Fundamental analysis of stocks is the use of company-specific financial information (usually compared to sector peers) to assess the expected future value of shares based on balance sheet criteria and earnings growth over time.
In essence, a stock is priced based on the value of the assets it represents and future cash flow to shareholders.
Technical analysis of stocks, on the other hand, values stocks entirely on what the market is willing to pay for them, with attention paid to supply (selling pressure) and demand (buying pressure) and the associated volume.
A fundamentally strong company can show poor technical performance (such as when the market sees it as fairly valued with little potential for upside momentum), and a technically strong stock can be fundamentally weak (such as highly speculative stocks that may be driven by news or hypothetical future prospects).
It’s useful to look for both technical strength and fundamental strength when buying a stock, as sound fundamentals raise the price floor for shares while technical momentum lifts the ceiling.
Oftentimes, technical analysis will seek to identify recurring patterns in how shares trade. History may not repeat itself, but it does rhyme, and these patterns appear across all stocks, asset types, and investments.
As you read Cabot newsletters and listen to investing news, you will probably hear terms like “head-and-shoulders pattern,” “trendline,” “support and resistance,” “double top” or “double bottom,” “triangle,” and “gap.”
Understanding these basic patterns and how to read stock charts will make you a better, more profitable investor. Timing is everything, and even a basic understanding of technical analysis will greatly improve the timing of your entry and exit points. And that can be the difference between a successful and a failed investment.
No technical indicator or system is perfect. There will be times when the signal given by the charts turns out to be wrong. But often, when technical analysis leads you to a certain conclusion, the stock will behave accordingly.
2 Terms to Know for Technical Analysis
Momentum is a common term used in technical analysis and is one of the most basic ways of tracking the performance of a stock. Momentum is determined by comparing the Relative Performance (RP) line of a stock to a major market index. If the RP line of a stock is trending higher than the index, then it is performing better than the overall market. And if the RP line of the stock were to trend lower than the index, that means the stock is performing worse than the overall market. An RP line that aligns with that of the index means that the stock is basically performing at the same rate as the market.
Moving averages are another common technical analysis tool. A moving average simply determines the average price of a stock over a specific period of time. Calculating a simple moving average is straightforward. All you have to do is add up the closing prices of a stock over a certain period of time and then divide by that period of time. For example, if you wanted to find the moving average of a stock over a period of 30 days, you would just add the closing prices of the stock for each day and then divide by 30.
Moving averages are commonly seen as support and resistance levels, meaning stocks in a downtrend may pause or reverse that downtrend when they hit “support” at moving averages below the share price, and stocks in an uptrend might do the same when they bump their heads against moving averages serving as overhead “resistance.”
A Guide to Technical Analysis of Stocks
If you want to learn more about technical analysis, consider reading “Technical Analysis of Stocks” by Mike Cintolo, chief analyst of Cabot Growth Investor and Cabot Top Ten Trader.
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*This post is periodically updated to reflect market conditions.