Fundamental vs. Technical Analysis

25th May '17 by minnow

22 comments 7896 reads

I'm trying to weigh / balance the approach of stock buying using fundamental vs. technical analysis, but have conflicting thoughts. A stock which may have a strong StockRank or QVRank value may be doing bad technically, and vice versa. (A stock with a low StockRank or QVRank may have a strong BUY signal based on technical indicators, but their fundamentals say to stay clear.)

How about this approach, only buy high QV stocks, say over 95+ with a low momentum. I figure if you wait long enough, say a 1 year or so, surely their strong fundamentals will make them winners eventually. Or is this a fallacy?

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About the Author

Minnow

Premium Member

22 comments

Trigger14

26th May '17

All of the stockranks are just statistical indicators based on historic information of whether a share is likely to do well rather than measures of any objective truth. 'Fundamentals' are not the be-all and end-all - they are severely limited as they are backwards looking!

To actually predict whether a share price will do well you also need to predict the future to some extent. Assuming it will be the same as the past is a reasonable starting point but is pretty inaccurate, particularly if you invest in decent quality growing businesses. If you focus on high QV stocks with low M you run the risk of picking stocks that have had a profitable past but are now more cheap because their future is not so bright. The low M may often indicate the fundamentals are about to deteriorate rather than the other way round. I think it would be foolish to ignore momentum as it is probably the most powerful predictive factor (and works well in combination with the other two). In my view it often actually indicates value as prices in the stock market are often pretty slow to rise towards efficient prices when news flow is positive (their are lots of practical and behavioural reasons for this).

Rusty2

26th May '17

If you check QV is the worst performing out of QM, VM and QV. By some margin, in fact 95-100 QV is not even the best of the QVs, nor is 90-100 unlike the QM and VM. This is the trouble you may have to wait a long time, why not buy shares that are going up?

Stephen Hoad

26th May '17

One of my strategies - find the stocks fundamentally and use the technicals for when the conditions are right for timing your entry into the trade. This will negate some of those sucker stocks. Use technicals to get out to create a more systematic process and get the most bang for your buck. You can also adjust the time frames of your technical analysis to suit your objectives.

dmjram

26th May '17

Do you look at the state of the overall market as well Stephen or is the buy/sell decision taken only at the individual stock level with regard to the specific stock's fundamentals/indicators?

Thanks

Mike

Stephen Hoad

26th May '17

This may sound a 'wishy washy' answer but it depends on the strategy and in my world its not quite that straight forward.

I compartmentalise my strategies - and I have many of them! In equities I have the fundamental strategies that will give me a shortlist of stocks that I will time my way in using technicals. Some are short term, others long term - i can factor in sector/ industry strength of eg the FTSE100 to some of these and some are purely only stock driven and I dont care for the overall market.

What I never do is trade purely based on the fundamentals. That is just my style. I've worked with many great pure fundamental traders as well as 100% technical traders - I'm a blend, especially in equities.

Other strategies I have I completely ignore the fundamentals and trade purely off the technicals and again some of these factor in say the technicals of the FTSE and others are purely 100% technical on the stock.

All my strategies are backtested either quantitatively or through experience and as a portfolio they work.

Not sure if that helps you at all!!

Trigger14

26th May '17

Following Stephen's comments, I would also say that having a systematic mechanical trading strategy that exploits momentum by holding and adding to 'winners' (I.e. rising price) and cutting losers quickly can mean you make money even if you are wrong about your picks most of the time. This is because the size of your gains when you are right will be much greater than the size of your losses when you are wrong. Personally my % of profitable trades is under 50% but my returns over the last year are over 60%, mostly because by holding winners and cutting losers I've ensured my gains are much bigger than my losses (probably more than 5 times bigger on average). This is only possible because momentum is generally a very important factor.

minnow

26th May '17

Thanks, very helpful.

minnow

26th May '17

Good advice here Stephen. Thank you.

minnow

26th May '17

This is good to know Herbie, Thanks.

minnow

26th May '17

Thanks for your reply Trigger.

tochered

6th Jun '17

Thanks guys for all your comments I sometimes get out of a good trade too quick and sometimes don't get out of a losing trade quick enough. Studying technicals to try and correct this. Not done too badly though I'm up 690% over the last 5 years.

Andrew L

6th Jun '17

Minnow - I read that over two-thirds of the movement of share prices is due to the speculative return. This reflects changing investor sentiment and is highlighted by the changing P/E ratio. Some aspects of technical analysis seek to make money from the change in sentiment. This sounds potentially easy but in reality it involves trying to guess how the mood of others will change. That is actually very, very hard.

It is also the case that a lot of technical analysis is about getting into a position and then selling quickly if it goes below a support line. This can be very costly as even high quality companies can see their share prices temporarily falter. If markets are volatile but are going sideways this kind of approach may lose significant value.

There are also momentum type technical analysis strategies which can be but are not always the same thing. Momentum might be used to identify quality companies but there are also lots of low quality businesses that can have momentum and then collapse. Much of the technical analysis literature is about getting out when momentum fades. However, this isn't always possible due to unexpected profit warnings etc.

I think I would turn the question around and ask what will determine the value of the shares in say 40 years time. Over that period it is almost entirely the fundamentals of a company. Surely then the strategy that pays off best is to try to focus on fundamentals. We can forecast fundamentals but forecasting the mood of investors is much harder.

It is also the case that the more investment decisions you make the lower their quality will be. Technical analysis typically involves lots of decisions as you are in fact partly trading. Fundamental analysis only needs a few decisions and as such there is a greater probability of getting them right.

Technical analysis is popular because it is quick, simple and easy to understand. However, it seems to me like fool's gold in the main. The Restaurant Group probably had good momentum a few months before it collapsed.

If you want to effectively be in a room guessing what other people are about to do next then technical analysis is for you. It is exciting, involves lots of decisions and has its own bizzare language. If you want to compound value then I would suggest fundamental analysis.

I would say there is something of a catch-22 though. High quality companies with great fundamentals naturally have strong share price momentum. Accordingly, a technical analysis approach can help identify them even though it would also identify weak companies.

If you looked for share prices that have had momentum for say 20 years and invested in them you would probably do very well. This is because it would exclude the companies which exhibit short-term momentum but then collapse. The strategy would effectively be identifying high quality businesses such as Unilever, British American Tobacco etc.

So I am a vague fan of looking at share price graphs for say 20 years as this is effectively an indicator of whether a business is quality in nature. Although, clearly the quality drivers of a business can fade over time i.e. what was quality in the past may not be in future due to structural changes and competition.

underscored

6th Jun '17

If you can predict what will happen to a company over the next 20 to 40 years. Hats off to you.

Andrew L

6th Jun '17

underscored - sorry but this is entirely possible for many companies. The regulated water companies and National Grid are predictable. Unilever and Reckitt Benckiser are predictable. Diageo is predictable. Intertek is predictable. Facebook is predictable. Rightmove is predictable. Amadeus IT is predictable. Kone is predictable. These firms have strong competitive positions, stable demand aren't aren't exposed to disruptive trends.

I take your point that some companies are predictable with retailing trends changing for example. But other companies are predictable. I don't know how old you are but I would be happy to bet that I can predict the futures for a number of companies over 20 to 40 years.

Even if something isn't predictable over 20 to 40 years this doesn't mean you can't have a fundamental hypothesis and then test it against new information that comes forward. I might have the hypothesis that Cineworld is an excellent play in the leisure sector. However, this depends on cinema remaining popular with people despite the growth of on-demand films. I would monitor this risk closely to see if it occurs but otherwise I would hold. Just because something isn't predictable over the long-term doesn't mean that a long-term forecast can't be used to analyse the investment case.

You are putting forward a technical/momentum school of thought that nothing is predictable and therefore it is best to trade emotion changes in the market. This is completely bonkers. I have read this argument in a number of books on trend trading etc and I do wonder if the author of these kinds of books is smoking something they shouldn't.

underscored

6th Jun '17

Tesco was predictable. Next was predictable.

Utilities carry increasing political risk etc etc.

- Edit to say that I am not a proponent of any extreme. But multiple mental models are best.

Andrew L

6th Jun '17

underscored - thanks for the reply. Agree on mental models. But to turn around the initial question you posed about predicting companies over the long-term: how easy is it to predict share prices over the short-term using technical analysis?

Essentially you are betting on investor sentiment improving/weakening. It is essentially a trading approach that may say buy momentum and then sell when it fades. Or it would buy a breakout and sell when it doesn't follow through. The reality is that this isn't investing it is trading.

Combining technical analysis (momentum) with some value/quality factors in theory has merit. However, if technical analysis is a buy/sell determinant then in reality you are still trying to pick a sentiment change or using price signals. Or perhaps using it as an insurance system in case the fundamental analysis is poor.

Technical analysis is a popular, exciting and fun way to trade and appeals to our gambling instinct for short-term hits. However, I think it was Jim Slater who said that technical analysts always wear dusty old jackets given that they are always broke.

Maybe use some momentum filters if you want. But primacy should go to fundamental analysis. I understand, though, that technical analysis can be a way of spotting trends and potential performers early on. Given the deluge of data it is impossible to follow every company. We can follow new highs and early signs of stock momentum. Trends do tend to persist.

It is clear that Gear4Music of FeverTree, for example, could have been spotted early using a momentum or breakout filter system. However, you would also have spotted a host of junk stocks whose momentum reversed.

I would say technical analysis may be helpful as a filter system to identify early winners and potentially high quality companies. Using it in other ways will generally fail because computer algorithms will beat you. Even the computers can't do the price only system well i.e. Man Group's trend following AHL fund has not been performing all that well.

underscored

7th Jun '17

All stock are speculation, and I agree that predictions, both long and short term are hard.

I would go much further and say that perfect predictions are impossible, the future is unknown and unknowable. To my mind the market behaves like a biological system, it is complex and it is adaptive.

Andrew L

7th Jun '17

underscored - sorry but your comment above is simple not true. Looking at the definition and a speculative stock involves a high risk of loss. Speculation is defined as investment with the risk of (a meaningful) loss.

It simple isn't the case that all stocks are speculation. All share prices vary but some underlying businesses have a very high probability of retaining long-term value. It is simply not the case that "all stocks are speculation."

The future - it also simply isn't the case that the future is "unknown and unknowable". I suggest you read the book Superforecasating which looks at this issue. I can predict that some people will use Unilever products tomorrow so by definition your interpretation of the future is incorrect. Just because low quality, speculative companies are hard to forecast it doesn't mean all companies are.

"predictions are impossible" - this isn't the case. If you focus predictions on areas that are predictable then you can predict the future. The problem is that if you try to predict things that aren't predictable. Some things are predictable.

If the future is impossible to predict why is it that the sun seems to rise and set every day? Surely I can predict that the sun will rise and set tomorrow. Therefore the future can be predicted in areas where it is predictable. The approach of the "future cannot be predicted" is an extreme and incorrect view.

underscored

7th Jun '17

I recommend that you read the signal and the noise.

Andrew L

9th Jun '17

I know the author and the rough message of the book. I don't think it has anything new or of relevance though. He called one election in the US fairly well. But a lot of his forecasts since then have been poor (Brexit) etc.

I'll try and read it but I don't rate the individual that highly.

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Fundamental vs. Technical Analysis

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Minnow

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