Explain the key features of technical analysis, including the strategies and techniques used in technical analysis. Discuss the features of fundamental analysis, critically evaluate fundamental analysis versus technical analysis.
The following paper will critically evaluate the differences between technical and fundamental analysis. Even though both technical and fundamental analyses are tools used to make investment decisions there is sharp differences in the two approaches. Technical analysis is in sharp contrast to efficient market hypothesis (EMH), which contends that past performance has no influence on future performance market values. Fundamental analysis involves making investment decisions based on the examination of the economy, an industry, and company variables that lead to an estimate of value for an investment, which is then compared to the prevailing market price of the investment. Technical analysis involves the examination of past market data, such as prices and the volume of trading, which leads to an estimate of future price trends and therefore an investment decision. In the case of fundamental analysis economic data is used, whilst in technical analysis using data from the market itself is considered as good because the market the underlying assumption for technical analysis is that the market is its own best predictor. Therefore technical analyses attempts to provide answers to questions relating to what securities should an investor buy or sell? And when should these investments be made? Thus technical analysis involves the study of a stock’s trading patterns through the use of charts, trend lines, support and resistance levels and many other mathematical analysis tools, in order to predict future movements in a stock’s price, and to help identify trading opportunities. For instance if the technical analyst observed a rising trend channel they would hold the stocks as long as the stock price stayed in the rising channel. Whilst if the market was trading in a flat pattern, the technical analyst would sell, most would hold to see if the stock experiences a period of consolidation and then breaks out of the flat trend channel. The following diagram will clarify the point:
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The techniques used to conduct technical analysis are sub-divided into four main sections based on attitudes of the technical analysts, namely
In the case of contrary opinion rules, the technical analysts trade against the crowd using contrary opinion signals. Thus, the analysts try to determine when the majority of investors are either strongly bullish or bearish and then trade in the opposite direction. The measures used are to determine the percentage of speculators in stock index futures that are bullish; other measures include a general belief that if a large proportion of investment advisory services have a bearish attitude; this signals the approach of a market trough and the onset of a bull market. In the case of the second approach of following the smart money, technical analysts have crated a set of indicators that they expect to indicate the behaviour of smart, sophisticated investors and create rules to follow them. The confidence index is a ratio of Barron’s average yield on top 10-grade corporate bonds to the yield on the Dow Jones average of 40 bonds. Similarly The T-Bill and Eurodollar yield spread is an alternative measure of investor attitude or confidence on a global basis. It is believed that at times of international crisis, this spread widens as money flows to the T-Bills, which causes a decline in this ratio, stock trends indicate that trough follows shortly thereafter. Amongst the other popular market environment indicators is to measure the breadth of the market, which indicates the number of issues that increase on a daily basis. Diffusion index shows the daily total stocks advancing plus one-half the number unchanged, divided by the total number of issues traded. The market is considered to be oversold when the diffusion gets down to 40-44. Looking at the 200-day moving average of prices has also been fairly popular indicator to understand the general investor sentiment. Hence, when less than 20%of the stocks are selling above their 200-day moving average, the market is considered to be oversold, which is bullish and means investors should expect a positive correction. Finally, stock price and volume techniques highlight that prices moves in trends that persist, and they seek to predict future price trends. Charles Dow postulated three types of price movements over time:
Followers of the Dow theory hope to detect the direction of the major price trend recognising the intermediate movements may occasionally move in the opposite direction. They recognise that a major market advance does not go straight up, rather includes small price declines as some investors decide to take profits.
From the preceding paragraphs it can be concluded that while technical analysis looks at stock price trends and refutes the Efficient Market hypothesis, fundamental analysis tends to analyse company information like cash flow, balance sheets etc. However, the common point is that both sets of tools are used to pick stocks. It must be highlighted that to ensure the right choice is made both sets of tools must be used at tandem to derive the best result. There are no conclusive results to suggest that fundamental analysis has generated better results than technical analysis and vice versa. Thus, it can be summarised that for day trading and other forms of short term trading technical analysis would be a better option while for longer term investment fundamental analysis tools would be more useful. Thus depending on the nature and time span of the investment either technical or fundamental analytical tools can be used to make the right investment decision.
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