Market Analysis: Fundamental vs Technical

By: Todd Horwitz

The following is an excerpt from Todd "Bubba" Horwitz’s Bubba’s Guide to Trading Options

What causes the market to move?  Fundamentalists would lead you to believe that it is a balance sheet, or P/E ratios, or Inventories, or the Producer Price Index.  They believe that future price can be predicted from this information.  They believe current price is just a function of buyers and sellers meeting temporally.  It is indeed technical, but they believe price patterns and tendencies have no effect on the longer term direction of price.

Technicians believe that price discovery is all that is necessary.  Understand this: Traders using technical analysis only study price movement and historical price patters and tendencies to predict future price discovery points.

All investors, traders, and hedgers use fundamentals, technicals, (or some blend of both) to analyze the markets.  Here we will look at some the classic examples of both styles and further differentiate each to value the market and specific values therein.

Fundamental Analysis

Fundamental traders look at the market, an individual stock or commodity, based on various supply and demand functions.  They use a number of tools that they believe will help to predict the future price.  If they are investing in stocks there are many ways to look at the market fundamentally, here are some of the most common data points.

Price/Earnings (P/E) Ratios: The ratio of net profits to the price of the stock.  If a stock is priced at $5 for every $1 of net profit, it is said to have a P/E of 5.  Fundamental theory would then compare that ratio to what other companies in a particular industry are earning.  If the industry average is 9, this stock would be said to be “undervalued”.  If the industry average is 4, it is said to be “overvalued”.  Investors would then combine this information with other factors to predict the future price.

Balance Sheet: A statement of the financial condition of the company at any point in time.  It represents the company’s net worth.  It uses the formula: Assets – Liabilities = Equity (Net Worth).  When the company has a strong balance sheet the fundamental investor could compare that to industry averages and use it as the gauge to predict price.

Inventory Turnover:  Measures how quickly accumulated inventory can be turned into sales.  Generally the faster the inventory turns the healthier the company.

Debt to Equity Ratio: Measures how leveraged the company is.  If the company has too much leverage (debt), a change in the economy could be devastating.  If it does not have enough, it is probably not getting full use of its equity.

If the investor were looking to trade commodities they would use a different set of numbers to try and predict price.

Supply/Demand Ratio: Tells the investor the current supply and the ratio to demand for the commodity.  If too much gas is on hand the price should fall.  Not enough and it should rise.

Housing Starts: If there are not enough homes being started it could have a dramatic effect on many different commodity prices.  If there are too many homes in the market, negative price movements occur.

Producer Price Index (PPI): Compares the cost to produce a commodity to a base time period.  If this number is rising too fast it could signal high inflation and commodities sensitive to inflation should rally.  Declining PPI should forecast lower prices.

Retail Sales: Exactly what it sounds like; retail sales represents the amount consumers are spending in stores.  It is said to be a leading indicator.  Some see retail sales as a forecaster to future trends in spending and the prices related to those commodities used in production.

Unemployment Rate: The granddaddy of all fundamental numbers.  Released the first Friday of each month; it measures the annualized rate of unemployment and how it is related to the change in the past month, as well as past year readings.

These are just a few of the fundamental indicators.  We could write multiple pages worth of formulas.  The interesting thing about fundamental numbers is that it all depends who looks at them.  They are always subject to interpretation.  The fundamentalists only care about current price as to how it should relate to future price based on their interpretation of the data.  The numbers are factual; the way they are interpreted by the investor will determine whether he/she is bullish or bearish in the market place.  The exact same number that was bullish fifteen minutes ago could now be viewed as bearish.  A different set of experts will interpret what the number says in relation to last month’s number, and the market will spin off on its merry way.

Technical Analysis

Technicians discount all of the above fundamental information.  Technical analysis is based on price discovery.  The current price tells us all that we need to know.  It is really quite simple.  No matter what you may believe, the market is never wrong!  It will be your nemesis.  It is never tired, sick or distracted; it never makes a mistake.  It will always find a price that inflicts the most pain on the most participants.

Unlike fundamental numbers, which are subject to interpretation, the price is not!  How the price got there, and where it may be going is another story.  Technicians use many tools to try and predict, or react, to future price movement.  Some technicians will try to pick the extent that the price will increase or decline.  Some, simply want to follow the price movement that is occurring and don’t care where the top or bottom is, they will let the market tell them what to do.  Technical tools work well in all tradable markets.

Remember, the definition of a tradable market is one that has liquidity.  Without liquidity it is almost impossible to make money.  The bid/offer spread and commissions will eventually wear you down.  What matters is that you take a specific set of indicators and work with them.  Consistency is the key.