What is fundamental analysis?
Every trader who comes to Forex to make money, sooner or later realizes that instead of making wild guesses about further movements of prices they should follow a logical and consistent system of trading. To create it, the analyst has to choose a method of market analysis: tech analysis, fundamental analysis, or a mixed technique. Many tend to prefer tech analysis, explaining their choice by its clearness. Fundamental analysis is chosen by the minority; however, everyone sheds a look at it once in a while. The hybrid model is used by experts.
While the information on tech analysis is available, the problem of its fundamental counterpart is not so much the depth of the analysis and the interpretation of its results but the lack of available data that is to be processed to make some conclusions.
In this article, we will discuss fundamental analysis, its peculiarities, the influence of news, macroeconomic data, and all other fundamental factors on the market, the price, and the value of goods.
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Well, what is fundamental analysis? Fundamental analysis is a set of methods of studying, analyzing, and forecasting the market value of companies, their stocks, financial derivatives, and currencies. Fundamental analysis is based on macroeconomic indicators and business indices. Its techniques presume analyzing financial and processing indices of companies, the credit and monetary policy of central banks, social, political, and force-majeure factors.
Fundamental analysis is frequently used by investors for the estimation of the price of companies and their stocks. To understand the state of affairs in a company and its profitability, investors analyze its financial indices: revenue, EBITDA, net profit, net cost, commitments, money flow, dividends, and production results.
The net cost does not necessarily coincide with the stock price of the company in the exchange. In the stock market, the price is based on the balance of supply and demand. Investors use fundamental analysis for the situations when the net cost of a company is higher than the stock price in the exchange. Such stocks are called underpriced and become interesting for investments. Buying underpriced stocks, investors expect their market price to try and reach the net cost; in the case of underpriced stocks, this means the price will grow. This is a controversial opinion from the point of view of tech analysis, according to which the current price already accounts for all important information. This is the stumbling block between the apologists of tech and fundamental analysis, respectively, because this principle nulls the very idea of fundamental analysis. A Forex trader who uses the ideas of fundamental analysis, normally reads the economic calendar that features data, news, speeches, and statements of various importance.
How does news influence Forex?
We have all seen quotations move in the trading terminal in the form of lines, bars, or Japanese candlesticks. Looking at candlesticks, we could see smooth waves of up- and downtrends. However, in the midst of all the grace we sometimes come across sprawling spike-like candlesticks with large up- and downward shadows. Most often, these candlesticks are the traces of some market news — because, at the moments of the publication of important news, public announcements, extraordinary events the market may become turbulent, demonstrating surges and falls of quotations.
The publication of news in the hands of a skillful trader may be used as an instrument for making money in Forex, as long as the news is the repercussion of the world economic and political events that influence the market greatly, pushing quotations in either way.
Thanks to IT, we can stay in the course of almost all the events that happen in the world. Out of all the informational noise, only market experts can pick up the news that is, indeed, important for trading and forecast how each piece of news can influence the quotations of certain currencies and the market on the whole.
Analyzing news for their forecasts and calculations, Forex traders perform fundamental analysis. Deciding when to buy or sell this or that currency, they look at the data on the economic calendar. Such economic data as the GDP and inflation, indices from different sectors of the economy, and many other economic references published regularly, mostly influence market participants and the quotations of currencies.
Trading for real, the trader gets to know that in the market, there are many more factors to be accounted for when making predictions about the price; however, this topic requires in-depth studies. The main thing to remember and realize when working with the news feed is the idea that an unexpected piece of news may seriously change the course of trade.
Crucial data
GDP and GNP
The Gross Domestic Product (GDP) represents the economic activity of the country on the whole. Unlike it, the Gross National Product (GNP) also accounts for the income generated by foreign economic activities.
The laws:
- the currency will grow along with the growth of the GDP/GNP;
- the currency will fall along with the falling of the GDP/GNP.
The GDP/GNP and their forecast value are regularly discussed before the official publication. In this case, trading news might be inefficient, because the market might act on the expectations, and the news can influence the market significantly only if there is a considerable difference between the forecast and the factual results.
July 30th, 2020: first estimation of the US GDP in the second quarter, -32.9%.
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Producer Price Index (PPI)
This index is directly connected to retail prices that consumers pay, in the end. The market is very sensitive to this, and an unexpected change in the index may lead to the following:
- the currency will grow alongside the index;
- the currency will shrink together with the index.
Also, the PPI depends a lot on the prices of the crude materials because they influence the cost of production and, hence, the net cost of goods — and the PPI, before the goods get to retail sales networks.
Industrial Production Index (IPI)
This index reflects the general monthly production volume of the whole industrial sector of the country (plants, shafts, etc.). It signals economic growth, which means that:
- the currency will grow together with the index;
- the currency will fall alongside it.
Unemployment rate
The publication of the unemployment data is one of the most popular pieces of news for trading among most of the market participants. If the unemployment rate is high, the growth of the country’s economy is slow. I.e. the more unemployed people there are in the country, the worse the purchasing power is. The government tries to stimulate buying by decreasing the interest rate and the price of crediting. This means that:
- the currency will grow while the unemployment rate falls;
- the currency will fall while the unemployment rate grows.
Retail sales index
This index illustrates the general volume of sold goods in the retail sector of the economy; it consists not of the sales volume of each retailer but of that of a selection from the whole range of companies. The higher the retail sales index, the higher the level of expenses in the economy, which must increase the profit of corporations, promising more stability, and a more positive market attitude. This means that:
- the currency will grow alongside the retail sales index;
- the currency will fall alongside the index.
Trading news, pay attention to the correlation between inflation and revenue levels. The higher the purchasing power, the higher the consumer demand, which means retail prices will grow.
Interest rate
On March 11th, the Bank of England decreased the interest rate for the first time since 2018 by 50 base points at once.
The interest rate is the rate of the Central bank for the operations of other commercial banks. Through this rate, the Central bank has an opportunity to influence the interest rates of other commercial banks across the country and the exchange rate of the national currency.
When the interest rate shrinks, the PMI and inflation increase, while the price of the national currency goes down. An increase in the interest rate pulls the PMI down alongside inflation and pushes the national currency upwards.
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The influence of geopolitical events, force majeure events, and disasters on the currency market
The reaction of the market the GBP/USD to the voting on Brexit
Geopolitical factors that influence the currency market:
- Political events;
- Natural disasters;
- Wars, terror acts, etc.
Important political events lead to noticeable fluctuations in currency rates and may cause reversals of long-term trades and general market turbulence. Unlike economic and statistical news that have the date of the publication known to everybody beforehand, most geopolitical events, such as revolutions, terror acts, wards, natural disasters, defaults, etc., are totally unexpected and may literally devastate the market of this or that country and the price of its currency. Note that the effect of such news tends to fade away with time: as a rule, the new trend does not last long. In these cases, traders open short positions, waiting for pullbacks. The situation in Forex depends on the whole range of interconnected factors that reflect the state of the global economy and the economies of different countries. The knowledge of these factors and the understanding of global processes help traders to make correct decisions on time and estimate the length and power of fundamental news.
The price of a national currency is influenced by both domestic and foreign policy. For example, instability weakens the currency and may even devalue it. During presidential or parliamentary elections, the exchange rate may fluctuate due to the rumors about changes in the course of the state policy; quite often, the rumors have no base under them. In certain cases, such situations are provoked deliberately to use the period of turmoil to make a profit.
Some political news has a limited influence on the market. For example, if the viewpoint of a politician is known beforehand, we should not expect nay fluctuations of the prices after its official publication. Sometimes traders face totally unexpected factors: a viewpoint may be announced “faulty”, or it might be said that the market “got it wrong”. Such situations normally lead to impulses of growth/decline and equally quick restoration.
The role of political events in trading is relatively small. The fundamental analysis in Forex usually interprets them as additional factors that influence mostly long-term trading, while short-term trading is mostly based on economic indices.
Such natural disasters as earthquakes, hurricanes, tornadoes, droughts, floods have a most unexpected influence on the market. Of course, meteorological observations and news help to forecast them but trading such forecasts is risky. The same is relevant for industrial accidents. There is no way to predict them or their consequences, so the trader will see the effect post factum.
It is easier to work with social and political factors, such as coups, military conflicts, revolutions, and strikes. Any such event may provoke market volatility up to a decrease in the price of the national currency. The consequences of such force-majeure events can be forecast but only if they take long.
Closing thoughts
the fundamental analysis of financial markets, and Forex, in particular, is not an easy job and cannot be addressed carelessly. This method helps to make your way through the market not only in the short term (by trading news) but also forecast the market behavior in the medium and long perspective, for investors and traders.
No doubt, fundamental analysis requires good preparation, studying much data, the skill to interpret correctly even those events that seem insignificant. Hence, many traders fear of this and prefer tech analysis. However, the skills of fundamental analysis help to switch easily between financial and stock markets.
Anyway, we must note that even a beginner, having studied certain laws of how statistical data influence the market and knowing how to use the economic calendar, can confidently trade by short-term strategies. Time and hard work will let you not just master some basic skills of fundamental analysis but also extend your mental horizons, which, in the end, will help you make a profit.
Good luck and profitable trading for you all!
By Dmitriy Gurkovskiy, Chief Analyst at RoboForex
