What is Fundamental Analysis?
Fundamental Analysis of the Forex Market
Forex fundamental analysis is a type of market analysis that identifies and measures factors that determine the intrinsic value of financial instruments such as economic and political environment. It is included in the fundamental analysis any factor affecting supply and demand of the instrument traded. For example, a study of fundamental analysis for a currency include supply and demand for the currency as well as products and services in the country, government policies, historical and projected performance and economic indicators.
From these data, the analyst constructs a model to determine the present value of the currency and forecast future changes. Most traders who use technical analysis, use fundamental analysis too, to get an overview of the general trend of a currency pair. After that they use their knowledge in technical analysis to determine optimal entry and exit points to trade in the market.
The basic idea of fundamental analysis is that increasing the supply of a currency warrant unprecedented value will depreciate, while increased demand will drive up the value. Given the large number and diverse nature of the variables involved, subjetivity is always an important component of fundamental analysis as the experience of the analyst. Furthermore, in the case of a market so big like Forex, the market tends to anticipate to events, taking some time until the market recognizes itself if the exchange rate between a currency pair is or not in accordance with the intrinsic value of the currencies that conform it.
Among the most important factors affecting the value of a currency are the political and economic changes that affect the country. Traders take this information from various news sources to stay informed of major economic events and important economic indicators such as employment situation, inflation, interest rates or central bank policy decisions. Also, the market could be affected by statements of politicians and economists of relevance, like for example the statements made by the central bank president, although no official data.In the following chapters on fundamental analysis, we will see in some detail the economic indicators used and how they affect the value of a currency.
For the Forex Market, the fundamental analysts base their decisions in dozens of economic fundamental indicators. However, the main indicators of this type are:
- Consumer Price Index (CPI).
- Employment Cost Index (ECI).
- Employment Situation Non Farm Payrolls.
- Existing Home Sales.
- New Home Sales.
- Producer Price Index (PPI).
- ISM Manufacturing Index.
- ISM Services Index.
- Personal Income and Consumption.
- GDP Gross Domestic Product.
- Internacional Trade & Trade Balance.
- Retail Sales.
- Initial Jobless Claims.
- Durable Goods Orders.
Fundamental Analysis of the Stock Market
In the Stock Market, Fundamental analysis is based on careful study of the financial statements of a company and their future expectations, plans expansion and the socioeconomic factors that may affect the progress of the company. To achieve a valuation on a share, the analyst makes an estimate of sales, cash flows, profits and future dividends. The fundamental analyst set target prices based on future discounted cash flows, levels of PER, profit growth, comparisons with the market and the industry sector and sum of parts of the different businesses, among other methods. After that, the analist assigns recommendations of ‘overweight’ (if he think the stock will perform better than the market), neutral (if he think that the stock will behave like the market) and underweight (if he considers that the stock will perform worse than the market).
Fundamental Analysis Tools of the Stock Market
Unlike technical analysis, the tools of analysis of the fundamental approach, given the objective of obtaining the “true” value of a stock, are all elements that may affect the value of the stock.
In principle these elements are:
- Periodic financial statements
- Business valuation techniques.
- Economic Forecasts: Analysis of the environment.
- General economic information.
- Any additional information that affects the value of a stock
In following chapters we will see in more detail the most important fundamental aspects that can affect the value of a stock.