There are some profound questions asked from time to time in the history of men such as, which came first, the chicken or the egg? One such question that investors in the stock market often encounter is, Which is more relevant, fundamental analysis or technical analysis?
Most investors would be familiar with the basics of fundamental analysis as it is one of the subjects in college (if, that is, they happen to be students of commerce). Wikipedia defines fundamental analysis of a business as the study of its financial statements and health, its management and competitive advantages, and its competitors and markets. The analysis is performed on historical and current financials, though the objective is to predict the future stock or business performance.
The picture that technical analysis conjures up for most of us is one of weird graphs blinking on the screen and tense faces staring at them as if their lives depended on it. The mystery is compounded by noted technical analysts such as W. D. Gann using astronomical notations in the charts or R. N. Elliott talking about nature's laws.
What are technicals about
Technical analysis, as we know it today, was developed towards the turn of the 20th century. Before the discovery of computers, technical analysts would go around with thick files containing graphs of various securities. These graphs would be updated manually at the end of each trading day. This laborious process intimidated those who ventured to learn the method. With the advent of computers and the Internet, creating graphs is just a matter of clicking the mouse. That would account for the increasing interest in this kind of analysis in recent times.
What technical analysts actually do is to study the past market action and use this information to predict where the prices will head. Market action is studied mainly with the help of graphs. It is represented through price, volume and open interest. Technical analysts believe that market action (captured through graphs) reflects all the factors affecting the price — fundamental, political, psychological, and even manipulative action. They go to the extent of claiming that `Technicals are what people think the fundamentals are'.
Scenting news
This statement is reinforced in situations where the charts give early indication of a major event that is about to happen in a company. It is often perceived that the stock price starts moving up much before the news affecting the company is announced to the public. The adage "buy on rumour, sell on news" owes its genesis to this anomaly that exists in most markets. Many a time, even the rumour may not reach the lay investor. The only way to scent out a major event is by perusing the charts. A sudden break-out in price or a steady increase in trading volumes, denoting accumulation by insiders, could be a precursor to some major announcement by the company. To illustrate, the chart of Sesa Goa made a sharp breakout on December 21, 2006 and has gained 70 per cent since then. The rumour of Mitsui selling its 51 per cent stake in the company was published on December 26. The buzz regarding Arcelor-Mittal eyeing Mitsui's stake hit the market much later, on January 24, 2007.
Yet, there is little doubt that fundamental analysis should serve as basic guidepost to investors. Fundamental analysis drills down a company's financials to identify under- or over-valued stocks and may help investors stay away from the emotional excesses triggered by a sustained bull or a bear phase.
Fundamentals help maintain sanity during periods of irrational exuberance. The investors who chased the Internet stocks trading at an average price-earning multiple of 100 during 1999 and 2000 would be ruing their folly to this day. And yet, `glamour stocks' or `idea stocks' exist in every market and tempt investors. Using technical analysis to buy into such stocks can take the investor speeding up a road that ends in a steep drop.
For the long-term too
There is a popular misconception that technical analysis is for short-term traders and fundamental analysis is for the long-term investors. The message seems to be that if you are a long-term investor, technical analysis has little role to play in your investments. In reality, that is far from the truth.
With the Indian market moving up continuously since 2003, with short corrective phases, the `long-term investor' now has reason to be sanguine. But there was a 10-year period between 1992 and 2002, when the Sensex oscillated between 2500 and 5000. Long-term investors, who followed a buy-and-hold strategy would have had a taxing time in this period unless they timed their entry and exit with the help of technical analysis.
They can co-exist
In fact, long-term investors can profit by meshing both fundamental and technical analysis into their investment decisions. Such investors can make the scrip selection based on fundamentals and time the entry and exit with the help of technicals. It is a common for an investor to buy in to the right stock at the wrong time.
A long-term investor, who bought, say, Rolta at Rs 450 in 1999 would be staring at a loss of 33 per cent today. Had he used technical analysis, he could have exited with a 100 per cent profit in March 2000.
Conversely, it is widely believed that traders rely on technicals alone and ignore fundamental analysis. While this may be true of some traders, the more professional and successful traders track the fundamentals closely. The larger traders go to the extent of hobnobbing with the management of the companies that they trade in, on a regular basis. After all trading is all about anticipating the market's next move. Fundamentals are indispensable in this game.
As mentioned above, the debate can be endless and fruitless. Fundamental and technical analysis can co-exist and complement each other. The weightage given to each of these forms of analysis by an investor can vary according on the frequency with which he churns his portfolio and the secular trend in the market. Every savvy investor knows that ignoring either of these would only peg down the performance of his portfolio.