lag between the time that economic data is collected for the tabulation of various leading indicators, and when it is analyzed and finally released. Because these reports are evaluating conditions from one to three months or more in the past, technical analysts downplay the value of studying fundamentals and dismiss this approach as being based on stale information.

Chartists believe that serious market watchers already have a ‘feel” for market conditions and do not need to wait for two consecutive months of negative GDP growth for instance, to recognize that the economy is in recession. The exact level of recession may not be known, but it will be well understood by all market participants that the economy is shrinking and this will naturally affect currency rates and prices. The fact that expert market commentaries are widely-available and most news items won’t come as a shock to diligent traders only reinforces the technical analysts’ belief that trends are a far more effective means of determining sound trades.

This is not to say that technical analysis is free from its own set of detractors; and fundamental analysts warn that those that choose to ignore the influence of the economy on the markets do so at their own peril. One need only witness the effect that unexpected news such as higher inflation or higher unemployment can have to realize that some correlation does exist. The expression “flight to safety” is a specific reference to investors spooked by economic news turning to traditional safety nets such as bonds and GICs in times of uncertainly.

Despite this – and while it is tempting to think of fundamental analysts and technical analysts as being on opposite sides of the fence – the reality is that most successful traders employ methods from both disciplines even if favoring one approach over the other. The larger brokers with a more conservative investment approach have historically favored fundamental analysis but nevertheless maintain technical analysts on staff as well. In the end, the best approach for you depends on your specific trading strategies and goals.

Whether you consider yourself a fundamental analyst or a technical analyst or vice versa, your primary goal should be to gather as much relevant information as possible. While the debate between fundamentals and technicals will not be resolved any time soon, when it comes to successful trading strategies, the best approach is to be as informed as possible and to employ a methodology with which you are comfortable and provides you with consistent and favorable results.

Efficient Market Hypothesis

No discussion of technical and fundamental analysis could be complete without some mention of the Efficient Market Hypothesis. This theory was introduced in the mid-60s by economist Eugene Fama and basically states that all news and information for any security is automatically reflected in the security’s price. Variances in the price are based on subsequent news and information and because prices incorporate this information immediately, prices themselves are random (i.e the “Random Walk Theory”) – therefore, future prices can not be predicted beforehand. Please see Efficient Market Hypothesis for more information.

References

1. ↑ Now barely five months later, oil shows no sign of stopping and is currently flirting with $125 a barrel (May 8, 2008)

Related Links

Leading Indicators