Technical analysis is essentially the search for recurring and predictable patterns in stock prices. Although technicians recognize the value of information that has to do with future economic prospects of the firm, they believe such information is not necessary for a successful trading strategy. Whatever the fundamental reason for a change in stock price, if the stock price responds slowly enough, the analyst will be able to identify a trend that can be exploited during the adjustment period. Technical analysis assumes a sluggish response of stock prices to fundamental supply and demand factors. This assumption is diametrically opposed to the notion of an efficient market.
Technical analysts sometimes are called chartists because they study records or charts of past stock prices, hoping to find patterns they can exploit to make a profit. As an example of technical analysis, consider the relative strength approach. The chartist compares stock performance over a recent period to performance of the market or other stocks in the same industry. A simple version of relative strength takes the ratio of the stock price to a market indicator strength, because its price performance is better than that of the broad market. Such strength presumably may continue for a long enough period to offer profit opportunities.
The efficient market hypothesis predicts that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past prices has already been reflected in stock prices. As investors compete to exploit their common knowledge of a stock's price history, they necessarily drive stock prices to levels where expected rates of return are commensurate with risk. At those levels, stocks are neither bad nor good buys. They are just fairly priced, meaning one should not expect abnormal returns.
Despite these theoretical considerations, some technically oriented trading strategies would have generated abnormal profits in the past. We will consider these strategies, and technical analysis more generally in chapter 19.
Fundamental analysis
Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. Ultimately, it represents an attempt to determine the discounted present value of all the payments a stockholder will receive from each share of stock. If that value exceeds the stock price, the fundamental analyst would recommend purchasing the stock.
Fundamental analysts usually start with a study of past earnings and an examination of company financial statements. They supplement this analysis with further detailed economic analysis, ordinarily including an evaluation of the quality of the firm's management, the firm's standing within its industry, and the prospects for the industry as a whole. The hope is to attain some insight into the future performance of the firm that is not yet recognized by the rest of the market.
Once again, the efficient market hypothesis predicts that most fundamental analysis will add little value. If analysts rely on publicly available earnings and industry information, one analyst's evaluation of the firm's prospects is not likely to be significantly more accurate than another's.
There are many well-informed, well-financed firms conducting such market research, and in the face of such competition, it will be difficult to uncover data not also available to other analysts. Only analysts with a unique insight will be rewarded.
Fundamental analysis is much more difficult than merely identifying well-run firms with good prospects. Discovery of good firms does an investor no good in and of itself if the rest of the market also knows those firms are good. If the knowledge is already public, the investor will be forced to pay a high price for those firms and will not realize a superior rate of return.
The trick is not to identify firms that are good, but to find firms that are better than everyone else's estimate. Similarly, poorly run firms can be great bargains if they are not quite as bad as their stock prices suggest.
This is why fundamental analysis is difficult. It is not enough to do a good analysis of a firm; you can make money only if your analysis is better than of your competitors because the market price may already reflect all commonly available information.
To determine a proper price for a firm's stock, the security analyst must forecast the dividends and earnings that can be expected from the firm. This is the heart of fundamental analysis, that is, the analysis of determinants of value such as it can pay to shareholders and the price it will command in the stock market. Because the prospects of the firm are tied to those of the broader economy, however, valuation analyses must consider the business environment in which the firm operates. For some firms, macroeconomic and industry circumstances might have a greater influence on profits than the firm's relative performance within its industry. In order words, investors need to keep the big economic picture in mind.
Fundamental analysis---the analysis of determinants of firm value, such as prospects for earnings and dividends.
Technical analysis is in most instances an attempt to exploit recurring and predictable patterns in stock prices to generate abnormal trading profits. In the words of one of its leading practitioners, the technical approach to investment is essentially a reflection of the idea that the stock market moves in trends which are determined by the changing attitudes of investors to a variety of economic, monetary, political, and psychological forces. The art of technical analysis, for it is an art, is to identify changes in such trends at an early stage and to maintain an investment posture until a reversal of that trend is indicated.
Technicians do not necessarily deny the value of fundamental information, such as we have discussed in the three past chapters. Many technical analysts believe stock prices eventually "close in on" their fundamental values. Technicians believe, nevertheless, that shifts in market fundamentals can be discerned before the impact of those shifts is fully reflected in prices. As the market adjusts to a new equilibrium, astute traders can exploit these price trends.
