Fundamental Analysis vs Technical Analysis

1. The Debate Continues
2. Expectations and Sentiment

1. The Debate Continues

Nonetheless, further empirical evidence reveals that technical analysis of long-term trends helps identify longer-term technical "waves", and that fundamental factors do trigger short-term developments.

Let’s take the declining USD/JPY exchange rate in 1999 as an example. The pair lost 16% in the second half of the year, reaching a year low of 101.90. Both fundamentals and technicals alike could explain the downward move. Fundamentals attributed it to the continuous capital inflows into Japanese assets, which reflect investors increased optimism with the Japanese recovery. Technical analysts were likely to explain the move with the simple argument: the language of the market voiced a clearly downward tone that became more resounding after the breach of key technical landmarks (115 yen and 110 yen).

Thus, both technicals and fundamentals reached the same conclusion. Yet the devil is in the details. Fundamental analysts with a technical blind spot risk missing key market turnarounds after the breach of an important support/resistance level.

Conversely, a technically inclined analyst with a disregard for fundamentals and news releases would have missed the rebound in EUR/USD which was triggered by the release of a stronger than expected German business sentiment survey (IFO) in July 19, 1999. Up to that point, the euro had lost 15% reaching an all time low of $1.010. Most market observers-fundamentals and technicals –were predicting the euro to break below $1.00. Technical analysts stated psychology, momentum and moving averages as arguments for further downfall. But fundamentally inclined analysts who paid attention to the strong survey would have been able to promptly exit their long dollar positions in favor of the euro. On that day, the euro jumped 200 points against the dollar with an additional 260 points on the following day, and an extra 150 days in the third day. In just two weeks, EUR/USD soared by more than 800 pts.

Obviously, the IFO survey release was not the single reason behind the euro’s 7% rebound. Other factors over the subsequent weeks also helped prop the currency. These included a broadening improvement in economic fundamentals throughout the Eurozone and increasingly hawkish stance (favoring higher interest rates) from the European Central Bank. Nevertheless, the release of the IFO survey was the turning point in shifting expectations of the euro.

It has been often stated that combining fundamentals with technicals was counterproductive. Owing to their contrasting types, technical and fundamental analysis are often said to be mutually exclusive. Yet, a large number of traders combine the two approaches, even instinctively. Thus, technically inclined traders do pay attention to central bank meetings, give consideration to employment reports and heed the latest inflation numbers. Similarly, fundamental traders are often trying to figure out the major and minor levels of support, and determine the percentage of retracement formations.

There does not exist a specific formula for figuring out the optimum approach of combining fundamental and technical analysis in the Forex market. Some computer software packages claim to be able to make such decisions, weighing one approach against another depending on economic, technical and quantitative parameters. Yet, these are based on models from past patterns of inter-market dynamics and previous technical and fundamental behavior. The FX market is too dynamic for such pre-formed frameworks.

2. Expectations and Sentiment

Expectations are formed ahead of the release of economic statistics and financial data. Solely paying attention to the figures released does not suffice in grasping the future course of a currency. If, for example, US GDP came out at 7.0% from 5% in the previous quarter, then the dollar may not necessarily move as you would expect it to. If market forecasts had expected an 8% growth, then the 7.0% reading might come as a disappointment, thus causing a very different market reaction from the one you were expecting had you not been aware of the forecast.

Nonetheless, expectations could be superceded by market sentiment. This is the prevailing market attitude vis-à-vis an exchange rate; which could be a result of the overall economic assessment towards the country in question, general market emphasis, or other exogenous factors. Using the above example on US GDP; even if the resulting figure of 7.0% undershot forecasts by a full percentage point, markets may show no reaction. A possible reason is that sentiment could be dollar positive regardless of the actual and forecasted figures. This might be due to solid US asset markets, or poor fundamentals in the counter currency (euro, yen or sterling).

A term that is commonly interchanged with "sentiment" is "psychology". During the first two months of 2000, the euro underwent fierce selling pressure against the dollar despite persistently improving fundamentals in the Eurozone. That is because market psychology had decidedly favored US dollar assets due to continuous signs of non-inflationary growth, and sentiment that further increases in US interest rates will work in the advantage of US yield differentials, without derailing the economic expansion.