Introduction to the Art and Science of Technical Analysis
fIgure 1.4 Price Forecasting Based on Intrinsic Value of a Stock.There are various ways to determine the degree of over- or undervaluation in a
stock, some of which include comparing P/E and earnings per share (EPS) ratios or
investigating to what extent a stock is trading at a premium or discount in relation
to its net current asset value, debt, and other fundamentals. Fundamental analysis
helps provide indications as to which stocks to buy based on prior company per-
formance, that is, over the last accounting period. Some investors resort to more
active asset‐allocation methods to try to time the market for a suitable stock to buy
into or get out of, rather than just relying on the traditional buy‐and‐hold strategy.
They resort to studying broad market factors and sector‐rotation models in order to
buy into the best fundamentally performing stocks within a strengthening industry
or sector. This method is popularly termed the top‐down approach to investing. A
bottom‐up approach relies more on a specific company’s fundamental performance.
A buy‐and‐hold strategy in today’s volatile markets may not represent the most
effective way of maximizing returns while minimizing potential risks. As a result,
many fundamentalists frequently look to various asset pricing and modern portfolio
models like the Capital Asset Pricing Model (CAPM) to try to achieve the best bal-
ance between risk and expected returns over a risk‐free rate (along what is called
the efficient frontier).
One of the problems with fundamental analysis is the credibility, reliability, and
accuracy of the accounting practices and financial reporting, which is susceptible
to manipulation and false or fraudulent reporting. There are various unscrupulous
ways to dress up a poorly performing company or financial institution. A simple
Internet search will reveal numerous past and ongoing investigations related to
such practices. The other problem is the delay in the financial reporting of a com-
pany’s current financial state in the market. By the time the next audited report is
completed and published, the information is already outdated. It does not furnish
timely information to act upon, especially in volatile market environments, and,
as a result, does not directly account or adjust for current or sudden developments
in the market environment. Nevertheless, fundamental analysis does give valuable
information about specific securities and their performances. Its main weakness is
its inability to provide clear and specific short‐term price levels for traders to act
on. Therefore, fundamental information is better suited to longer‐term investment