Fundamental Analysis of the Market. An Introduction
Investors and traders use various methods to predict the price movements of stocks, currencies, and other instruments. Technical analysis tools have become the most common. They use mathematical algorithms to calculate the patterns of changes in quotes and draw conclusions about further developments with a certain degree of probability. The other approach - the fundamental analysis - although complicated, is considered by many investors to be more effective. A beginner in the market should know at least its general provisions.
Fundamental Analysis: The Methodology
The difference between supply and demand is used to make a profit in trading. In this, the currency market is no different from others. Fundamental factors are everything that affects the supply and demand ratio, causing changes in the exchange rate of assets:
Economic indicators - discount (interest) rates, GDP, inflation, etc.
Political events - elections, resignations, scandals, wars, etc.
Force majeure situations - natural and man-made disasters, pandemics, etc.
The following methods are used to evaluate the impact of these factors on exchange rates:
To properly assess asset movements, it is important to compare the macroeconomic indicators of different countries. In fundamental analysis, key indicators are considered to be: GDP, interest rate, the balance of payments and trade, unemployment, industrial production index. By comparing their values in different countries over some time, you can identify trends that affect the rate of assets. And knowing the general direction of the processes in the economy of the country or region - you can predict future changes in the exchange rate.
Example: EUR/USD exchange rate is strongly influenced by the U.S. Federal Reserve and the European Central Bank interest rates. The unemployment rate, GDP data, and inflation in each country of the European Union can affect the rate of the EUR/USD currency pair with the U.S. dollar. This can be seen easily in the EUR/USD price trend during the economic crisis in Spain and Greece. Once you determine the current trend, you can predict the behavior of the currency and use it to trade the EUR/USD pair.
This is the method of analysis "from the particular to the general". Bringing together individual factors for complex evaluation and obtaining a general result. It is used when evaluating statistical data.
Example: "The Beige Book" - an economic survey based on the analysis of reports of the banks that are members of the U.S. Federal Reserve System. It is considered an important tool for assessing the state of the economy in the United States. Information published in this document can cause a noticeable increase in the volatility of the dollar.
The method of analysis is "from the general to the particular". Examining the history of an asset's exchange rate and looking for factors that may weaken or reverse the current trend.
Example: The impact of the commodities and the stock market on the AUD/USD exchange rate. The increase in oil prices in 2010 has had a negative impact on the U.S. stock market, which caused the AUD/USD currency pair growth.
The study of the dynamics of currencies that have a direct or inverse correlation. When the correlation is positive, the asset rates move in one direction, when the correlation is negative - in the opposite direction. Knowing this correlation, you can predict possible changes in the market.
Example: Dependence of the USD/CAD pair on international oil prices. The USD/CAD rate has a negative correlation with the rate of oil. If you compare the graphs, you can see that they almost mirror each other. Tracking oil prices allows for predicting the dynamics of the USD/CAD rate.
Grouping and Summarizing
Using this method, assets are grouped into blocks, and a general index is calculated for them. The dynamics of the index are considered to be the key to all assets of the group.
Example: The S&P Index is an overall index of 500 select U.S. companies whose stocks are traded on major U.S. exchanges. The S&P index reflects their total capitalization and is considered an important indicator of the U.S. economy. Its changes are reflected in the U.S. dollar exchange rate, which affects the entire global foreign exchange market.
What Lies Behind the Fundamental Analysis
Fundamental analysts take a rigorous approach to analyzing stock performance. They look at a variety of factors that they believe affect stock returns. These include the industry as a whole, the competition, a company's management structure, its earnings and revenue, and its growth potential. All of this data is publicly available and easily accessible, usually through the company's financial statements. The goal of the fundamental approach is to ultimately determine which stocks are priced right and wrong by the market.
To help you better understand this, let's use the following simple analogy. Imagine that the stock market is a shopping mall, where stocks are commodities that are sold in retail stores. The eyes are focused solely on the goods in the mall. Most buyers are fooled as an unreliable, emotional herd with no idea of the real value of the goods being sold, transacting on momentary "wants" and emotions. Fundamental analysts are slow to store around for the best deals and offers.
Let's imagine that both walk into a personal computer store. Once the crowd moves away from personal computers (PCs), the analysts will take a close look at what they have been missing. Fundamental analysts may try to determine the disposal value of a PC disassembled down to the hard drive, memory cards, monitor, and keyboard. In the stock market, this is similar to calculating the book value or liquidation price of a company. These analysts also look very closely at the quality of the PC. Will it be functional or will it break within a year? Fundamental analysts will take a close look at the specs, look at the manufacturer's warranties, and look at consumer reviews. Similarly, equity analysts will check a company's balance sheet for financial strength.
Fundamental analysts can then try to understand PC performance in terms of, say, processing power, memory, or image resolution. These are similar to projected earnings and dividends as determined from the company's income statement. Finally, fundamental analysts will gather all the data and determine the real value of the product or value independent of the current selling price. If the sale price is less than the estimated real value, the fundamentalists will buy the PC. Otherwise, they will either sell the PCs they already own or wait for prices to fall before buying a new one.
Major Economic Indicators Affecting Forex Fundamental Analysis
Macroeconomic indicators are numerical indicators that are used in the global economy to reflect its state. They play a sufficiently important role in fundamental analysis.
A macroeconomic indicator in simple words is the expected news, which shows the current data on the main indices of the financial and economic state of the state.
The advantage of using macroeconomic indicators in forex or stocks trading is that every trader can know in advance the moment when any data from the economic calendar will be released.
However, it is necessary to keep in mind that such indicators influence the exchange rates only in the short term. Therefore, it is better to trade in medium- and short-term time frames, keeping track of all subsequent news.
Several types of macroeconomic indicators are important for trading on the forex market.
Balance of Trade. This indicator shows the volume of exported goods to imported ones. When exports are higher than imports the balance is positive. This situation suggests a strengthening of the currency, since higher exports increase the demand for the national currency of the exporting region.
Discount Rate. This indicator is the most important factor on which the financial sector of the region is based. It forms the basis of interest rates on deposits and loans. Also, the discount rate has a direct impact on economic development and inflation in the country. When the national bank rate rises, the currency strengthens, when it falls, it weakens.
Gross Domestic Product (GDP). This indicator characterizes the economic situation of the country as a whole. The volume of GDP is obtained by summing up the entire range of services and goods that were produced in the country per capita. Because GDP lends itself to inflation, it cannot be considered an accurate reflection of the state of the economy. However, an increase in GDP always leads to the strengthening of the national currency against other currencies.
Inflation. An increase in this indicator leads to the depreciation of the national currency. Data on inflation are published directly or through separate components: the cost of consumer and industrial goods, utilities, and energy.
Unemployment Rate. The indicator indirectly demonstrates the deterioration of the economy. As a rule, an increase in this indicator is followed by a decline in production, rising inflation, and a negative change in the trade balance. For this reason, data on unemployment have a strong pressure on currencies and an increase in the indicator causes the fall of the exchange rate.
It is worth noting that all of these macroeconomic indicators may have a more detailed presentation or slightly different names. You can regularly receive data on all indicators by subscribing to the news feed of any forex broker.
Influence of Fundamental Factors on the Market
There are two types of influence of fundamental indicators on the value of assets.
Short-term. Fundamental information has an impact on the market for several minutes or hours.
Long-term. This type is a set of fundamental factors that determine the state of macroeconomics or economy of a certain country for a period from 3 to 6 months up to several years. The results of long-term forecasts are used for strategic positions.
The value of the fundamental factors, as a rule, is determined by the degree of influence on the state of the national economy as a whole or by the depth of influence on the interest rate.
When carrying out fundamental analysis, it is necessary to keep in mind that any data always has a relative nature.
The analysis of information begins with the consideration of macroeconomic indicators and ends with the consideration of individual states, industries, and individual firms and enterprises. In other words, the process of analysis proceeds from the general picture to particular details.
Basic Principles of Forex Fundamental Analysis
Fundamental analysis is based on the study of macroeconomic indicators with constant consideration of their influence on currency rates. The accuracy of the forecast depends on the correctness of the trader's conclusions regarding the priority of these indicators. Fundamental analysis also examines the historically regular reasons, which put pressure on the rates. Thus, fundamental analysis mainly uses the study of the causes, leading to changes in the market.
In practice, there is a difference between analyzing macroeconomic data and important news. Macroeconomic factors are easier to predict than news: unemployment data, as well as news about a natural disaster, cause strong movements in rates, but it is impossible to predict an emergency.
The basic principles of using fundamental analysis are as follows:
Level of Influence. The more weight an event has, the more tangible is its influence on the national currency. For instance, the news about the terrorist attack on September 11, 2001, brought down the dollar, whereas the data on one of the important indices did not have a considerable effect on the exchange rate.
Duration of Effect. Any trend-setting event lasts for some unit of time. More often than not, ordinary news is less influential than a predicted macroeconomic indicator. That said, some news requires special attention. For example, a notice of oil exporters switching from the dollar to the euro in their calculations will necessarily increase demand for the single currency, causing it to strengthen in the long run.
The Principle of Variability. This principle is expressed in the volatility of the trend under the pressure of all significant data. For example, the published report on Greece's economic problems caused the Euro to fall, but the news about the approval of a large loan to the region, which was released a few hours later, reversed the rate upwards.
Any news is evaluated from several points of view depending on the specific circumstances of the country it refers to. For example, Japan, as a major supplier to the EU and the U.S. will not suffer from a sharp collapse of the yen, as a cheap currency will cause an increase in demand for goods, which in turn will strengthen it again. In such a situation, short-term sell orders and long-term buy orders, which will inevitably happen, are applied.
Basic Levels of Fundamental Analysis
There are several basic levels of research to carry out the fundamental analysis.
The level of the national economy. At this level, there is made a complex analysis of the economic and political indices of the chosen country, and also evaluates its monetary and raw material resources.
Sectoral. Supply and demand, prices, technologies, and also production parameters are researched at this level, and also a development forecast is made.
Individual company level (financial instrument, share, index). Here the financial reports, management technologies, business strategies, and competitive environment are evaluated.
The classical scheme of fundamental analysis looks as follows:
Analysis of global financial markets, the presence of signs of crisis and force majeure phenomena, the situation in the economy and politics of the leading world powers.
Evaluates economic indicators and the overall level of stability of the region (industry), the currency, or other instruments under analysis.
The degree of impact of regional and global economic indicators on the dynamics of the selected financial instrument in the short and medium-term is determined.
Advantages of Fundamental Analysis
Long Term Investing
Fundamental analysis is good for long-term investing, the longest term. The fundamental analysis makes it possible to predict long-term economic, demographic, technological, and consumer trends with high probability, thus helping investors select good tools for long-term investing. Given that technical analysis is not as good for long-term investing, this specificity of fundamental analysis is a serious advantage over other methods of market analysis.
Good fundamental analysis allows you to discover valuable (precisely valuable, not expensive) stocks, that is, those that have high intrinsic potential and value. Many investors are looking for valuable instruments, and are willing to wait long enough for them to show themselves. It is the fundamental analysis that helps find companies that have strong assets, strong balance sheets, stable earnings, and growing profits.
One of the most obvious (but indirect) benefits of fundamental analysis, is that fundamental analysis provides a very good understanding of businesses and businesses in general. After such a thorough analysis, investors will be able to see companies "through." You will be able to determine exactly what is affecting a given company's earnings, or where its weakest link is. A background in fundamental analysis will allow you to identify companies that are most likely to fail soon, as well as those that are aiming for a long, hard, and successful run. Not only that, but fundamentalist experience will open you up to the skills to identify the driving forces behind entire sectors, areas, and industries. It is no secret that the price of an instrument depends on the industry and the competition. By analyzing these groups of companies, investors will be able to more clearly identify risky, reliable, growth, valuable, cyclical, non-cyclical, and other types of companies.
Stocks, like any other financial instrument, never move individually: they always move in groups. By understanding a particular business or company, investors can successfully correlate that company with other companies in that industry. Companies can change dramatically, and returns and profits can change with them. It is important to be able to identify the area in which a company operates. For example, online stores, which are supposed to grow rapidly because of the growth of the Internet in general, can fail because they are essentially just retail stores, of which there are a ton. So, knowing what a company does, an investor can use this advantage of fundamental analysis, correctly correlate the company with the industry, and make conclusions based on observations of the group of companies as a whole.
Disadvantages of Fundamental Analysis
Fundamental analysis can indeed open your eyes to the inner workings of companies, industries, and the market as a whole, but a thorough fundamental analysis requires a mass of time. Unfortunately, lengthy analyses can result in very controversial results about stock prices. When this happens, analysts often claim that the entire market is wrong. Of course, there are always undervalued and overvalued companies in the market, but it would be too brazen to claim that the entire market is wrong.
One of the disadvantages of fundamental analysis is the need to tailor it to each company. The methods of fundamental analysis can differ depending on the industry and on the unique factors of a particular company. Therefore, each industry and each company requires its unique approach. This fact is not in favor of fundamental analysis, because the adaptation of the analysis methods for each company or industry can be very long, which by itself reduces the amount of analytical work in terms of time. After all, some analysis methods are necessary for the same online store, and for an oil company, for example, the analysis methods are completely different, because their spheres are completely incompatible.
The next disadvantage of fundamental analysis is the hope for a certain outcome. The fair value of a stock is based only on assumptions. Any changes in the substituted coefficients or calculation formulas can greatly shift the final result of the value calculation. Often, fundamentalists are aware of such errors, and carry out the analysis in three modes, knowingly expecting:
- bad result
- good result
- neutral result
But experience shows that even with the awareness of this phenomenon, fundamental analysts still introduce distortions: even deliberately expecting the worst result, the fundamental analysis often predicts growth.
Most of the background information for fundamental analysis is taken directly from the company. Usually, companies hire special professionals - IR managers (Investor Relation Managers) to publish new information and follow the analysts. And when the time comes to release some noisy news about the company, IR managers show themselves in full force. After all, it is not in their interest to release unfavorable news. Companies usually have hired financial analysts, who "treat" the news to the outside world and release it to the public. We should not forget that hired analysts can misjudge (either intentionally or not) the effect of this or that news on a company's stock price. We outside investors need to keep this in mind and rely only on the original, "raw" reports on the company's performance.
Determining the Fair Price
When the price of a stock reaches an incredible (low or) high, there is usually a desire in the market to adjust that price, or to put it another way, to bring the stock to its fair price. If the real price of a stock is, say, 30, and a fundamental analyst says the fair price is 20, he has no choice but to agree with the market and admit he is wrong. The old wisdom says that the fair value of a security is determined by the price one is willing to pay for it. Thus, the question arises, if fundamental analysis says one thing and the market says another, who is to be believed...?
Despite the disadvantages of fundamental analysis, this method of analysis and forecasting is very popular all over the world, because it has some undeniable advantages.
Fundamental or Technical Analysis
Fundamental analysis is very different from its "brother", technical analysis. Whereas fundamental analysis focuses on measuring the intrinsic value of a stock, technical analysis focuses solely on the trading and price history of a stock, looking at trading signals and other analytical tools to assess the strength or weakness of a stock.
Technical analysts believe that a stock's past performance - its price and trading activity - can help determine where it will go in the future. Essentially, technical analysis theory is based on the fact that price movements are not random. Instead, technical theory believes that patterns and trends can be identified and repeated over time.
To demonstrate this, let's return to the analogy above. Technical analysts ignore the products they sell, their quality, and their properties. Instead, they follow the crowd to determine what to buy. So, if a technical analyst notices that customers are congregating at a computer store, he will try to buy as quickly and as many computers as possible, betting that rising demand will drive up PC prices.
The use of fundamental analysis methods for the forex market in combination with the economic calendar allows a better understanding of the processes taking place on the world market. That is why experienced traders often refuse quick strategies. They switch to long-term investments, based on the methods of fundamental analysis, and get significant financial results.