An introduction to fundamental analysis

Introduction

Fundamental analysis involves looking at economic, industry, and company-specific data to evaluate the intrinsic value of an asset, such as a currency or stock. Unlike technical analysis, which relies entirely on market data, fundamental analysis uses outside sources like economic indicators, company financials, market trends, and broader industry conditions to make predictions instead of just relying on price action. This approach rests on a different market philosophy that believes markets can be undervalued or overvalued, whereas price action for technical analysis is driven by market psychology. Fundamental analysis is a broader topic than technical, touching on economics, politics, and international trade, and is more favoured by long-term investors than short-term traders, but CFD day traders still need to understand the basics.

Key concepts

Fundamental analysis operates on a few key concepts about market dynamics. One fundamental principle is that markets aren’t always perfectly efficient and are influenced by both psychological sentiments and actual economic factors. This understanding allows fundamental analysts to assess the value of assets based on long-term economic indicators, industry performance, and company financials. Fundamental analysts emphasize that market movements reflect not only investor behaviour but also underlying economic realities. By understanding political and economic realities, emerging market trends can be identified before they happen, and price targets can be set that reflect the intrinsic value of an asset.

Macroeconomics

The most important concepts in fundamental analysis come from the field of macroeconomics. Macroeconomics focuses on trends in the broader economy, whereas microeconomics looks at individual markets and the behaviour of single consumers. A very broad field, macroeconomics encompasses the study of national economies, with indicators like GDP (Gross Domestic Product), inflation, interest rates, unemployment all contributing to the overall picture. Fundamental analysts observe macroeconomic factors to gauge the health and trajectory of an economy or market. Changes in these indicators can significantly influence the performance of various assets, industries, and markets, so a fundamental trader will base investment decisions on underlying economic conditions rather than the recent price moves followed by technical analysts.

Economic data and announcements

All of this external data has to be collected and announced, and this is formalised into a system of regular market announcements. Because early access to economic data would offer an unfair advantage to inside traders, these statistics are collected and then sent out to the market at fixed times. Often markets will make a sudden reaction to announcements such as GDP, non-farm payrolls, and unemployment, especially when they give an unexpected figure.

The market prices in its expected result, so if manufacturing output is expected to decrease, a surprising announcement differs from the expected result. Even a negative news announcement could be seen as positive by the market if it is not as bad as expected. It is important to consider both the announced figure and the market expectation when interpreting a given announcement as good or bad. Traders follow the largest markets the closest, so US economic data announcements are the most important, followed by China and other major economies.

Intrinsic value

Fundamental analysis claims that markets can be wrong, and that a stock, currency or commodity can have an intrinsic value that is different – either higher or lower – than its current market price. Fundamental analysts also believe that markets will eventually move to reflect this price, though this can take longer than expected, resulting in loss making positions. So, the old adage: markets can stay irrational longer than you can stay solvent. You can find out more about intrinsic value on ADSS.

How to calculate intrinsic value depends on the underlying asset you are trading, for CFD traders this could be an index, currency pair, stock or commodity. For stocks, fundamental analysis requires calculating earnings metrics based on the businesses financial reporting, such as price / earnings ratio (PE ratio) and price / book ratio. Stock traders find an industry standard for PE ratio and identify companies which have a lower value, then checking to see if this is because of a problem with the business rather than market undervaluation. If they are happy there is nothing wrong with the underlying business, they will then set a target price based on its intrinsic value and enter a long trade. This is a classic long-term equity trading strategy.

Fundamental analysis and day traders

As CFD traders, we stick to shorter time scales than buy-and-hold equity traders, who may hold positions for months or even years. Because the markets we trade in are volatile, the risk of holding on to such long-term positions is unacceptable, so typically CFD traders will enter and exit positions on the same day, or over a small number of days. So why are we interested in fundamental analysis? Simply put, because even when trading small term fluctuations, it is important to know the direction of the broader trend.

If you are used to trading on different timescales, this becomes obvious. A one-month bar or candlestick chart might show a clear prevailing up trend, but many of the intraday charts within it show sustained subtrends in the opposite direction. CFD day traders take advantage of these smaller movements, but being aware of the prevailing long-term trend is always helpful. When trading against the trend, traders need to use tighter stop losses and keep a close eye on risk management, as the chance of the price moving against them is higher.

Interest rates and FX

Interest rates are of special interest to forex CFD traders. Central banks use interest rates, also known as bank rates, as a tool to manage inflation, economic growth, and changes to interest rates are the most important part of monetary policy. When a country’s interest rates rise, the currency strengthens because higher rates attract more foreign capital due to relatively improved return on investment. This increased demand for the currency pushes its value higher in the FX market. Conversely, when a country lowers its interest rates, its currency may weaken as investors seek higher returns elsewhere. Lower rates may also stimulate borrowing and spending, potentially leading to economic growth but causing depreciation of the currency due to decreased demand.

The most important interest rate announcements, not just in the US but globally, are made by the Federal Open Market Committee (FOMC) at regular meetings, where a panel of twelve members vote on changes in bank rates. Changes in fed rates profoundly influence currency values, making it essential for traders and investors to monitor central bank policies and anticipate interest rate movements. Unexpected announcements, even a shift in opinion of a single voting member of the FOMC, can have big impacts on global markets, so rate announcements are tense times for forex traders.

Balance of trade and FX

FX traders also look at the balance of trade, the difference between imports and exports in a single national economy. This balance directly impacts a nation’s currency in the FX market. A trade surplus, where exports exceed imports, usually leads to a stronger currency. A surplus indicates higher demand for the country’s goods, increasing demand for its currency. In contrast, a trade deficit, where imports surpass exports, can weaken the currency. A deficit suggests higher demand for foreign goods than for domestic products, requiring more of the country’s currency to pay for imports. In reality, the picture is a little more complicated, as many exports are denominated in foreign currency (US dollars) and FX rates are directly interfered by central banks with as a way of promoting exports.

As well as the real balance of trade, FX markets are influenced by perceptions of a country’s trade balance. Hard to quantify exports such as services may alter the given figure, and cheap imports in some cases can boost domestic manufacturing. The relationship between balance of trade and currency values is therefore nuanced and influenced by various external factors, including interest rates, inflation, investor sentiment, and geopolitical events. There is not universal agreement that a negative trade balance is harmful for a currency’s market value. In fact, major exporting countries (which have a positive trade balance) may deliberately devalue their currency in order to make exports more competitive, a common situation in East Asia during the 1990s.

Summary

Fundamental analysis is not the most important technique for CFD traders, a title that goes to technical analysis, but it is still necessary to understand the basics. Often the longer-term trends behind short market moves will be driven by fundamental factors such as GDP growth and balance of trade, and knowing about these will help you make better tactical decisions in live markets.

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