There are two schools of thought on how best to analyze the stock market. On one hand are the fundamentalists and on the other are the technicians. It's typically advisable for investors to make their own separate peace with each. The result can be two sets of indicators that complement each other - and a strategy that helps with investment decisions.
Fundamental vs. Technical Indicators: The Basic Difference
The basic difference between fundamental and technical analysts is what they look at to make their decisions, with fundamental analysts looking at companies and technicians looking at charts. More specifically, fundamental analysts study the numbers and ratios of businesses - profits and revenues, dividend yields, and ratios of debt to equity and price to earnings. Technical analysts focus their attention on charts that track the price history of an index or stock and the changes in the number of shares traded over time.
Underlying these different focal points is a belief in what makes stock prices move. For fundamental analysts, it's a judgment of what a company is worth in the open market, given its strengths and weaknesses compared to its competition. Fundamental analysts sift through the performance data of like companies to estimate what the price of a company should be.
Technical analysts base their approach on the idea that stock prices change for the same reasons that the price of everything else changes: the balance of supply and demand. That means comparing the number of owners of the security who want to buy it at that price. Technical analysts believe that the peaks, valleys, and plateaus of a stock price - compared with changes in the volume of shares bought and sold - reveal that relative balance.
Key Fundamental Indicators
Fundamental analysts use a large number of indicators to determine what they believe is the true potential market value of a stock or stock index. Here are a handful of the most popular ones:
- Price/Earnings Ratio (P/E). This is the number that results from dividing the earnings per share of a company's stock into its price per share. It's also commonly called the "earnings multiple" or simply a stock's "multiple." Historically, the average P/E for U.S. stocks in the S&P 500 is somewhere between 14 and 16, depending on the time frame. Based on the commonly held principle that over the long run the P/E ratio for U.S. stocks reverts to its average, there are times when professionals say the market is "overvalued" or "undervalued" - suggesting that the market is poised for a change in trend. Similarly, stocks can be said to be overvalued or undervalued based on their P/E ratio.
- Estimated Future Earnings Growth Rate (EGR). Wall Street analysts usually prepare an estimate of a company's earnings growth rate for a period of time, expressed as an average annual growth rate. Investors who want to buy "growth" stocks look for EGRs of more than 20%, while investors who favor "value" stocks can be satisfied with EGRs in the teens.
- P/E to Growth Ratio (PEG). This is calculated by dividing a stock's future earnings growth rate into its P/E multiple. For example, a stock with a P/E of 30 and an EGR of 15% has a PEG of 2. Stocks with PEGs of less than 1 are considered to be bargains and are more likely to keep rising in price, while stocks with PEGs of more than 2 are often considered pricey and more likely to offer a slower rate of return.
- Dividend yield. This is simply an expression of a stock's annual dividend divided by its price. Growth stocks often don't pay dividends, so dividend yield is a way of sorting out the comparative attractiveness of value stocks. One way for a stock's yield to rise is for the price to come down while the company maintains the same dividends.
Key Technical Indicators
- Resistance and support levels. Technical analysts pore over charts to detect prices where a stock has had difficulty moving higher, as well as where it has resisted going lower. On the high side, these are prices where owners sell to take their profits, and the sellers outnumber the buyers. On the low side, these are prices where buyers believe the stock is a bargain and begin to outnumber the sellers.
- Price and volume signals. Technical analysts use the combination of changes in a stock price and volume of shares traded as a sign of its likely future price trend. Although not infallible, any move that occurs on higher volume is regarded as likely to continue in the same direction. Conversely, when the price changes on lower volume, technicians view continued movement in that direction as less likely. These signals are regarded as particularly strong if the pattern continues over several days, weeks, or months.
- Moving averages. Technical analysts make heavy use of the moving averages of stock prices. A moving average is computed by adding the closing price for a specified number of days (typically 10, 20, 50, and 200 days) and dividing the total by the number of days. These moving averages appear on charts as lines of different colors that rise and fall and often cross over one another. Some traders use specific crossovers as buy or sell signals. Moving averages are also used by some traders as levels of resistance and support; these traders will buy or sell a stock when the price moves above or below the moving average line.
- This acronym is short for a powerful indicator known as Moving Average Convergence and Divergence. It is considered an indicator of a stock or index's price momentum - the strength and direction of its price trend. MACD measures the difference between a short- and long-moving average of closing prices (normally 12 and 26 days) and uses changes in the difference as buy or sell signals.
- Relative Strength Index (RSI). Like MACD, this indicator is known as an "oscillator" because its value continuously moves up and down, usually in sustained trends. It measures where in the range of a stock's closing prices over the prior 14 days the current price is. When a stock is in the upper 30% of its range, the stock is regarded as "overbought" and poised to pull back in price. When a stock is in the lower 30% of its price range, it's regarded as oversold and likely to begin moving higher.
- Fundamental and technical analysts are often very partisan about their methodology. But many professional managers use both methods to fine-tune both their short- and long-term strategies. In the words of some Wall Street professionals, fundamental analysis tells you what to buy and technical analysis tells you when to buy it.
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