Technical vs Fundamental Analysis: How the Pros Pick Stocks

Chapter 5 kicks off Part Two of the book: “How the Pros Play the Biggest Game in Town.” On a typical trading day, shares worth hundreds of billions change hands. Fresh Harvard Business School grads pull $200,000 salaries in good years. The top money managers handle over a trillion dollars in hedge fund assets.

So how do these well-paid professionals actually decide what to buy and sell? Two methods: technical analysis and fundamental analysis.

The Chart Readers

Technical analysis is chart reading. You look at a stock’s past prices and trading volume, draw lines connecting the highs and lows, and try to spot patterns that predict where the price goes next.

The first principle of technical analysis is that everything you could ever know about a company is already reflected in its stock price. Earnings reports, management changes, new products. It’s all baked in. So why bother reading the news? The second principle is that prices move in trends. A stock that’s rising will keep rising. A stock that’s sitting still will keep sitting still.

True chartists don’t even care what business a company is in. One of the original chartists, John Magee, worked in a Springfield, Massachusetts office with boarded-up windows. He didn’t want sunshine or rain to influence his judgment. Only the charts mattered.

These analysts look for patterns with names like “head-and-shoulders formations” and “channels.” They watch for “resistance levels” where a stock keeps bumping into a ceiling and “support levels” where it keeps bouncing off a floor. When a stock breaks through resistance, they buy. When it drops below support, they sell.

Malkiel has some fun noting that chartist vocabulary includes “double bottoms,” “breakthrough,” “ascending peaks,” and “buying climax.” A psychiatrist even suggested the whole practice has overtones of romantic pursuit. All of it happening under the symbol of the bull.

Why Charting Might Work (In Theory)

Malkiel gives three reasons why charting could plausibly work.

First, crowd psychology. When people see a stock going up, they want in. The price rise feeds more enthusiasm, which feeds more buying. It becomes a self-fulfilling prophecy.

Second, information doesn’t reach everyone at the same time. Insiders know first. Then their friends. Then the institutional investors. Then regular people like us. If a stock is gradually climbing, maybe the “smart money” knows something. The chartist tries to catch that early.

Third, people tend to underreact to new information. When a company reports surprisingly good earnings, the stock goes up, but not all the way. The full adjustment takes time, creating momentum that a chart can capture.

There’s also a psychological angle. If you bought a stock at $50 and it dropped to $40, you’ll probably sell the moment it gets back to $50 just to break even. Lots of people thinking the same way creates predictable price ceilings and floors.

Why Charting Might Not Work

Here’s where Malkiel gets skeptical. And he has solid reasons.

The chartist only acts after a trend has started. By the time you spot the pattern and buy, the move might already be over. You’re always late.

The method is also self-defeating. If everyone uses the same signals, everyone tries to buy at the same time and nobody gets the advantage. Traders start anticipating the signal before it happens. Then others anticipate those anticipators. Pretty soon nobody is following the charts. They’re just guessing about guessing.

The strongest argument is about speed. If a company’s research chemist discovers something that will double earnings, insiders don’t wait for the chart to form a pattern. They buy immediately, the price jumps in minutes, and there’s nothing left for the chartist to capture.

As Malkiel puts it: if some people know the price will go to 40 tomorrow, it will go to 40 today.

The Number Crunchers

Fundamental analysis takes the opposite approach. Instead of reading charts, you calculate what a stock is actually worth based on earnings, dividends, growth rates, risk, and interest rates. If the market price is lower than your calculated value, you buy.

About 90 percent of Wall Street analysts consider themselves fundamentalists. Many look down on chartists.

Malkiel lays out four rules that fundamentalists follow:

Rule 1: Pay more for a stock with higher expected growth. A company growing at 25% is worth more than one growing at 5%. This seems obvious, but the magic of compound interest makes the differences enormous. A $1 dividend growing at 25% for 25 years becomes $264.70. At 5%, it’s only $3.39.

Rule 2: Pay more for a stock that pays out a larger share of earnings as dividends, all else being equal.

Rule 3: Pay more for less risky stocks. A stable company like Johnson & Johnson that barely dips during recessions deserves a higher price than a volatile stock that crashes 30% when the market falls 20%.

Rule 4: Pay more for stocks when interest rates are low. When bonds pay 15% like they did in the early 1980s, stocks have tough competition. When rates are near zero, stocks look a lot more attractive.

The Three Caveats

This all sounds clean and logical. But Malkiel has three warnings.

You can’t predict the future. All of fundamental analysis rests on forecasting earnings growth. And nobody can do that reliably. During the Internet bubble, everyone projected endless growth. During the 2008 crash, everyone projected doom. Both were wrong within a few years.

You can’t get precise answers from rough guesses. An analyst tried to calculate IBM’s intrinsic value. He estimated 16% growth for 10 years, ran the formula, and got $172.94 per share. IBM was trading at $320. So he extended his growth forecast to 20 years and got $432.66. Same growth rate, different guess about duration, and the answer nearly tripled. If you can get any price you want by tweaking assumptions, what’s the point?

Malkiel’s verdict here is blunt: “God Almighty does not know the proper price-earnings multiple for a common stock.”

The market’s mood changes. Even if you correctly identify a cheap growth stock, the market might not come around to your view. Instead of the cheap stock rising, all growth stocks might fall. The market can “correct” by repricing everything downward rather than your pick upward.

Using Both Together

Malkiel ends the chapter with three practical rules that combine both approaches.

Buy companies with above-average earnings growth expected for five or more years. Growth is the single most important factor in stock returns. Apple, Google. The big winners were all growth stocks.

Never pay more than a stock’s firm-foundation value. Look for growth stocks selling at reasonable P/E multiples. Peter Lynch used this at Magellan Fund. He calculated the PEG ratio (P/E divided by growth rate). A stock growing at 50% with a P/E of 25 (PEG of 0.5) beat one growing at 20% with a P/E of 20 (PEG of 1.0). Buy growth at a low multiple and you get a double bonus: both the earnings and the multiple increase.

Pick stocks with stories that can catch the crowd’s imagination. This is where the castle-in-the-air theory sneaks back in. A stock needs to excite people, not just show good numbers. If the story never catches on, the multiple might not expand even if earnings grow.

The big question, of course, is whether any of this actually works in practice. That’s what the next two chapters will test.

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