A Holistic Approach to Security Evaluation: Investors Tend to Measure the Equity Markets with Either Fundamental or Technical Analysis. While Either Approach Has Worked for Some over Time, the Right Answer May Be to Use a Combination of Both

Article excerpt

Fundamental equity traders rely on factors such as earnings, earnings growth or valuation ratios to select securities. Technical traders use moving averages, trading volume patterns or price breakouts.

One method is not necessarily better than the other; each has its merits. By leveraging the strengths of both of these styles, we can not only increase our success rate in selecting securities, but also improve our portfolio management.

To understand the nuances of the two methods, it helps to think of a company and its stock as two separate entities. For the most part, fundamental analysis dissects the company, its business and its financial statements. Technical analysis focuses on changes in the company's stock price and volume. Integrating fundamental and technical analysis helps investors see a holistic picture ofthe investment opportunity.

Here, we will use the stocks of two companies to illustrate how fundamental and technical analysis can be combined to select securities, make weighting decisions and determine entry points.

Sound fundamentals

Let's examine the energy sector. First, we'll screen companies using fundamental criteria, including the most recent quarter's earnings surprise, 12-month expected earnings per share (EPS) growth and the forward P/E multiple. BP and Marathon Oil are among the companies that comfortably pass the management execution, growth and valuation criteria (see "Fundamental litmus test," above).

Both BP and Marathon Oil are executing well as evident from positive earnings surprises. Over the next 12 months, the companies are expected to increase EPS at a relatively rapid clip. For fundamentalists looking to buy shares of growing companies at a reasonable price, BP and Marathon Oil look quite attractive. These shares trade at relatively modest forward P/E multiples. In fact, the forward P/E multiples are lower than the expected EPS growth rate.

Technical dissection

Three types of technical indicators are commonly used to get a handle on the technical picture (see "Technical overview," right). They are:

* Trend indicators, such as moving averages and moving average convergence/ divergence (MACD)

* Momentum indicators, such as the relative strength index (RSI)

* Volume indicators, such as Chaikin money flow (CMF)

Now, let's examine how BP and Marathon stack up on these technical indicators. For BP, refer to the chart "Bouncing higher" (right).

1) BP's share price chart shows that the stock is on an uptrend. The 50-day and 200-day simple moving averages (SMA) are both nicely moving higher. The MACD line is above zero, confirming the uptrend.

2) The green-shaded area exceeds the red-shaded area under the CMF panel. This suggests that BP shares are under buying pressure for some time. This raises the probability of the uptrend extending into the future.

3) The RSI reading of 69.37 is close to 70.00, suggesting an overbought condition. As such, a correction in BP shares could ensue at any point.

Due to the RSI indicating an overbought condition, we may not want to get in BP immediately. One approach would be to wait for the RSI to return to 50 before establishing half of a position. Then if the long-term bullish signals persist, we could invest the other half when a dip back below the 50-day SMA signals a short-term buying opportunity.

Marathon Oil is charted in "Sideways swing" (page 48). Here's a quick analysis of what we see for MRO:

1) The strength on MRO's uptrend seems to be wearing off. Even though the 50-day SMA is holding above the 200-day SMA, the share price has fallen below its 50-day. MACD has recovered after dipping into negative territory in the early part of December. The recent decline in MRO threatens to push the MACD below its moving average.

2) The area shaded green is generally in line with the area shaded red under the CMF panel. …