What is fundamental analysis?

In this lesson, we look at:

• What fundamental analysis is
• The role of central banks
• The main differences between fundamental and technical analysis

The two most common types of analysis when it comes to the financial markets are technical and fundamental analysis.

During this lesson, we look at fundamental analysis in more detail.

Unlike technical analysis, which focuses predominantly on price action, trends and patterns to help pinpoint where prices may head to next, fundamental analysts consider all available data to help them to determine the relative value of a market. They then look for discrepancies between the current market price and their own valuation to spot trading opportunities.

Let’s imagine you want to buy a car. You’ve seen one you like for $10,000, but you don’t know whether this is a fair price. So you’ll research around on the internet, ask other people their opinion, compare it to prices offered at various car dealerships, and do general background research to assess whether the price is ‘fair’ and whether the car is worth the money.

What you’d be doing in this scenario is essentially fundamental analysis - you take into account all the fundamental factors in play to decide if the price reflects the real value of the asset.

Searching for clues

Fundamental analysts use an array of available data including corporate earnings reports, geopolitical events, central bank policy, environmental factors and more to help them with their analysis. They search for clues as to the market’s direction in the future.

Such clues can often be found in macroeconomic data, which is why knowing when important data is released is so important to fundamental traders. The markets tend to focus on potentially crucial macroeconomic readings that could affect the market and provide volatility.

Here are some examples of macroeconomic data releases and why they can have an impact on financial markets:
 

• Inflation - Inflation is the rate at which the general level of prices for goods and services is rising. Central banks attempt to limit inflation, and avoid deflation, in order to keep their respective country’s economy running smoothly. They do this by hiking interest rates. As an example, when central banks announce a rate hike, this could lead to an appreciation in its respective currency
• Unemployment - Data from labour markets, such as the US non-farm payrolls, can be highly influential in the financial markets and can spark volatility in indices and forex. The employment report is released on the first Friday of every month, and represents the total number of paid US workers of any business. This market can be very sensitive to this type of data, because of its importance in identifying the rate of economic growth and inflation.
  Just to set some examples, if the non-farm payroll is increasing, this could be interpreted as a good indication that the economy is growing. If increases in the non-farm payroll occur quickly, this could indicate that inflation could be increased. If the payrolls come in below expectations, FX traders could potentially sell USD in anticipation of a weakening currency. If it beats expectations, the value of the US dollar may increase.
• GDP - Gross Domestic Product is a measure of all goods and services produced in a specific period. Central bankers and investors look at GDP growth to see if the economy is getting stronger. As the economy rises, companies generate higher profits and people earn more, which could potentially lead to a rising stocks market and a stronger currency.

The way in which macroeconomic releases can affect the market depends strongly on the market’s expectations. Generally speaking, the bigger difference between expectation and reality, the bigger the reaction could be. If a market expects a central bank to hike interest rates and the bank does so, the reaction could be ‘priced in’ and it’s business as usual. When a release takes the market by surprise however, that’s when major volatility can be sparked.

You can keep informed of all fundamental data releases with our comprehensive economic calendar. The effect on the market highly depends on the comparison between the actual reading of a macroeconomic reading and the market expectations, where the bigger the difference, the bigger the effect on the market. You can keep informed of fundamental data releases with our comprehensive economic calendar. Each announcement is categorised as either High, Medium, or Low, in terms of its impact and potential to spark market volatility.

Central banks run the world

As previously touched upon, one of the most important factors in fundamental analysis is the monetary policy carried out by central banks. Interest rates, open market operations and central bank interventions influence market conditions and are closely monitored by financial analysts and traders. Some of the most influential central banks include the Federal Reserve (US), the Bank of England (UK), the European Central Bank (EU) and the Bank of Japan (Japan). 

Let’s take a look at an example. The US economy rose 3% in Q1 of 2017, while inflation inched to 2.5% on a year-to-year basis. The Fed elected to raise interest rates. Interest rates increased, higher, so traders decided to put their money in the USD as it could generate a higher return. Such a move can lead to a higher demand for the US dollar, which drives prices higher. Please bear in mind that there are multiple factors that can affect market prices, and the previous is just an example for educational purposes.

Not just bankers and data

Fundamental analysis also considers outside influences that could affect an instrument’s value or price movement. Natural disasters, such as flooding or earthquakes, can also have a major impact on the fundamental strength of an asset. For example, an explosion of a crucial pipeline may lead to a rapid increase in oil prices as the commodity becomes more difficult to transport and to buy. In such a situation, you could go long on Oil using CFDs.

A different point of view

• Unlike technical analysis, which focuses primarily on price action and trends, fundamental analysis uses all available data to determine the value of an instrument
   
• While technical analysts believe all the information they need is contained in the chart, fundamental analysis looks at other aspects, including political, social and economic factors, as well as macroeconomic releases and corporate earnings
   
• Fundamental and technical analysis do not have to be exclusive; indeed, some of the most successful traders argue that a blend of both is required

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