TECHNICAL AND FUNDAMENTAL ANALYSIS:
HOW THE PROS MAKE INVESTMENT DECISIONS
STUDENT LEARNING OBJECTIVES
After reading Chapter 8, students should be able to answer the following questions.
1. How do technical and fundamental analysis differ?
2. What are some technical indicators?
3. How well does technical analysis work?
4. What is the process of fundamental analysis?
5. How well does fundamental analysis work?
SUGGESTIONS FOR USE AND TEACHING TIPS
Chapter 8 reviews the two major techniques used by professional investors to make
investment decisions: technical and fundamental analysis. We believe this is important
material and recommend you require students to read the whole chapter. The material
in Chapter 8 is not conceptually difficult and we think you’re students will find the
chapter to be interesting and fairly easy reading. The chapter affords numerous
opportunities for students to examine actual investment decision making, successes
and well as failures.
We suggest that you lecture over most, if not all, the material in Chapter 8. This chapter
is the only place where technical analysis is examined in any depth (though some of the
issues associated with technical analysis were also discussed in Chapter 7). Most
students have heard of technical analysis, and will want to learn more. On the other
hand, we devote four chapters to the process of fundamental analysis. If you plan on
covering Chapters 11 through 14 in detail, you may wish to merely summarize
fundamental analysis at this point.
Throughout Chapter 8 we have attempted to present a balanced picture of how
professionals make investment decisions. We have considered both the successes and
failures of both technical and fundamental analysis. Too often, we believe, academics
tend to dismiss technical analysis as being virtually worthless. Fundamental analysis is
usually presented in a somewhat more positive light, but often academics tend to dwell
on the mistakes and blown calls. We would agree that much of what many technicians
have to say may be of little or no value, but some technicians have what appear to be
excellent track records. Further, while analysts blow calls occasionally, investors are
often wise to listen to what they have to say.
If you’re too negative about technical and fundamental analysis, students can get
confused. After all, they can watch Wall Street Week on PBS or various programs on
CNBC and see technicians or analysts being praised for this or that correct call. Ask
yourself how many times you heard this comment from a student: “[Some pro] has
made millions of dollars for those who follow his or her advice. How can you say that
this pro’s technique has no value?” We believe students should be able to objectively
evaluate professional investment advice. Why professionals are right is as important as
why they are wrong.
If you want to give your students some more practice interpreting the success or failure
of a technical indicator, albeit a somewhat whimsical one, we’ve included some data on
the “Super Bowl Theory” at the end of this section.
Some other suggestions and teaching tips for Chapter 8 include:
Make sure students understand the basic premise behind all technical
indicators—that past patterns in security prices repeat themselves. The key is to
recognize the pattern.
Our discussion of technical indicators is not comprehensive. We’ve tried to put
together a representative sample but there are many more.
An important point to stress is that interpreting technical indicators is more of an
art than a science. One technician may see a bullish pattern while another might
see a bearish pattern from the same set of technical information. In addition,
technical indicators are often ambiguous. Testing technical analysis, however,
requires the establishment of mechanical buy and sell rules.
Students often get confused over the role supply and demand play in setting
prices. Technicians believe that a whole host of factors—some economic some
psychological—determine supply and demand. Fundamentalists, on the other
hand, believe that, in the long run, economic factors determine supply and
Make sure students understand the pressure exerted on analysts to say positive
things about the companies they follow.
I. Technical versus fundamental analysis
A. The premise behind technical analysis
B. The premise behind fundamental analysis
C. The role of supply and demand
II. Understanding technical analysis
1. Dow theory
2. Support and resistance levels
3. More complex price patterns
5. Moving averages
B. Investor sentiment indicators
1. Contrary opinion indicators
2. Smart money indicators
C. Market momentum indicators
1. What is market momentum
2. Advance/decline ratio
3. Relative strength indicators
III. Assessment of technical analysis
A. Two minutes of fame on Wall Street
B. Why technical analysis might work
1. Inadequate fundamental information
2. Self-fulfilling prophecy
C. How well do technical indicators work?
IV. What is fundamental analysis
A. Some historical background
B. The process of fundamental (security) analysis
C. An example of fundamental analysis in action
V. Assessing fundamental analysis
A. Stock price reaction to analyst comments
B. Track records of fundamental analysts
1. Forecasting earnings
2. Blown calls
3. Success stores
C. Why fundamental analysis might fail
1. Delta Airlines’ 1991 earnings
2. Behavior of the analysts
VI. Implications for investors
A. Mixed track record
1. Hold a well diversified portfolio
2. Limits of human judgment
B. Value of professional advice
1. Think for yourself
2. Be skeptical of anyone who claims to have a “system”
3. The past is never a guarantee of the future
INVESTMENT HISTORY BOX – The Future of Investment Research
The Investment Insight box raises interesting questions about the conflict of interest for
investment banking firms that provide investment research on the firms that they
service. If reforms add prohibitive costs to the investment banking firms to create semi -
autonomous research units, they may abandon their research department altogether.
Some questions and issues to discuss with your students concerning this box include:
What are the implications for small investors?
How will the internet information age help small investors?
Will it change how small investors obtain information to invest? Why or why not?
INVESTMENT INSIGHT BOX – The Limits of Human Judgment
The Investment Insight box raises an interesting, and controversial, point that human
behavior is the biggest obstacle to outstanding investment performance. Successful
investing often runs contrary to human nature. Some questions and issues to discuss
with your students concerning this box include:
Why does successful investing sometimes run contrary to human nature?
Give another example of people ignoring the information contained in base rates.
Why do investors prefer personal experience to base rates? Give another
investment example of people substituting experience for the information
contained in a base rate.
What is the relationship between the “herd instinct” and speculative bubbles?
ANSWERS TO END OF CHAPTER EXERCISES
1. The major assumption behind technical analysis is that past patterns in securities
prices repeat themselves. By looking at such indicators as price charts, trading
volume, or relative strength indicators, all of which are based on past patterns,
the technician can reliably predict the direction of future securities prices.
Technicians believe that past price patterns, and the indicators based on them,
show the beginnings of shifts in supply and demand. Supply and demand,
technicians argue, are determined by a whole host of ra tional and irrational
2. A support level is a secondary low and a resistance level is a secondary high
within a primary movement (either up or down) in securities prices. If prices
break through a support or resistance level, this suggests that the secondary
move has become a primary move. For example, if prices break through a
support level during a bull market, this may suggest that the secondary down
move has become a primary move; the bull market has become a bear market.
3. A trend line is a straight line that connects all the secondary highs or lows. If the
upper and lower trend lines are moving closer together during a bull market, a
technician probably would take this as a sign that the bull market is going to
4. The weekly prices and four week moving average are shown below. The moving
average is considered to be a better indicator of the overall trend because it
ignores the weekly price volatility and the moving average smooths out the
movement over the four weeks.
Week Price Moving Week Price Moving
1 35.875 11 41.625 40.969
2 36.625 12 41.500 41.531
3 38.000 13 40.750 41.594
4 39.000 37.375 14 40.375 41.063
5 40.125 38.438 15 40.875 40.875
6 39.250 39.094 16 40.750 40.689
7 38.000 39.094 17 40.375 40.594
8 39.250 39156 18 40.000 40.500
9 40.500 39.250 19 40.375 40.375
10 42.500 40.063 20 40.500 40.438
5. Investor sentiment is how investors “feel” about the market. Are investors
optimistic or pessimistic. Examples of investor sentiment include the various
contrary opinion indicators. If, for example, investors as a group are optimistic,
then the market is about to peak.
6. If prices are rising, on rising volume, that is taken as a sign that the bull market
has a good deal of momentum behind it; prices should go even higher since it will
take longer for the bull market (the “train”) to stop. Measures of relative strength
are often considered to be indicators of momentum.
7. Reasons why technical analysis might work include the inadequacies of
fundamental information, the role of investor emotion security valuation, and
through the effects of a self-fulfilling prophecy. Technical analysis might fail to
work if technical indicators give clear signals only after its too late and if investors
try to anticipate buy and sell signals. Another reason technical analysis might fail
to work comes from the fact that the financial markets function pretty well and
prices adjust very quickly to new information.
8. The main reason it is difficult to assess the record of technical a nalysis comes
from the fact that interpreting technical indicators is very subjective--more an art
than a science. The appropriate standard is to compare the returns (adjusted for
differences in risk and transactions cost) from an investment strategy using
technical analysis to a simple buy-and-hold strategy.
9. Fundamental analysis is based on the belief that all securities have an intrinsic
value and, in the long run, all securities’ prices will equal their respective intrinsic
value. A fundamentalist, for example, would recommend buying securities with
prices below their respective intrinsic values. On the other hand, technical
analysis is based on the believe that stock prices caan be predicted through the
study of the trends from past data. Moreover, the two analyses are different in a
way that technical analysis base their decisions mostly on supply and demand of
the stocks while fundamentalist base their decision on true intrinsic value.
Intrinsic value is the true economic value of the stock. It is important to the
fundamentalists because they believe all stocks will converge to its intrinsic
values. Thus a stock trading below its intrinsic value is a “good” investment
(undervalued) while a stock trading above its intrinsic value is a “bad” investment
10. The three step process moves from the general to the specific: economic
analysis to industry analysis to company analysis. While economic and industry
factors are important, company analysis is probably the single most important
step. The four variables that, in general, determined stock prices are current
earnings and dividends, future growth rates in earnings and dividends,
uncertainty surrounding growth rates, and interest rates.
11. Several reasons fundamental analysis might fail to work include bad data, the
influence of random events, and the behavior of the analysts themselves. Many
argue that technical analysis simply cannot work, no matter how well the
technician does his or her job. It is based on faulty assumptions. On the other
hand, most critics of fundamental analysis do not question the validity of the
assumptions fundamental analysis is based on. The problem is the execution
12. Analysts are under pressure from both the firms they work for and the companies
they follow to say positive things. Analysts who say negative things about a
company risk being cut off from sources inside the company making it difficult to
do their jobs. The herd instinct states that a normal human reaction in the face of
uncertainty is the tendency to stick together and follow the crowd. Moreover, if
the consensus recommendation is off, it “probably could not have been
predicted, but if one person who stands out is off, he was dead wrong.
Critical Thinking Exercises
1. The computer work required by this exercise is not difficult. What is difficult,
however, is establishing support and resistance levels and then interpreting the
buy and sell signals. This exercise should give your students a pretty good idea
of the subjective nature of technical analysis.
a. The graph will reveal that the Nasdaq rose sharply during the two year
period, albeit somewhat erratically. The graph is shown in the Instructor
b. The graph will show that the moving averages are far more stable than the
raw series and better illustrate the general upward trend in the Nasdaq
index. The graph is shown in the Instructor workbook.
c. The first resistance level is established at around 2,000; the first support
level is established around 1,500. The index breaks through the
resistance level and continues rising up 2,500 where another resistance
level is established. The index then moves sideway for a while and
establishes another resistance level at around 2,750. It breaks through
that resistance level on its way up to 4,000.
d. The 10 day moving average breaks above the 200 day moving average in
late October of 1998 (a buy signal). It remains above the 200 day moving
average for the rest of the period. The index breaks above the 2,500
resistance level in November 1998.
e. Your students should understand why interpreting technical indicators is
difficult and often ambiguous. Whether following either chart would have
produced higher profits than simply a buy and hold strategy is debatable.
2. This exercise is slightly more difficult than the first exercise and your students
may need a little more guidance to answer the questions.
a. The relative strength measures are in the Relative Strength worksheet in
the Instructor Workbook.
b. Very clearly Boeing’s relative strength declines throughout the time period.
Disney’s relative strength initially increases and then falls sharply. Only
the Gap’s relative strength increases.
c. Many students will have a difficult time coming up with some sort of a
trading rule based on relative strength. Suggest they think about how a
moving average might help to develop buy and sell signals (i.e., when the
relative strength falls below the moving average, a sell signal is given, and
3. This exercise is fairly straightforward and will require only a minimal amount of
guidance. Suggest students utilize the Internet—it will save them a great deal of
time. The investment oriented Web sites are a good place to find data on
a. Many investment oriented Web sites have sections on “earnings
b. Students will likely find several earnings surprises that are fairly
substantial, especially on the upside. For example, in April 2000
Advanced Micro Devices announced quarterly earnings that were 150%
higher than the consensus forecast.
c. There should be little relationship between the size of the surprise and the
number of analysts following the stock. ADM, for example, is followed by
d. In the case of ADM, the analysts underestimated the demand for the
company’s latest chips and the success of its recent restructuring plan.
THE “SUPER BOWL THEORY”
Some students have probably heard of something called the Super Bowl Theory of
stock prices. It says that if a NFC, or old NFL, team wins the Super Bowl, stock prices
will rise. If an old AFL teams wins, stock prices will decline. Now, we’re convinced the
Super Bowl Theory started as a joke, but it seems to have acquired too serious
reputation in recent years. (Alas, some people have no sense of humor.) Some
classify the theory as a technical indicator; others classify it as a market anomaly. If
you’re in the later group, you could use what follows while covering Chapter 7.
In the table below we present enough data for your students to “test” the theory. You
might suggest students construct two portfolios, one active and one passive. In the
passive portfolio, stocks are purchased at the end of January 1967 and held through the
end of January 1997. The other holds either T-bills or stocks depending on the
outcome of the Super Bowl. If you use this approach, your students should discover
that the active portfolio outperforms the passive portfolio by a wide margin. Ask
students, does this mean the Super Bowl Theory is a good market timing device?
The table includes the winner each year and the prediction for stock prices. The returns
are from the end of January of the year indicated to the end of January of following
year. Have fun!
Year Winner Conference Indicator Stocks T-bills
1967 Green Bay NFC Hold stocks 9.47% 4.12%
1968 Green Bay NFC Hold stocks 14.15% 5.20%
1969 NY Jets AFC Hold bills -15.93% 6.42%
1970 Kansas City AFC Hold bills 15.76% 6.11%
1971 Baltimore Old NFL Hold stocks 11.19% 4.21%
1972 Dallas NFC Hold stocks 13.85% 3.89%
1973 Miami AFC Hold bills -15.10% 6.92%
1974 Miami AFC Hold bills -18.10% 7.64%
1975 Pittsburgh Old NFL Hold stocks 31.16% 5.54%
1976 Pittsburgh Old NFL Hold stocks 5.04% 4.83%
1977 Raiders AFC Hold bills -8.59% 5.12%
1978 Dallas NFC Hold stocks 16.63% 7.23%
1979 Pittsburgh Old NFL Hold stocks 18.72% 9.89%
1980 Pittsburgh Old NFL Hold stocks 17.68% 10.87%
1981 Raiders AFC Hold bills -2.20% 13.49%
1982 San Francisco NFC Hold stocks 24.36% 9.91%
1983 Washington NFC Hold stocks 16.34% 8.51%
1984 Raiders AFC Hold bills 14.13% 9.28%
1985 San Francisco NFC Hold stocks 20.92% 7.35%
1986 Chicago NFC Hold stocks 29.11% 5.84%
1987 NY Giants NFC Hold stocks -3.32% 5.21%
1988 Washington NFC Hold stocks 18.34% 6.41%
1989 San Francisco NFC Hold stocks 13.45% 8.06%
1990 San Francisco NFC Hold stocks 8.05% 7.47%
1991 NY Giants NFC Hold stocks 20.46% 5.26%
1992 Washington NFC Hold stocks 10.00% 3.35%
1993 Dallas NFC Hold stocks 8.79% 2.62%
1994 Dallas NFC Hold stocks .57% 3.90%
1995 San Francisco NFC Hold stocks 38.58% 5.60%
1996 Dallas NFC Hold stocks 18.98% 5.21%
1997 Green Bay NFC Hold stocks 26.37% 5.23%
1998 Denver AFC Hold bills 23.18% 4.75%
1999 Denver AFC Hold bills 21.00% 4.90%
2000 St. Louis NFC Hold stocks