Why technical analysis : the lack of fundamental analysis

Technical analysis has a quite different approach to the estimation of buying and selling levels compared with fundamental analysis.

Indeed, fundamental analysis, as used by bank analysts (leading to recommendations), mainly relies on financial ratios linked with the company’s fundamentals.



Thus, ratios such as stock price on expected earnings, market cap on turnover, debt level, will be studied…. As norms are determined, they enable to determine the risk level associated with an acquisition or a sale of a share. For example, a quite common norm consists in looking mainly for stocks whose stock price / expected earnings per share ratio stands below twenty, which is considered as a major threshold. Similarly, a major level for the market cap / turnover ratio stands around two.

Still, this method may lack some elements. Let us take the case of IT stocks at the beginning of the year. Many of these stocks reached a stock price / earnings ratio above 100 and a cap / turnover ratio above 10. From a fundamental point of view, how can we behave? Either we establish new ratios, specific to the “New Economy”, which can take some time, either we stay with the former ratios, which leads to avoiding some good opportunities.

Moreover, it often appears that the stock price evolution does not necessarily reflect actual fundamentals of the companies, as over-reaction effects (both on the downside and on the upside) are quite common, especially relatively to announcements.