Despite many thousands of books written on the subject of market analysis and countless theories that attempt to explain the movement of stocks, bonds, commodities and currencies, there are, at heart, only two types of analysis: fundamental and technical.
Fundamental analysis involves assessing the economic conditions that influence price, such as supply, demand, and the overall state of the domestic, and global economy. In the case of the stock and bond markets, it also involves looking at the balance sheet and financial health of a corporation, or maybe at the prospects for a specific industry.
Technical analysis, on the other hand, is about analyzing past price action and from that deriving a predictive model for the future.
The question I am most frequently asked by those new to trading is “Which is more important, technical or fundamental analysis?”
When that question arises one of the hardest things for me is to avoid answering with a cliché, as there are really only two honest answers: ”Both” or “It depends.”
As is so often the case, what is presented as a binary choice in that question is anything but that. There is no reason that traders or investors need to choose between fundamental and technical analysis. In an ideal world each trade would come about from a combination of the two, with technical analysis supporting the fundamental, or vice versa.
That makes “both” a valid answer to the question, but “it depends” can be just as accurate. In general, fundamental analysis is more useful for long term trades and investments, whereas technical analysis is more useful from a short term perspective. Over a period of a few minutes to a day or two technical levels of support and resistance can influence the direction of a price massively. Take a look at the chart below for Microsoft (MSFT) as an example.
Following the earnings release in October the stock jumped to a high of 61.40 before retracing. When that level was tested again at the end of November it proved to be a significant point of resistance, and after several tries to break through, MSFT dropped back around 4.5% in just a couple of days. Clearly previous price action matters, but then look at what happened after that.
Microsoft at that time was growing its enterprise business significantly, and stocks in general were in the midst of what has become known as the “Trump Bump”. Fundamental conditions, both micro (pertaining to Microsoft) and macro (pertaining to the broader economy), made MSFT an attractive stock, and as a result it smashed through that level a few days later and carried on higher. This ably demonstrates that while technical factors can have a huge short term influence, fundamentals win in the end.
If forced to choose between the two I would pick fundamental analysis as the more influential. There is no real reason for what happened in the past should influence the future. It does so only because we, as human beings, seek to impose order on things. We look for reasons to do things, and past price history can provide us with them. Understanding that also leads to the conclusion that the best technical analysis is the most simple.
The significance of a particular price level is a function of how many people identify it and act accordingly. In the MSFT example above, the previous high attracted enough sellers to push the price down, but it was an obvious level. The more obscure analyses that demand advanced math skills or calculations may appeal to our vanity, but if nobody else recognizes the levels that they suggest they are essentially worthless. When it comes to technical analysis the old KISS adage (Keep It Simple, Stupid) definitely applies.
It should be clear that both technical and fundamental analysis have a place in devising a trade. Ideally, fundamental analysis is used to determine direction, while technical analysis suggests timing and specific entry and exit points. Of course nothing can guarantee that every trade is successful, but if you use that formula you give yourself a better chance of success than relying on one or the other.