Just one month before the scandalous US energy firm Enron was busted for accounting fraud in late 2001, of the 15 most highly influential company analysts in the US, 13 analysts recommended the stock as a “buy” or “strong buy”, while just two labelled it as a “hold” or “sell”.

It’s understandable, therefore, that investors who lost money as Enron collapsed would question the validity of fundamental analysis, the dominant theory of stock analysis utilised by analysts and investors worldwide. Indeed, if selecting stocks based on fundamentals was so foolproof, then why didn’t the most highly skilled investment practitioners in the country see the telltale signs of a company on the verge of collapse?

Meet the critics of fundamental analysis, who say that fundamental analysis is so subjective and so often swayed by market noise and opinion that it’s not worth the bother. Such critics would argue that the company analysts who held “buy” recommendations on Enron were caught up in the company’s hype; its regular press releases to the market and the overall market perception of Enron as a dynamic and rapidly growing company. In effect, the analysts became wedded to the stock, unable to objectively analyse a company in crisis.

Over the past two weeks we’ve outlined the popular schools of fundamental analysis, including value, growth and GARP, or growth at a reasonable price. This week, we’ll spend some time on what many regard as the antithesis of fundamental analysis – called technical analysis.

The chartists

Technical analysts are often called chartists because historical prices downloaded into a variety of charts are the primary sources of information for the technician. Most technical analysts don’t know, or care, about a company’s underlying business model. They just care about its price history, its volume and whether their indicators are telling them to buy or sell. In this way, the technician is saved from a company’s hype and its ability to baffle company analysts.

Since fundamental analysis – which analyses such things as a company’s financial statements, industry growth rates and its competitors – is based on publicly available information, the technical analyst argues that knowing the fundamentals of a company hardly offers one investor an advantage over others. In other words, since a company’s fundamentals is common knowledge (and therefore applied by investors to buy and sell the stock), the technician assumes that such information is already factored into a stock’s price. So rather than stressing over calculating the return on equity (ROE) of a stock, or coming up with the price/earnings ratio as a guide to valuation, the technician simply looks to the share price. According to the technical analyst, price changes over the short term hinge on the psychology of the market or forces of supply and demand. And all of this information is summed up in the chart.

Technical analysts believe that investors are fairly predictable. They regularly follow patterns of behaviour such as succumbing to emotions of greed and fear. If a company announces headline-grabbing news, for instance, investors gobble up its shares because other people are doing the same.

A November 2006 study by Brad M Barber and Terrance Odean at the University of California noted this tendency of investors to act in patterns, such as gravitating towards attention-grabbing stocks, including companies in the news, stocks experiencing abnormally high trading volume and stocks with extreme one-day returns. Since there are so many stocks to choose from investors limit their choices to companies that have recently caught their attention. (The study concluded that this behaviour does not generate superior returns, in fact, quite the opposite).

This tendency of investors to react to market stimuli in similar ways creates patterns of price behaviour. The technician aims to use this behaviour to chart the timing of their entry and exit into a stock.

As an example, let’s say that a large super fund started buying an enormous tranche of shares in a given stock over a period of a week. The aim of the technician is to spot activity that can lead to extreme price movements. The heightened volume and buying pressure of the super fund picking off orders should alert the technician to the activity. A clever technician would jump on for the ride.

As a quick aside, heavy trading volume during a share’s upward ascent is regarded as a bullish sign, while heavy trading volume accompanying a price fall smells of bearishness. This is applied equally to gauging sentiment in the overall market.

Technical analysis versus fundamental analysis

Technical analysis isn’t foolproof. And since there is no single system or technical analysis strategy it’s almost impossible to prove whether it actually works or not. Critics label it voodoo and poke fun at its fancy trade-speak – its triple bottom breakouts, ascending triangles and Fibonacci number patterns. They say that historical data will tell you what would have gone up yesterday but not what will go up today.

Who’s right? Well, some say that both approaches have their merits and the answer is to successfully combine the two. For instance, you might use technical analysis to detect trend changes, and fundamental analysis for an understanding of the longer-term value of a stock. Technical analysis could be used to time an entry and exit into a stock that you’ve already noted is fundamentally sound.

Anyone serious about share trading should probably have a basic understanding of both approaches – since some of the tools utilised could come in handy at some point. Indeed, a broader knowledge base can alwasy help in better interpreting the market forces at play.