The main methods of analyzing stocks

September 27, 2011

Investors & punters through the years look for ways & means to improve their performance in the stock market. The main methods employed are fundamental analysis and technical analysis. Fundamental analysis attempts to value a stock & if the value derived from this analysis is higher than the market price; the stock would be rated as a BUY. Technical analysis attempts to gauge the price direction for a stock and if the reading is bullish, the stock is similarly rated as a BUY. You can read more about this by visiting Investopedia (here) or googling for these phrases.

The purpose of this article is to explain the difference between these two important methods and how you can benefit from applying them in your investment. The main strength of fundamental analysis is that it can put a price on a stock. The techniques used are mathematical, logical & systematic. And, as such, it is very reassuring. In a hand of an experienced analyst, it is a powerful tool.

Fundamental analysis is not without its flaws. Its most serious shortcoming is that it ignores price signals. Sometimes the price of a stock would move in the opposite direction of what was predicted and the fundamental analysts would brush this important input aside.

On the other hand, technical analysis is a grossly misunderstood & much maligned method of stock analysis. I remember reading about technical analysis in my Financial Management subject for the Chartered Institute of Management Accountants (CIMA) examination. Technical analysis was allotted a total of 3 pages in a book of 600 pages. Without much explanation, the reader would be thrown into the deep-end when we were introduced to the Head-&-Shoulder reversal pattern. Without sufficient background knowledge, a lay person would not be able to comprehend this very reliable reversal pattern. In fact, I suspected the writer is trying to discredit the concept of technical analysis. However, a lot has changed & with the advent of behavioral finance, technical analysis should be given its rightful place next to fundamental analysis in any study of investment.

The strength of technical analysis is that it deals mainly with prices, which is determined by supply & demand. Technical analysts are aided in their analysis by rules that have been laid down & indicators developed over the years. The main premise is that human behavior repeats itself and historical price patterns can be used to ascertain future price movement. Since technical analysts do not study the company’s business & financial data, this can lead to prices of stocks going to the extreme as buyers bid aggressively for rising stocks or dump plunging stocks mercilessly. That’s the main shortcoming of technical analysis.

If you look at some of movers & shakers in the world of investment- people like George Soros or Jimmy Rogers- they analyzed the markets from a strategic point of view. They use their formidable knowledge in economic matters in order to get a big-picture view of the markets. Once this big-picture has been conceptualized, they would make their huge bets. George Soros is known as "the Man Who Broke the Bank of England" after he made USD1 billion during the 1992 Black Wednesday UK currency crises. Jimmy Roger bet heavily on commodities in 1990s & was rewarded handsomely. These visionaries studied the economy using fundamental analysis & quantitative method. They probably did not rely on technical analysis as they were running ahead of the market. As they made the market, they became the market.

However, not every bet placed by George Soros & Jimmy Rogers came out smelling like a rose. George Soros lost big in 1999-2000 when he bet against the Technology sector during the crazy bull-run on Nasdaq. Jimmy Rogers is now heavily invested in China & everyone knows that if you are invested in China these days, you are sitting on huge paper losses. Could they have benefited from using technical analysis? I believe they would have. If technical analysis was not important at the conceptualization stage, it would gain greater prominence as the investment progresses. With technical analysis, you can gauge the strength of the market & how far a security or commodity could rise.

Not many of us have the privilege of being served by a team of research staff, like George Soros or having many investment advisors on call, like Jimmy Rogers. We have to do the ground work on our own. I would recommend that you familiarize yourself with both fundamental & technical analysis. Use them together & the return on your investment would improve handsomely.

(This is my latest article in Merdeka Review. For the Chinese version, go here)