TRADING TECHNIQUES
Combining Technical And Fundamental Analyses
by Mark C. Snead, Ph.D.
The two forms of analysis approach market forecasting in radically different styles. Can they be combined?
Few topics generate as much heated discussion as the time-honored debate of technical vs. fundamental analysis. The two schools do, in fact, offer radically different approaches to market forecasting; fundamental analysis is concerned with identifying the relevant variables underlying price action, while technical analysis attempts to extract tradable information from price action itself.
FIGURE 1: INTEREST RATE MODEL. Historical 10-day returns for the S&P 500 following interest rate conditions ranging from rapidly falling (quartile 4) to rapidly rising (quartile 1) rates for the prior 20 trading days.
What is most interesting about this is the tendency for forecasters to rely solely on either fundamental or technical analysis. Many are merely following the conventional wisdom that each technique is logically more compatible with a given trading horizon. Because long-run movements in a market are ultimately steered by the underlying fundamentals, fundamental analysis is considered more suitable for long-term investors. Conversely, since short-term market movements are dominated by volatile price adjustments, technical analysis is the method of choice for most short-term traders.
Regardless of the reasoning, forecasting models that fail to incorporate both approaches will suffer predictable lapses in forecasting accuracy. The reason? A model based on only one type of indicator is all too easily bamboozled by the market conditions not being modeled. This happens because an indicator can see only the market behavior that it is specifically designed to see. A model using only fundamental indicators is incapable of adjusting to the constant flux of technical market conditions, whereas the strict use of technical analysis ignores the powerful influence of the underlying fundamentals on market prices.
Technical and fundamental analysis should not be treated as incompatible approaches to market forecasting. Instead, they should be considered complementary methods, each with a strong dependence upon the other. The interdependent nature of the two is so remarkable that asking either approach to stand alone in providing a market forecast is asking more than perhaps either method can deliver individually.
The payoff from using both technical and fundamental indicators is an enlightened glimpse inside overall market action that otherwise would remain unobservable. A trader using a combined model can compare and contrast the fundamentals, which dictate what it should be doing, with technical conditions, which represent what the market is doing. Instead of using fundamental indicators blind to the influence of technical conditions, and vice versa, you can identify occasions when technical and fundamental factors are pushing a market in either the same or opposing directions. This makes it possible to exploit the most reliable trading conditions that occur when the underlying fundamentals are in agreement with the current technical stance of the market. Without explicitly modeling both, the best you can hope for is that the unaccounted-for factor does not assume control of the market at an inopportune time.
COMBINING INDICATORS
Building a combined forecasting model is easy to demonstrate. The only ingredients needed are reliable technical and fundamental indicators and a method by which to combine them. It is the method of combining them that deserves special attention, because battle-tested fundamental and technical indicators are already widely available.
M ark Snead is a finance professor at Oklahoma State University and president of TradeTools, Inc. (www.tradetools.com), a provider of historical financial market data and custom financial market modeling tools.
Excerpted from an article originally published in the September 1999 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1999, Technical Analysis, Inc.
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