What should I learn first in the stock market? Should it be fundamental analysis or technical analysis? Or should I just learn how to mine datasets and look for an algorithm that beats the market?
This question is usually asked as the choice between fundamental analysis and technical analysis. A simple answer is that when you want to learn to invest, then you learn fundamental analysis first and if you want to trade then learn technical analysis first.
This is a massive simplification of course.
And then is there any merit in the idea that you could approach making money on the stock market through data mining and so you should learn how to mine data first. This is the quantitative approach, also referred to as algorithm investing or algo trading.
Well, probably not really.
This approach means you would look to find patterns in past price movements, develop algorithms that identify those patterns and how they predict future price developments. Then you would backtest your algorithms against past price data to see how well it should perform in the future.
So an obvious question would be, how would you know what kinds of price patterns to look for? But even this is an approach build either on some knowledge of technical analysis or fundamental analysis or preferably both. 1)What should I learn first in the stock market? https://www.quora.com/What-should-I-learn-first-in-stock-market-fundamental-analysis-or-technical-analysis
Why learn fundamental analysis
We should first define fundamental analysis.
Fundamental analysis in the case of a company is the study of the finances, competitive position, and management of the company in the context of its industry, markets, and the wider economy to arrive at an assessment of its inherent value. Through the understanding formed of the inherent value of the company, assessments of the value of financial instruments and derivatives issued by the company can also be derived. Fundamental analysis can also be used to assess the inherent value of fixed income financial assets.
I know that is a bit of a mouthful.
There are probably more user-friendly ways of explaining fundamental analysis. Like that it is all about getting deep into a company’s financial statements, and comparing how measures like ratios of one financial value to another compare with similar companies in the same line of business. This is the realm of price to earnings ratios, quick ratios, cash ratios, dividend cover, and all that good stuff.
You might be wondering whether you need an MBA in finance to really master fundamental analysis. That question reminds me of a saying that was common in offices years ago.
You don’t have to be crazy to work here, but it helps.
In a similar way, you don’t have to have an MBA in finance to get to grips with fundamental analysis but it certainly helps. Actually, on reflection, I could just as easily support the other side of that argument. Sometimes you can bury yourself too deeply in the minutiae of the financial intricacies of a company and miss the big picture.
So as long as your MBA in finance trains you to lift yourself out of the details and see the big picture, you should be fine. But the point is that in the world of analysis of a company’s finances, there are rabbit holes at every turn. You just have to be careful not to get lost down them.
Why do you need fundamental analysis?
A textbook answer is so that you can dig into the financial statements of a company and after examining its financial ratios and where its sales and earnings and debt and market position and management quality is in relation to its competitors, then you can determine whether the shares and bonds and any of its other financial instruments are undervalued or overvalued by the market.
As I say that is the textbook answer.
That is certainly true if you are going to enter the financial industry as an analyst.
The reality is that as an individual investor it is far more likely you will be reading and trying to understand the analysis conducted by financial professionals. The better you understand fundamental analysis, the better chance you have of really understanding someone else’s analysis. On the basis of that understanding, you will be in a better position to decide whether you want to invest or trade in that company’s shares or bonds.
Let’s take an example.
An analysis report says that company A has a dividend cover ratio twice that of its industry peers and its current ratio is a third higher than its peers and it is in an industry that is highly leveraged. You would understand why the analysis might then go on to say that company A’s stock price is likely to be less sensitive to interest rate rises than its industry peers.
Of course, the market might take a different view.
A large portion of company A’s shares may be held by ETFs and mutual funds as part of an industry basket, and company A’s shares may just get dumped along with all the others in the basket if institutions decide to offload the funds en masse.
But the argument in favor of getting to grips with fundamental analysis is that this will just improve your financial literacy and that can only be a good thing.
So what about technical analysis?
Again, let’s start with a definition of technical analysis.
Technical analysis is the study of past price action seeking to identify patterns of price movement that can lead to assessments of the probabilities of different future price movements. One of the basic tenants of technical analysis is that human psychology is reflected in price movements and human psychology follows patterns.
Generally speaking, fundamental analysis is highly rational, objective, and scientific while technical analysis is more of an art.
Having said that, technical analysis can use many highly mathematical ways of analyzing price movement. This is the realm of candlestick patterns, charting, and a plethora of indicators calculated from price and volume sometimes using simple arithmetic and other times using complex statistics and calculus.
It is fair to say that because fundamental analysis is fundamentally rational while technical analysis uses interpretation and is a bit of an art, there are camps and schools of fundamental analysis that shun technical analysis. At the same time, there are schools of technical analysis that say that fundamental analysis doesn’t matter. We’ll come back to this a bit later.
And when I said there is a plethora of indicators used in technical analysis I wasn’t joking. It is probably fair to say that there have been periods in the development of technical analysis where every self-respecting grad school student would have felt they were letting the side down if they didn’t create a new indicator and publish a paper on it.
So what could an example of technical analysis of a company’s share price sound like?
Someone might say that after building what looks like a long base, after a breakout on heavy volume company B’s shares have been trading in a channel for the last 6 months with the 50-day moving average serving as support while the price has encountered resistance that looks to be weakening and is a probable precursor of another price breakout which is likely to hit resistance at the first Fibonacci extension level of $x.
There could be more technical analysis that you could throw at that situation. There always is. Different practitioners can look at the same situation and see different things and others see nothing at all.
I suppose you could cynically say that one reason for learning technical analysis is so you can BS your friends with convincing-sounding stock tips.
Another good reason for learning and applying technical analysis is that a huge proportion of trading volume these days is driven by institutions using program trading. In other words, computers are executing many trades and they are using many of the common techniques of technical analysis so a lot of observed price action follows these same principles.
That is actually an important statement so it is worth going over again. 2)Algorithmic Trading Market – Growth Trends https://www.mordorintelligence.com/industry-reports/algorithmic-trading-market3)Machines are driving Wall Street’s wild ride, not humans https://money.cnn.com/2018/02/06/investing/wall-street-computers-program-trading/index.html
Analysts tell us that computers account for between 50 and 70% of stock market trading on any one day. Well, actually that is on a calm day. When the markets are really volatile the computers pretty much take over and can account for anywhere up to 90% of the trades on the stock market.
So a question would be – how are those computers programmed and what triggers trades? The answer is that they are programmed using a mixture of common technical analysis techniques such as moving averages, Fibonacci levels, and others.
What is important in technical analysis?
There are a few things that are important in technical analysis, here would be a list.
- Price is the most important indicator
- Know your investing/trading timeframe, zoom out from there to see the next longer-term timeframe, and determine the general market direction
- Understand what any indicator is telling you, what it really means
- Avoid the endless quest for the best indicator, it doesn’t exist
- Start simple, with price and at most just a few indicators and study many charts using the same simple approach
- Plot levels of price support, resistance, and congestion
- Watch volume, volume means validity
As we already said, there is any number of indicators you can watch, but it is best to use a system. The system I use is to look at candlestick price and volume charts over different timeframes with 50-day and 200-day moving averages. I also occasionally look at the RSI with the standard 14-day settings and sometimes at the MACD also with standard 12, 26, and 9-day settings. Once a breakout or a breakdown is confirmed, project price targets using Fibonacci levels.
With these indicators, it is very important to remember what they are saying.
The RSI is an indicator that oscillates between 0 and 100 and measures the relative strength of the most recent closing price moves. In simple terms when the RSI gets high it shows that the price has closed up a lot recently and when it gets low it shows that the price has closed down a lot recently.
I’m trying to be super simple here as I think it is too easy to hide behind fancy definitions. Here is an article that goes into more depth on the RSI.
The common thing to do with the RSI is to look at whether a stock is getting overbought or oversold. We should underscore here that this condition is in relation to price movement over the last 14 days. So this classic way of using the RSI is only telling us whether something is overbought or oversold in this short-term window. The long-term situation could be quite different.
Generally, an RSI reading above 70 is considered overbought while an RSI reading below 30 is considered oversold. However, that really only applies if the stock is trading pretty much sideways. In an up-trending market, both the overbought and oversold regions are going to be higher in numerical terms. Conversely in a down-trending market, both the overbought and oversold regions are going to be lower in numerical terms.
And again speaking generally, a stock that gets overbought in the short-term is ripe for a downward price correction while a stock that gets oversold in the short-term is getting ready for an upward price move. Both of these likely movements would likely also be over the short-term.
The easy way to remember what the MACD is telling you is to spell out what the letters stand for. Moving Average Convergence Divergence. The MACD line is calculated by subtracting the long-term moving average, which is usually set to 26 days from the shorter-term moving average normally set to 12 days. The MACD line oscillates above and below zero.
So when the MACD is positive and increasing this means that the short-term moving average is moving higher above the long-term moving average. This is an indication of increasing upward price momentum. A second line, called the signal line is plotted, usually as a 9-day moving average of the MACD line.
What I mostly look for in both the RSI and the MACD is a negative divergence. This article explained negative divergence in the MACD and in the RSI.
We’ve seen some negative divergence in the main market indexes lately. There are also many signs that market breadth is thinning out. It has only been a small handful of the really mega-cap stocks that have been pulling the market indexes up for the last few months really up until September 2021.
Fibonacci extensions and retracements
Another important technique in technical analysis that is well worth mastering, or at least gaining familiarity with is Fibonacci extensions and retracements. Here is an article that explains how Fibonacci levels are derived and used.
If we take the case of a price breakdown after a sustained up-trend, we would set a high point at the peak price and a low point at the last significant level of support. The difference between these two levels is 100% in Fibonacci terms. We would then project Fibonacci retracement levels between those points to find likely points of price support.
Fibonacci extension follows a similar principle projecting likely levels of price resistance when price is breaking out into areas of new highs. As for retracement, the last significant price high is the 100% mark and the last significant price low is the 0% mark. Fibonacci extension levels are then at 138.2%, then 150% and then 161.8% and 200% etc. Generally speaking the 150% and 200% levels are given more weight.
Oh, and by the way, there should be no need to mess with complex math to use Fibonacci levels. Your online broker should have a charting package that includes Fibonacci extension and retracement levels with a few mouse clicks.
What is essential in fundamental analysis?
This will depend to an extent on why you are interested in investing in a stock. Whether you are looking for a stock that will accumulate in price over the next few years or a stock that will pay dividends and have the financial strength to ride out a storm.
If there is one common thread in all companies that you are looking to invest in over the long term, it is the quality of the management. Well, that’s good to know, but how do you gauge the quality of management of a company? There is no simple figure you can measure or read to determine whether a company has high-quality management or not. There are, however, a few things to look for.
- Management ownership of company shares. If the directors believe in the prospects of the company then they will invest in the shares.
- Keeping promises to shareholders. Read the statements in annual reports from one year to another, to see that there is follow-through on things promised for future periods.
- Ethical behavior with their employees, suppliers, customers, the community where the company is located, and the broader public. Search for news reports on the company.
The quest for growth
If you are looking for a stock that is likely to rise over the next few years, then you want to see,
- A strong balance sheet, compare debt to equity ratios with industry peers
- Stong cashflow and liquidity, check the quick ratio, and cash ratio and compare with industry peers
- Increasing sales, over a few years, quarter on quarter taking seasonal factors into account
- Increasing earnings per share, over a few years
- Strong and increasing institutional ownership
Stocks as a source of income
Currently and over the last few years, buying stocks for dividends has not been a great way to accumulate wealth or create a reliable and meaningful income stream. However, assuming you are looking to building a portfolio of stocks that will pay out a decent stream of dividend income some years in the future, then there are certain kinds of stocks to look out for and things you can do to achieve your goals.
The first thing you need to do is diversify your dividend-paying stocks into a number of industries, around 7 to 10 industries would be good. Take each industry in turn and then start by looking at the top 20 companies in that industry.
Sift through the list to select only companies with sound and solid finances.
First look for a top credit rating, discard any companies that do not have the highest rating.
Then look for a comfortably low dividend payout ratio. This is the ratio of dividends to earnings. You want to see that the company consistently retains a healthy proportion of earnings as a buffer. Discard any with a payout ratio higher than 60%.
Now you want to look for companies with a long history of increasing dividends. There are various online sources you can turn to. One is the Standard and Poor’s 500 Dividend Aristocrats Index. 4)S&P 500 Dividend Aristocrats https://www.spglobal.com/spdji/en/indices/strategy/sp-500-dividend-aristocrats/#overview
You could pick some stocks in different industries from this list. Alternatively, if you wanted an easier approach you could just buy into an ETF that tracks the index.
You should also find that regular financial news sources for example Yahoo Finance has a list of high dividend yield stocks. 5)High Yield Dividend Stocks https://finance.yahoo.com/u/yahoo-finance/watchlists/high-yield-dividend-stocks/
Assuming you have an account with a decent online broker, they should also provide a list of high dividend yield stocks. For example, my own broker, E*Trade has a list of high dividend yield stocks that I can sort by 5-year dividend growth and other factors.
Something else you should do until you need the dividends as income, reinvest the dividends into the same stocks. The point is when selecting these stocks is that you are not looking for growth in the stock price. You are looking for financial stability, the highest credit ratings, a comfortable payout ratio, and a long history of increasing dividend payments. You also want a company that is likely to be in business for many years to come.
The point is here you are going to have to do some research. 6)Build a Dividend Portfolio that grows with you https://www.investopedia.com/articles/stocks/07/build_dividend_portfolio.asp
To invest or to trade?
This goes back to an earlier consideration. If you are looking to invest and build a portfolio of stocks that you will hold for a long time, many years for example, then fundamental analysis will be what you need.
If you are looking to trade stocks over the short term, then technical analysis is likely to be your better bet.
What about quants and algo trading?
Algo trading is a whole area in its own right. I wouldn’t necessarily say that the learning curve is steep but it can be a long one. If you have a reasonable understanding of how to use logic functions and a willingness to spend many months learning, backtesting, and paper-trading or dummy trading then algo-trading or investing could be for you.
But I will go back to an earlier point. In order to get into trading or investing using algorithms, assuming you want to create your own algorithm and not just copy or buy someone else’s, then you will have to have a theory or a hypothesis for a trading or investing strategy. In order to have a hypothesis in the first place, you will likely have to acquire some knowledge of fundamental analysis and technical analysis.
And by the way, copying or buying someone else’s algorithm is bound to fail. Algorithms are only working because there is some inefficient pattern in prices that the algorithm detects and exploits. The more that that algorithm is used or, that other algorithms spot and exploit the same inefficient pattern the more the profit potential of that inefficiency will be reduced and eventually eliminated.
Also, why would anyone want to sell an algorithm? If it is successful the owner would be able to make more money using it and trading with it than they could make by selling it.
Fundamental analysis and technical analysis
The other thing is of course to use both fundamental and technical analysis. They both have their place and are both equally valid.
Questions and answers
Q. How should a beginner learn the stock market?
A. Start reading books on the stock market and keep reading. There are a lot of short, over-hyped, repetitive, low-quality books out there pumped up in the ratings by fake reviews. The classics are still worth investing the time and effort into. Read up on what the masters of investment say, bear in mind that they recommend their own approaches which will differ one from the other. Take courses from successful traders and investors with a long track record. Open a brokerage account and start paper trading. When you are ready, start investing in large and safe companies.
Q. What stocks should I buy first time?
A. If you want to invest in individual stocks for the first time, start with the large-cap stocks that feature high up in the major stock market indexes like the Standard and Poor’s 500.
Q. What is the best investment for beginners?
A. If you are employed and if your employer offers a 401k plan start with that and maximize your employer’s matching contribution. Otherwise, start investing in broad market value and growth mutual funds and ETFs.
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Since we’ve been talking about financial education, one great way to accelerate your financial education is with the American Association of Individual Investors, the AAII.
When you join the AAII, you get access to reports, courses on investing, risk management, asset allocation, retirement planning, managing retirement finances, and other resources, all for a single annual membership fee.
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Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as personalized investment advice, good or bad. You should check with your financial advisor before making any investment decisions to ensure they are suitable for you.
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|↑1||What should I learn first in the stock market? https://www.quora.com/What-should-I-learn-first-in-stock-market-fundamental-analysis-or-technical-analysis|
|↑2||Algorithmic Trading Market – Growth Trends https://www.mordorintelligence.com/industry-reports/algorithmic-trading-market|
|↑3||Machines are driving Wall Street’s wild ride, not humans https://money.cnn.com/2018/02/06/investing/wall-street-computers-program-trading/index.html|
|↑4||S&P 500 Dividend Aristocrats https://www.spglobal.com/spdji/en/indices/strategy/sp-500-dividend-aristocrats/#overview|
|↑5||High Yield Dividend Stocks https://finance.yahoo.com/u/yahoo-finance/watchlists/high-yield-dividend-stocks/|
|↑6||Build a Dividend Portfolio that grows with you https://www.investopedia.com/articles/stocks/07/build_dividend_portfolio.asp|