Technical Fundamental and Empirical Analyses Finance Essay

In this research paper, we are going to describe fundamental, technical and empirical analyses. In order to predict high return and to receive a reward for the risk taken, financial investors and traders use different analysis and models. It is very important which position do investors/traders take toward these analyses. Moreover, by deciding which analyses they will use while investing, it directly and indirectly affects their investments and returns. Every investor investing in financial market in any asset would seek and hope that it will generate income or that the asset will appreciate in the future. In the economic sense, the investment is called the purchase of a good which is not consumed today but will be used in the future to create prosperity, however, in finance, an investment is a financial asset which is bought with the thought that the specific asset will generate income in the future or will gain value in order to be sold at a higher price. However, predicting the future value of an asset is not easy. This is the main reason why investors and many researchers have developed many strategies and models so the predictions of their investments are more accurate. There have been huge discussions which analyses are more accurate in predicting the future value of an asset. For this paper we are going to briefly elaborate Technical, Fundamental and Empirical Analyses. Each of these Analyses has its own weight toward the prediction of the future value. Technical Analysts strongly believe that past performance of an asset in markets are good indications of future performance. Fundamental Analysts do evaluation of a security by examining related economic, financial and different qualitative and quantitative factors. Empirical Analyses, in our case Capital Asset Pricing Model and Fama and French Model, are models which are developed to predict the future value of a security by taking into account the risk and premium. This paper is constructed as follows: Section I describes technical analyses, fundamental analysis are described in the Section II, Section III deals with Empirical Analyses, Section IV is Theory Comparisons and finally in Section V conclusion and recommendations.

Literature review

Technical Analysis

In attempting to explain the technical analysis the best description is found in Investopedia.com (2009) where technical analysis are described as a technique of evaluating securities by analyzing statistics which are generated by market activity, such as earlier period prices and quantity. Technical analysis do not attempt to measure a security's intrinsic value, but rather use charts and different tools to identify model that can recommend future activity. Moreover, technical analysts strongly believe that the past performance of stocks and markets are a hint of expected performance of a stock or market. W.LO et al (2000) define technical analysis, which are also known as "charting" as a practice that has been used for many decades; however, the discipline itself has not been given the same level of academic examination and acceptance as fundamental analysis did. Furthermore, numerous academic researchers recommend that even though its terminology and methods used, technical analysis may be a very good tool for giving useful information from market prices. Westerhoff, F. (2006) argues that volume gives an important confirmation of price action; increasing volume points out a strong trend, whereas decreasing in volume points out a weakening trend. Fyfe et al (1999) cite different studies which show that opposite to the Efficient Market Hypothesis, the volume traded and price of volatility are large, which both show important autocorrelation. According to Jagric et al (2005) Efficient Market Hypothesis is an investment theory which affirms that it is impossible to "beat the market" since stock market prices always incorporate and reveal all important information. Furthermore, this means that a stock will always trade at their reasonable value, which makes impossible for any investor to either buy at a lower value, or sell at a higher price. From the word technical analysis, we have also the word technical analysts. According to Yonatan Rom CEO of the Winning Edge, technical analysis has three key advantages. The first advantage of technical analysis is that can be modified to any trading medium or time horizon. The second one is that, technical traders can alter their investment horizon to whatever they want because they get daily, weekly, monthly or intraday charts. The very last advantage of technical analysis is that investors can look at any market at a time, instead of a narrow range of investment as other analysts do, which takes too much time. Yet, technical analysis remains an important "tool of trade" for professional traders. In a survey conducted with traders in the foreign exchange market, Taylor and Allen (1992) found that 90% of respondents reported to use technical analysis. There are many reasons and it is very common for large investments firms to hire technical analysts even though they use fundamental analysis. Finally and very importantly, many researches propose that it is very likely to make excess returns by using technical analysis and technical trading. Fyfe et al (1999b) have been investigating stock index trading by using two tests trading strategies, moving average and trading range break. After this investigation, they have found that these strategies generate significant returns which cannot be explained by any other standard, other than technical analysis.

Fundamental Analysis

According to Investopedia.com (2009a), fundamental analyses are a method of evaluating a security that demand to measure its intrinsic value by observing related economic, financial and other qualitative and quantitative factors. Fundamental analysis tries to study every factor that can affect the security's value, counting for macroeconomic factors (overall economy and industry situation). The term fundamental analysis itself is used mostly in the context of stocks; however, it is possible to perform fundamental analysis of any security, from a bond to any other derivative, (Elleuch and Trabelsi, 2009). As long as any analyst looks at the basics of economic fundamentals, he or she is doing fundamental analysis, (Elleuch and Trabelsi, 2009a). When analyzing company's profile, fundamental analysis attempt to look at specific factors such as financial situation and management of the company. Barchlev and Ramu (1993) describe fundamental analyses as analyses which aim is to find out the value of a company by carefully examining key values such as earnings, growth, risk, and competition. Moreover, Moube and Jannach (2003) found out that the theory find out which theory of fundamental analysis are most important indicators and factors for asset managers. Essentially, for every asset manager that was questioned, the very first factors that they look at the financial statement of the company are such as equity, sales, future earnings, debt to equity, equity ratio and all the other financial aspects of a company. From these analyses, fundamental analysts try to predict the company's future performance. Shostak (1997) raises an important point in defending fundamental analysis in contrary to efficient market theory, which states that the market price of any security always fully reflects public available information. According to Abad and Laffarga (2004) fundamental analysis can be understood in two specific ways. The first way is that fundamental analysis is predictive, which means examining information from financial statements and produce prediction of market value. On the other hand, the second way is that fundamental analysis is normative, which is again inspecting financial fundamentals of a stock or company, which will enable to calculate the market value under some carefully circumstances and optimal market valuation. In other words, the main goal of fundamental analysis is to have a value where investors can compare it with the current price, with the aim to figure out what position to take with a specific security. Bistrovaa and Lace (2009), state that the majority of institutional portfolio managers use fundamental analysis when making a buy list in order to create a portfolio. On the other hand, the applicability and significance of fundamental analysis when investing in markets is of uncertain value. Furthermore, a very high number of investors have many reasons which make them hesitant whether to use or not fundamental analysis because it is a waste of time and money on analyzing companies.

Empirical Analyses

The word empirical analysis itself explains that these are analyses which are based on empirical results and actually supports the hypothesis. There are numerous empirical models and empirical analysis which deal with securities, however, in this paper we will explain the Capital Asset Pricing Model (CAPM) and Fama and French Model.

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) gives the prediction of the relationship that an investor should observe between the risk asset and its expected returns, (Bodie et al, 2009). The Capital Asset Pricing Model is no more than an economic model which serves to value stocks, securities, and other assets by doing analysis in the relationship between risk and rates of return, Bruner et al (2008). According to Brigham and Daves (2004), the CAPM is only valid as a model if it is within a special set of theories and it should be based on the following assumptions: "All investors focus on a single holding period, and they seek to maximize the expected utility of their terminal wealth by choosing among alternative portfolios on the basis of each portfolio's return and standard deviation." "All investors can borrow or lend an unlimited amount at a given risk-free rate of interest and there are no restrictions on short sales of an asset." "All investors have identical estimates of the expected returns, variances and covariance among all assets meaning that investors have homogeneous expectations." "All assets are perfectly divisible and perfectly liquid meaning that they are marketable at the going price." "There are not transaction costs." "There are no taxes." "All investors are price takers. This means that all investors assume that their own buying and selling activity will not affect stock prices. " "The quantities of all assets are given and fixed" Very few of these assumptions are entrenched in the real world. Even though these statements are neither applicable nor met, yet Capital Asset Pricing Model is the most used model when investing and trying to determine the risk and return of an asset or security.

The CAPM formula is as follows:

Where: Ra is the return on asset Rf is the risk free rate Ba is the beta of the security Rm is the expected market return The formula for CAPM assumes that the rate on return on an individual security should be equal to its cost capital. Sharpe (1970) starts to develop CAPM model and states his idea that individual investment has two kinds of risk: Systematic risk where there are risks in the market that cannot be diversified away such as interest rates, recessions and wars. Unsystematic risk which are also known as "specific risk" which is associated to individual stocks and can be diversified away because the investor increases the number of stocks in his portfolio. According to researchers, the CAPM model is far away from a perfect model, however, it is very much recommended. Moreover, financial analyst can use the model in combination with fundamental techniques which can be useful in estimating the cost of equity capital (Mullins, 1991). CAPM can be easy understood and implemented by individuals or company's investors. Even though, CAPM comes out as a very precise model, it subsequently can be a subject to potential large errors (Brigham and Daves, 2004a).

Fama and French Model:

According to Investopedia.com (2009b), Fama and French model is an expansion of Capital Asset Pricing Model (CAPM) where there is value factor added in addition to market risk factor which CAPM predicts. Furthermore, this model considers "the fact that value and small cap stock outperform markets on regular basis and by including two additional factors, the model adjust for the outperformance tendency, which is a better tool for evaluating manager performance." In the book of Bodies et al (2009) "Fama and French model is described as additional factors which are empirically motivated by the observations, that historical average returns on stock of small firms and on stocks with high ratios of book equity to market equity are higher than predicted by the market line of the CAPM", (Bodies et al 2009a). A very interesting point is that in Fama and French there is a high return as a reward of taking on high risk. The empirical results shows that, the Fama and French three factors model embrace for most of stock exchange markets, because it takes into account time-varying betas, (Bundoo, 2008).

Theory Comparison

In this paper, we examined three methods of analysis; Technical Analysis, Fundamental Analysis and Empirical Analysis (Capital Asset Pricing Model and Fama and French Model). Firstly, we will start by comparing technical analysis with fundamental analysis and at the end empirical analysis with both of these two analyses. Technical vs fundamental analysis; it is a very old question, which is repeating from time to time by many traders, however, still remains unanswered, (Talati, 2002). According to the author, the merits of fundamental and technical analysis have been disagreed, disputed and a debate for many years, simply to answer which method fits best to the traders. Oberlechner (2001), states that it is the main question in all financial markets how market participants or traders forecast future market development, and participants are often classified into two categories of forecasting approach, fundamental and technical/chartists. "In the fundamentals, I'm looking at supply and demand around the world. I'm looking country-by-country and seeing how the (United States) fits into that, what it means for U.S.trade, what it means for prices, says David Bell, president of Bell Fundamental Futures, (Talati, 2002a). On the other side, a strict technician and president of Clarke Capital Managements, states "with technical analysis, it's all mechanical, (Talati, 2002b). Once we build a model on the computer and we like it, our job is simply to execute it. There is no room for subjectivity". From the above sections where technical analysis and fundamental analysis were described in details and from the above statements, we can state that, technical analysts support their investment, or more accurately, their trades, only on the price and volume movements of securities. Technical analysts use charts and many other tools in order to trade on momentum, and not thinking about fundamental analysis. However, fundamentalist dispute that it is only one way to forecast the future performance of a company and that is to carefully analyzing its financial statements. Moreover, fundamentalists neglect short term fluctuations because of the long term appreciation. Using fundamental analysis or technical analysis it is a matter of how a trader takes a position toward a security, even though; it is possible to use both methods in combination to forecast future returns. In contrary to both methods, supporters of Efficient Market Hypothesis usually disagree with both fundamental and technical analysts. Efficient Market Hypothesis states that it is impossible to beat the market in favor of returns through either using fundamental or technical analysis. In addition to fundamental and technical analyses, empirical analyses, more specifically CAPM and Fama and French Model are models developed to predict future returns. Capital Asset Pricing Model is an economic model which serves in valuing stocks, securities or any other asset by analyzing the relationship between risk and rates of return. The basic idea of CAPM is that when investing, the investor should be compensated in time value of money and risk. If the future expected value does not equal of strike the necessary return, then the investment should not be carry out. Fama and French model is an extension of CAPM, where there is value factor added to market risk factor, and there is a high return taking into account the high risk. Fama and French model has two additional factors than CAPM, and the idea is that by including these additional factors, the model itself change for a better performance, which is though consider to be a better tool for evaluating the performance.

Conclusions and recommendations

In conclusion, investing in securities is an investment that has on it risk and eventually reward in the future. Technical analysis are less time consuming and try to catch the returns by looking at trends of a security, while fundamental analyses are more time consuming and predicts the returns on a long term period. Capital Asset Pricing Model and Fama and French Model are pretty close to each other which try to predict the future value by equaling the expected returns of a security to the risk of the investment. As the best technique which is recommended by many researchers in order to predict the future value of an asset are the technical analyses in combination with CAPM and Fama and French Model.

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