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What is Fundamental Analysis?
Posted on Jun 15, 2015
What is Fundamental Analysis?
Fundamental analysis mostly refers to the use of economic data to predict forex price movements. While technical analysis focuses on historical price action and repeating behavior, fundamental analysis takes into consideration the demand and supply for a currency based on the current and expected return in holding it.
Fundamental analysis is considered to be the classic way of investing. It revolves around the theory that no matter what happens in the short-term, eventually the price of your investment must follow the economic numbers. The various fundamental factors can be grouped into two categories: quantitative and qualitative. Neither qualitative nor quantitative analysis is inherently better than the other.
In stocks trading, the biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company’s future performance. A good part of this tutorial will be spent learning about the balance sheet, income statement, cash flow statement and how they all fit together.
In qualitative analysis, analyst uses subjective judgment to evaluate investments based on non–financial information such as management expertise, cyclicality of industry, strength of research and development, labor relations and depth of operational infrastructure. Qualitative analysis evaluates important factors that cannot be precisely measured rather than the actual financial data about a company.
Demand and supply of a currency are influenced mostly by central banks and monetary policy. When a central bank decides to add to money supply or lowers interest rates, the value of the local currency goes down since there is more of it in circulation and the rate of return on assets denominated in that currency is lower. On the other hand, when a central bank decides to lessen money supply or increases interest rates, the value of a local currency goes up since there is less of it in circulation and the rate of return on securities denominated in that currency is higher.
What influences the central bank’s decision to adjust monetary policy by adding or reducing money supply and by increasing or decreasing interest rates? This is where economic data comes in.
Bear in mind that the central bank’s mandate is to maintain price stability. When an economy is doing well, inflation tends to climb and the central bank would need to tighten monetary policy by reducing money supply or hiking rates. When an economy is performing poorly, inflation tends to drop and the central bank would need to loosen monetary policy by increasing money supply or cutting interest rates. This is just a general simplified view of monetary policy changes, which will be covered in the next section, but of course there are plenty of other economic factors that could influence central bank decisions.
Traders who use fundamental analysis often make use of an economic calendar to keep track of how economies are doing. These calendars list down the upcoming data releases, usually for major economies, and their potential impact on price action. There are reports that could trigger a large or long-term effect on forex movements while there are other reports that result to small reactions only.
In FOREX trading, the fundamental analysis uses economic statistics to view the economy and its currency. Rather than looking at the economy as a whole, these statistics often reflect a particular sector of the economy. This means that different statistics may actually point in opposite directions. We refer to these reports as economic indicators.
Economic calendars also typically include the previous report’s result and the analysts’ consensus for the upcoming release in order to give the trader a basis of comparison in whether or not improvements were seen.
An economic indicator is information amassed and published by a government or private entity recording the activity in a particular economic sector, either in a specific industry or in an entire economy. Most indicators are statistical, but they can be anecdotal or subjective as well. Indicators are recorded and published on a regular basis by many organizations and are used by traders to assess the strengths or weaknesses of an economy, to predict future activity, to judge central bank policy, and to provide insight into the many economic variables that make up a modern industrial economy.
Aside from economic events, market sentiment also usually factors in fundamental analysis. This refers to traders’ appetite for risk, with higher-yielding riskier currencies usually rallying when confidence is up and lower-yielding safe-haven currencies climbing when confidence is down.
This can be gauged by looking at equity market performance, as stock indices generally surge when risk is on. When traders are feeling risk averse in general, this cautious trading behavior can also be monitored in global stock exchanges. Commodity prices are also sometimes used in gauging market sentiment, as covered in the latter sections
There are two types of indicators you need to be aware of:
- Leading indicators often change prior to large economic adjustments and, as such, can be used to predict future trends.
- Lagging indicators reflect the economy’s historical performance and changes to these are only identifiable after an economic trend or pattern has already been established. Leading indicators have the potential to forecast where an economy is headed, fiscal policymakers and governments make use of them to implement or alter programs in order to ward off a recession or other negative economic events. The top leading indicators are Stock Market, Manufacturing Activity, Inventory Levels, Retail Sales, Building Permits, Housing Market and Level of New Business Startups.
For these wich unlike leading indicators, lagging indicators shift after the economy changes. Although they do not typically tell us where the economy is headed, they indicate how the economy changes over time and can help identify long-term trends. The top lagging indicators are changes in the Gross Domestic Product (GDP), Income and Wages, Unemployment Rate, Consumer Price Index (CPI), Currency Strength, Interest Rates, Corporate Profits, Balance of Trade and Value of Commodity Substitutes to U.S. Dollar.
Most indicators are classified as either leading or lagging. If the indicators track economic factors that often change before the general economy, they are leading indicators. These indicators are generally used to predict future economic conditions. On the other hand, lagging indicators record activity that have already occurred and may or may not prove useful in prediction.
Economy-wide indicators are the broadest measures of productive activity and record the result for an entire economy. Usually collected by governments, they are among the most authoritative statistics.
The broadest measure of productive activity are economy-wide indicators. These indicators record the result for an entire economy, rather than that of a specific sector or industry. Economy-wide indicators are usually collected by governments and are among the most authoritative statistics.
Here are some examples or economy-wide indicators :
- Unemployment Rate
- Producer Price Index (PPI)
- Consumer Price Index (CPI)
- Gross Domestic Product (GDP)
Industry and sector based statistics normally pertain to a particular industry, such as housing or a particular economic activity, such as retail sales. Collected by both government agencies and private sector groups, the activity they track is more limited, and can have a close correlation to the broader indices, generating considerable trading interest.
Statistics that generally pertain to a particular sector, activity or industry, such as retail sales or housing, are industry and sector based statistics. These statistics are collected by both private sector groups and government agencies. The activity that is tracked by these statistics is more limited and can have a close relationship to the broader indices, which generates a considerable trading interest.
Here are some examples or industry and sector based statistics :
- Retail Saless
- Purchasing Managers Index
- Institute for Supply Management (ISM) Survey
- Building Permits
- New Home Sales
- Durable Goods Orders
- Housing Starts
Finally, the indicators that gauge business and consumer opinions on current economic conditions and their expectations and intentions for the future are called sentiment indicators.
Not all statistics on a single topic are of equal importance. Some government and central banks prefer one measure to another and the markets will assign that much more trading weight to the favored statistic. Other statistics gain or lose interest over time depending on their volatility, changes in the economy or newer and better measurement techniques.
Depending on what is believed to be more relevant to the current market and economic conditions, traders will also focus on other statistics.
Trading on fundamentals is more closely associated with the buy-and-hold strategy of investing than with short-term trading. There are, however, specific instances in which trading on fundamentals can generate some nice profits in a short period.
If fundamental traders are able to correctly identify the current position of currencies and subsequent price movements that are likely to occur, they stand a very good chance of executing successful trades. Trading on fundamentals may be risky in cases of euphoria and hype, but the astute trader is able to mitigate risk by making history his or her guide to short-term trading profits.
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