Fundamentals & Technicals

Understanding the value of an investment involves two primary schools of thought: fundamental and technical analysis.

Fundamental analysis involves evaluating a company's intrinsic or "true" value by scrutinizing various economic, financial, and qualitative factors. It's akin to understanding the health and potential of a tree by examining its roots, trunk, branches, and leaves.

Technical analysis (sometimes referred to as TA) focuses on statistical analysis of price movements, trading volume, and chart patterns to forecast future price movements. It's like reading the weather by observing cloud patterns rather than understanding the atmospheric conditions that create them.

Fundamentals

Fundamental analysis dives deep into the company's financial statements, market position, and broader economic conditions to assess its worth. Several key metrics are used when identifying a company's intrinsic value.

Financial Metrics

• This includes analyzing income statements, balance sheets, and cash flow statements. Key ratios like Price to Earnings (P/E), Debt to Equity, Return on Equity (ROE), and others provide insights into profitability, debt levels, and operational efficiency. 

• Earnings Per Share (EPS) and Book Value also give clues about the company's earnings capability and net asset value.

Economic Indicators

• Understanding macroeconomic factors like GDP growth rates, interest rates, inflation, and industry-specific trends helps in gauging how these might impact the company's future performance.

Qualitative Factors

• Beyond numbers, fundamentals consider management quality, brand strength, patents, competitive advantages (like economic moats), and market share.

Growth Prospects

• Evaluating the company's future growth potential through product pipelines, market expansion, or innovation.

Valuation Models

• Techniques like Discounted Cash Flow (DCF) analysis estimate the present value of expected future cash flows, providing a benchmark for stock pricing. 

• Other methods include the Dividend Discount Model (DDM) or Comparative Valuation using multiples like EV/EBITDA.

Often, you will hear stock analysts or banks release price targets for companies, which are their assessments of a company's worth after conducting rigorous fundamental analysis. However, these targets are not always accurate, and one should not place too much weight on them alone.

Technicals

Technical analysis is all about deciphering patterns and trends in stock price movements. To analyze a stock price, we use a stock chart, which is a visual tool that plots the price of a stock against a time interval. There are countless tools, indicators, and strategies within technical analysis. Here are some of the most popular tools and indicators you'll need to understand to read stock chart patterns and make informed investment decisions:

Candlestick

• A candlestick is a type of price chart used in technical analysis that displays the high, low, open, and closing prices of a security for a specific period. Each "candle" represents one period's price action, with the body showing the range between the open and close prices. 

• If the closing price is higher than the opening price, the body is typically colored green, indicating a bullish period. Conversely, if the close is lower than the open, the body is usually colored red, signaling a bearish period. 

• The thin lines above and below the body are called "wicks" or "shadows," representing the high and low prices during that period. 

• Candlestick patterns can provide valuable insights into market sentiment and potential price movements based on historical price action.

Bullish/Bearish Candlestick Patterns

• Patterns like "Wedges," "Head and Shoulders," "Cup and Handle," etc., give insights into market sentiment and potential price direction. 

• Each pattern has specific implications for future price movements, built from combinations of individual candlesticks.

Moving Averages

• Simple (SMA) and Exponential (EMA) moving averages help smooth out price data to identify the direction of the trend over time. 

• When multiple timeframe moving averages cross each other, it's known as a "crossover," which can be a strong indication of a shift in market sentiment.

RSI (Relative Strength Index)

• Measures the speed and change of price movements to identify overbought or oversold conditions, suggesting potential reversals. An RSI above 70 might indicate overbought, while below 30 could suggest oversold.

MACD (Moving Average Convergence Divergence)

• A trend-following momentum indicator showing the relationship between two moving averages of a security's price. 

• Includes a MACD line, a Signal line, and a histogram. 

• Crossovers between the MACD and Signal lines can signal buy or sell opportunities.

Logarithmic Y-Axis on Stock Charts

• What is Logarithmic? In mathematical terms, a logarithmic scale represents data where each increment on the axis represents a multiplicative change rather than an additive one. For example, moving from 10 to 100 is the same distance as moving from 100 to 1000 on a log scale.

• Why Use Logarithmic Scale? Viewing stock charts on a logarithmic scale rather than a standard linear one accounts for the exponential nature of growth and inflation. 

• Inflation and Growth: Since the S&P 500 has shown exponential growth since around 1942, a logarithmic scale better reflects percentage changes, making long-term trends and historical performance comparisons more meaningful. It helps visualize how much a stock has grown in real terms over time, especially for indices or stocks with significant historical price increases.

• Logarithmic vs. Linear: A logarithmic scale is particularly useful for stocks or indices with large price movements over time because it shows proportional changes. In contrast, a linear scale treats each unit increase in price as the same distance visually, which can distort the perception of growth rate for stocks with significant price changes. Using a logarithmic scale allows investors to better understand percentage changes, which are more relevant for long-term investment analysis, whereas linear scales are better for short-term, small-scale price movement analysis.

Understanding this section should equip investors with the tools to assess whether a stock is undervalued or overvalued by fundamentals, or if its price movements suggest a particular trading strategy using technical indicators. Both approaches are crucial and often used in tandem, providing a comprehensive view of market opportunities and risks. Remember, fundamentals always come before technicals, as they provide the basis for why a stock might move in a certain direction, while technicals can help time the entry and exit points of trades.