Technical Analysis operates on the theory that market prices at any given point in time reflect all known factors affecting supply and demand for a particular market. Consequently, technical analysis focuses, not on evaluating those factors directly, but on an analysis of market prices themselves. This approach theorize that a detailed analysis of, among other things, actual daily, weekly and monthly price fluctuations is the most effective means of attempting to capitalize on the future course of price movements. Technical strategies generally utilize a series of mathematical measurements and calculations designed to monitor market activity. Trading decisions are based on signals generated by charts, manual calculations, computers or their combinations.
Fundamental Analysis is based on the study of factors external to the trading markets which affect the supply and demand of a particular market. It is in stark contrast to technical analysis since it focuses, not on price but on factors like weather, government policies, domestic and foreign political and economic events and changing trade prospects. Fundamental analysis theorizes that by monitoring relevant supply and demand factors for a particular market, a state of current or potential disequilibrium of market conditions may be identified before the state has been reflected in the price level of that market. Fundamental analysis assumes that markets are imperfect, that information is not instantaneously assimilated or disseminated and that econometric models can be constructed to generate equilibrium prices, which may indicate that current prices are inconsistent with underlying economic conditions, and will, accordingly, change in the future.
Another definition of Fundamental Analysis:
Fundamental Analysis is an approach to analyzing market behavior that stresses the study of underlying factors of supply and demand. It is done in the belief that such analysis will enable one to profit by being able to anticipate price trends. A Fundamentalist is a market observer and/or participant who relies principally on Supply/demand considerations in price forecasting. Components of Fundamental Analysis:
Supply:
- Weather
- Acres planted to a crop
- Government Programs
- USDA Reports
Demand:
- USDA Reports
- Domestic usage — Feed & processing
- Value of the Dollar
- Actions of Other Countries
- Exports
- Transportation
How do trend followers view fundamentals for trading? Not favorably…
Why Trend Followers Reject Fundamental Analysis
The fundamental analysis definition above contains its own refutation. It “assumes that markets are imperfect, that information is not instantaneously assimilated or disseminated.” This assumption may have been defensible in the 1970s when information traveled slowly and institutional access to fundamental data was a genuine competitive advantage. In today’s markets, USDA crop reports are simultaneously disseminated to thousands of institutional participants with faster processing capability than any individual analyst. The assumption that a fundamental analyst can identify a disequilibrium “before the state has been reflected in the price level” is increasingly difficult to maintain.
David Druz identified the practical problem directly from his own experience: he did rigorous fundamental supply and demand analysis for years and “never saw a correlation between that and trading.” The analysis was correct. The trading signal was absent. The market had already priced in the information the analysis produced.
The fundamental analysis components list illustrates why this problem is structural. Weather, acres planted, government programs, USDA reports, domestic usage, the value of the dollar, actions of other countries, exports, and transportation all affect the supply and demand of agricultural commodities. All of these factors are monitored by hundreds of professional analysts at commodity trading houses, agricultural banks, government agencies, and hedge funds simultaneously. The price already reflects the aggregate of all their analyses. A single trader’s fundamental analysis adds one more data point to a pool of thousands. The incremental informational advantage of that one additional analysis is essentially zero.
The question fundamental analysis cannot answer is the one that matters most for trading: when do you exit? The supply and demand analysis produces a view that a commodity is undervalued or overvalued. It does not produce a stop loss level, a position size, or an exit criterion. Without those elements, the analysis is incomplete as a trading system even if it is correct as an assessment of value. Enron’s financial position was disclosed in SEC filings. The value investors who analyzed those filings were correct that the company appeared to be a fairly good growth stock. The price was wrong. The analysis was incomplete because it had no exit rule.
Trend following’s position on fundamentals is not that they are irrelevant to price. It is that they are already in the price. The weather, the USDA reports, the government programs, and all the other supply and demand factors have already been processed by the market’s aggregate of participants and expressed in the current price. Reading the price directly is reading the aggregate of all fundamental analysis ever performed on the commodity. No individual analyst can improve on that aggregate. They can, however, react to what it shows.
Frequently Asked Questions
What is the key difference between technical and fundamental analysis?
Technical analysis reads price directly, treating current price as the reflection of all available information. Fundamental analysis attempts to evaluate the underlying supply and demand factors that drive price, with the goal of identifying situations where current price does not yet reflect fundamental conditions. Trend following is a form of technical analysis: it reads price and reacts to its movement without independently evaluating the supply and demand factors behind it.
Why can’t fundamental analysis provide exit criteria?
Because fundamental analysis produces a view about value, not a specific price level at which the view is wrong. An analyst who believes soybeans are undervalued has no systematic rule for when to exit if the price continues falling rather than reverting to the analyzed fair value. The exit happens when the analyst changes the fundamental view or when losses become intolerable — neither of which is a defined, systematic rule. Trend following defines exit criteria before entering any position.
What did David Druz mean when he said fundamental analysis was “all baloney”?
He meant that despite rigorous application of fundamental supply and demand analysis at Stotler & Co., he never observed a reliable trading edge from that analysis. The research was thorough. The correlation between the research conclusions and profitable trades was absent. His experience led him to abandon fundamental analysis entirely and build a price-reactive systematic approach, which he ran profitably for decades from his firm in Hawaii.
Trend Following Systems
Want to learn more and start trading trend following systems? Start here.
