Fundamental analysis & Technical analysis

Fundamental analysis

Fundamental analysis is a study of the underlying factors that drive the market. This type of analysis is based on economic data and news events.

When a trader builds a strategy, he/she takes into consideration the dynamics of such economic indicators as inflation, interest rates, retail sales, jobs data, etc. You will find all important data releases in the economic calendar

News events include announcements of central bank governors; discussions of intercountry issues

Key elements

A challenge of fundamental analysis is to learn how to interpret changes in economic data and speeches of authorities.

Remember though the key logical rule: a domestic currency will rise if a country’s economic data improves and beats expectations. 

As you trade currency pairs in which two currencies are involved, you use fundamental analysis to compare economies of these countries. Whichever is stronger, the currency of that will rise versus the other one

Technical analysis

Technical analysis (TA) is a method of predicting the future performance of an asset’s price on the basis of its historical performance.

In other words, technical analysts study financial charts in order to determine what will happen with the price next.

In contrast to fundamental analysis which is regarding the “value” of the asset, technical analysis is only interested in price, volume and other market information. Some traders use either technical or fundamental analysis, while others combine these two methods to make trading decisions.

TA is based on the Dow theory, which is an approach to chart analysis proposed by Charles Dow (1851–1902), co-founder of Dow Jones and Company and the first editor of The Wall Street Journal. The other great contribution to technical analysis comes from Japan, where a specific type of chart was used for tracking the price of rice since the 1600’s.

Technical analysis is based on three assumptions

1# The market discounts everything.Technical analysts think that the price of a financial asset already reflects all the relevant information about it including the various economic factors and market psychology. As a result, to make predictions about the future price it’s only needed to analyze the chart and nothing more.

2# Price moves in trends.According to technical analysts, the dynamics of a market has a certain rhythm, an order to it. The movement of prices has a bias (upward, downward, or sometimes horizontal) that is called a trend. It’s necessary to analyze the market specifically looking for trends. If there’s a trend, the price will more likely continue moving in line with it rather than change direction. This assumption forms the basis for many trading strategies.

3# History tends to repeat itself.It is believed that the past movements of the price get reproduced in the present and the future. It happens because traders tend to react to specific things they see on the charts in the same way for psychological and emotional reasons. It’s possible to identify specific patterns and expect that these patterns will occur in the future causing the same price action that they used to provoke in the past. The conclusion is that it’s necessary to study the chart history in order to be able to read the signs of the upcoming price moves.

Technical analysis involves the study of price action as well as the use of technical tools and indicators. The term “price action” refers to movements the price makes. Price action trading means that you take hints on whether to buy or sell based only on the price you see on a chart. Such method suggests that you are not using technical indicators or give them a very little weight in your decision making

Comparison of analysis types in the table

How to choose stocks?

• P/E ratio simply shows how much investors are paying for a dollar of profits. Investors use this indicator to compare different stocks or even one stock with its historical record
• Dividend yield: The company pays some percentage of the stock's value to its investors, which is called a dividend. The yield is the annual dividend payout divided by the stock price. If a company increases its dividend payouts every year, it’s a positive signal for investors as it shows its economic sustainability over some period of time. There are some companies in the S&P 500 that increase their dividends for 25 years in a row. They are called dividend aristocrats. Among them are Coca-Cola, McDonald’s, Procter & Gamble, etc.

Types of stocks

Growth stocks are those expected to grow faster than the rest of the stocks, and that’s why they are named so. Sometimes, they can be riskier but traders prefer choosing them because of greater potential in the end. Examples are Google and Amazon. They have never paid a dividend as these companies prefer using their available capital investing in internal businesses.

Income stocks are those that are not volatile but have a good background of paying higher dividends than other stocks. For example, AT&T, a giant telecom company.

Value stocks are those that are undervalued. They are trading at a lower price than their underlying companies are worthy of, according to investors/analysts. The trick is to find it faster than the rest of the investors! When others recognize its potential, the owner of such a stock would gain. Examples are General Motors and Ford.

Blue-chip stocks are those that have been rising for a long time and thus considered low-risk investments. However, they tend to increase the value slower than the growth stocks or pay as well as income stocks. Examples are Microsoft and Alibaba.

Defensive stocks are those in which companies offer such necessary products and services that people would buy no matter what. They include the stocks of food and beverage companies and pharmaceutical companies. A good example would be the giant retailer Walmart.

Cyclical stocks generally follow the economic cycle of growth and recession – they rise in times of economic expansion but fall during recessions and market instability. Cyclical stocks are usually the travel and hospitality industries, automakers, and banks.

Speculative stocks are usually young companies with revolutionary technologies or unique products. The performance of these stocks is hard to predict, and they are viewed as high-risk investments as high returns always go along with high risk.

How to create a stock portfolio?

Diversify

It is the most universal recommendation for stock investors. The idea behind diversification is not to put all the eggs in one basket – to collect a set of various stocks that will react differently during the same economic events. The goal is to minimize the risks of unexpected price movements of one asset. To diversify, you need to do the following things.

1. Invest in different sectors. Try to choose the ones with a sustainable competitive advantage. For example, a healthcare stock, an auto stock, and a bank stock would be a perfect combo. Another way to diversify is between growth and value stocks; cyclical and defensive stocks.
2. Buy both undervalued stocks with higher potential growth and decades-proven titans like Amazon or Google.
3. Vary companies’ size and type.

Think long term

In the short term, the chosen stocks can fluctuate, drop during market shocks, but it’s necessary to stick to your long-term plan especially during a high-volatile market. 

Follow news and market trends

Be updated with the news of the stock market and experts’ opinions. For example, now the electric vehicles are on hype as Biden is planning to make the US carbon-free and analysts forecast the bright future for EV stocks. However, it’s not only Tesla, there are other stocks like Ford and General Motors which are trying to move from petrol to electricity and are also viewed as value stocks. Pay attention to both the overall stock market trends and to the news of the particular companies that you own or you’re interested in.

Link Translated: How to create a stock portfolio?