Fundamentals vs Charts

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It is one of those long-running feuds. Chartists (or technical analysts as they prefer to be known) bicker incessantly with fundamental analysts (who prefer to look at balance sheets and business background). Some chartists even refer to fundamentals as 'the f-word'.

Do we need to enter this argument and take sides?

No. The fact is that, for those of a less dogmatic turn of mind, the two approaches can be combined. In part, that's because they rest on different premises.

Technical analysis rests on the assumption that markets are perfect reflectors of all known information, and that therefore studying price movements is all we need to do to gauge future behaviour. In some markets this could work. For instance, there is not really much of a percentage edge to be gained by studying fundamentals if you are a minute-by-minute trader in the huge foreign exchange market.

Not perfect

But there are areas of the investing process where markets are not perfect, or where technical analysis cannot be used.

For example, how would you analyse a new issue other than on fundamentals, since no price history has been built up? Similarly there are plenty of anomalies among thinly-traded small capitalisation stocks; and identifying them successfully takes fundamental analysis.

For larger capitalisation stocks that are actively traded, fundamentals aren't redundant either. But technical analysis may have a role to play. The conventional, and largely correct, way of squaring this particular circle is to point to the role that fundamentals can play in identifying which share to buy or sell; while technical analysis can and should be used to pick the best time to make your move.

Art form

Many critics of technical analysis regard it as little more than observing the arcane patterns and conventions on a price chart. But there is more to it than that. Technical analysis is grounded in well-established statistical techniques: number theory (dating back - in some cases - many centuries) and the psychology of human behaviour. The charts are just a pictorial representation of the phenomena that these theories and techniques throw up

Support and resistance areas on charts reflect the very human need to want to buy or sell at a point where others - or you yourself - have done the same thing before.

If you sold half a shareholding at 100p and then saw the share drop to 80p before you could sell the remainder, it would be natural to assume that you might only want to sell the rest if the price came back to your original 100p sale price. Get enough people behaving like this and you get a resistance area, clearly visible on a price chart.

Well established

Chart software can draw a perfect 'least squares' regression line on a price chart and calculate the points that are two standard deviations away from the line. If the price moves outside these limits it's a fair bet, statistically, that a 'reversion to the mean' will occur. That is well-established statistical theory.

Many chartists also put their faith in the theories developed by individuals such as Fibonacci, a 12th century mathematician. Others follow the tenets of WD Gann and Ralph Elliott, both of whom developed theories of stockmarket behaviour in the 1930s and traded successfully off the back of them.

Were their theories correct, or were they just good traders? Who's to say?

Peter says

The best case for technical analysis, particularly in near perfect markets dominated by short-term traders, is the simplest one. It is that it works because there is a common belief among all the market participants that it works, and that all of the other players in the market will follow its dictates. Arcane though it may sound, technical analysis in these circumstances is quite simply a self-fulfilling prophecy in which the best profits go to those with the best systems.