Page 172 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 6: Technical Analysis

6.2 Basic Technical Assumptions Notes

Before we embark on the actual methods themselves, let us review the basic and necessary
assumptions regarding the technical analysis:
1. The Market Discounts Everything: A major criticism of technical analysis is that it only
considers price movement, ignoring the fundamental factors of the company. However,
technical analysis assumes that, at any given time, a stock's price reflects everything that
has or could affect the company - including fundamental factors. Technical analysts believe
that the company's fundamentals, along with broader economic factors and market
psychology, are all priced into the stock, removing the need to actually consider these
factors separately. This only leaves the analysis of price movement, which technical theory
views as a product of the supply and demand for a particular stock in the market.
2. Price Moves in Trends: In technical analysis, price movements are believed to follow
trends. This means that after a trend has been established, the future price movement is
more likely to be in the same direction as the trend than to be against it. Most technical
trading strategies are based on this assumption.
3. History Tends to Repeat Itself: Another important postulate in technical analysis is that
history tends to repeat itself, mainly in terms of price movement. The repetitive nature of
price movements is attributed to market psychology; in other words, market participants
tend to provide a consistent reaction to similar market stimuli over time. Technical analysis
uses chart patterns to analyze market movements and understand trends. Although many
of these charts have been used for more than 100 years, they are still believed to be
relevant because they illustrate patterns in price movements that often repeat themselves.

Notes Technical analysis and fundamental analysis are the two main schools of thought in
the financial markets. As we've mentioned, technical analysis looks at the price movement
of a security and uses this data to predict its future price movements. Fundamental analysis,
on the other hand, looks at economic factors, known as fundamentals.

Let's get into the details of how these two approaches differ, the criticisms against technical
analysis and how technical and fundamental analysis can be used together to analyze securities.

6.3 Technical vs Fundamental Analysis

With a view to making a broad comparison between technical analysis and fundamental analysis,
let us assume that the fundamentalist is a conservative who invests for the long-term and the
technician is a trader who buys and sells for short-term profits. Actually, of course, the value of
technical analysis lies between these extremes.
Fundamentalists study the cause, not the "should." They make their decisions on quality, value
and depending on their specific investment goals, the yield or growth potential of the security.
They are concerned with the basis, the corporation's financial strength, record of growth in sales
and earnings, profitability, the investment acceptance and so on. They also take into account the
general business and market conditions. Finally they interpret these data inductively to determine
the current value of the stock and then to project its future price. Fundamentalists are patient and
seldom expect meaningful profits in less than one year.
In the long run, the fundamentalist who selects quality stocks when they are undervalued and
sells them when they become fully priced will make substantial profits. But as John Maynard
Keynes often noted, "In the long run, we'll all be dead".

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