Fundamental analysis of the financial markets
Fundamental analysis is derived from economic data in order to forecast prices, while technical analysis is based on analysing price trends. Fundamental data include production, consumption, disposable income, interest rate trends, the consumer price index, and a company’s profit and loss account, to name just a few examples. Many successful traders use fundamental analysis to determine the basic market direction. They may use technical analysis to time their entries and exits.
Every trader has a different character and a different psyche. Since fundamental analysis tends to determine long-term trends, this analysis method is primarily used by traders who prefer holding positions in the long term. Traders who trade daily will use this analysis method at best to determine the basic direction or to better assess false signals.
What is fundamental analysis about?
Fundamental analysis tries to derive causal relationships between individual market-influencing factors. Some factors will be named and explained below. Please note that the analysis of the individual factors and markets is far from complete.
Fundamental analysis may offer a number of advantages for a trader.
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It provides additional information to increase the probability of a profitable trade.
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Fundamental developments may indicate major price movements early on, long before technical signals appear. This way, aggressive traders can enter the market much earlier to take their positions.
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Knowing the fundamental relevance of events may help traders stay calm when trading, even if developments do not commence at once.
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Market reaction to certain news can even be used as a trading tool by a technical trader.
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The information from the fundamental analysis can help the trader not to fall for false signals.
Factors that influence the market
Fundamental analysis uses various factors to forecast a price, index level or share price in the future. They differ based on the market under consideration. For example, indices consider different factors from shares. Seasonal factors are relevant, too. For example, the window dressing effect occurs at the end of the year. Fundamental analysis of the individual asset classes will be examined step by step below.
Fundamental analysis for valuation of shares
Fundamental analysis of shares assumes that there is a fair intrinsic value of a company. If this value deviates from the value currently traded on the stock exchanges, an under- or overvaluation will have occurred. Analysts will then derive corresponding trading signals from this. If the share is undervalued, it will be bought under the assumption that the traded price of the share will also adjust to the intrinsic value on the stock exchange at some point. Shares that are overvalued will be sold or sold short accordingly.
The following factors are considered when analysing shares:
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Turnover
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Profit
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Liquidity
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Financing power
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Order situation
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Business concept
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Industry
Some among these factors bring about a certain valuation leeway from the fair value of the company. For example, the business concept regularly leads to a company being incorrectly valued. The industry may also be a reason for incorrect valuations. Bad news from large companies in one sector may affect all companies in that sector, for example.
Such factors will then be used to derive corresponding indicators such as the price/earnings ratio. Trader can then recognise how the company is currently valued on the stock exchange from this. They can apply their trading logic subsequently.
Fundamental analysis of indices
The relevance of the numerous factors that influence the score of indices may change over time. Corporate earnings growth generally determines the overall direction of stock market trends. Factors that influence company profits are also included accordingly. However, not only the future profits of companies but also interest rates have a strong influence on the current value of the index.
Interest
The monetary policy of central banks is essential for the development of a stock market. If the money supply is extended, the stock market will usually do better as investments increase. Money may end up in many areas. It can be used for the purchase of capital goods, cars, luxury goods or investments in the stock market. The more liquidity is available, the better the stock market is doing.
Interest rates thus strongly influence the stock market.
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They influence the financing costs of companies’ borrowed capital. This influences the profits of companies in turn.
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They influence the discounting of future profit distributions (dividends) that are included in the share prices. If interest rates rise, future profits become less valuable and so do the shares.
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They make competing investments in bonds correspondingly attractive and, therefore, also influence the equity markets.
Psychological factors
The prevailing mood on the market is essential for price formation. This sentiment in turn will be influenced by given fundamental data. These sentiments can be measured using various sediment indicators (e.g., put/call ratio), which reflect this factor.
Economic factors
The state of the economy is another strong entry factor. A good economic situation and a good economy positively affect companies’ profits. This in turn leads to rising share prices.
Fundamental analysis for the valuation of commodities
The factors driving commodity prices are highly diverse and vary greatly depending on which commodity market you look at. The factors considered in the crude oil market are completely different from those in the gold market. For example, we do not know the actual global gold reserves in the gold market. As a result, we also do not know how much gold can be offered at the respective market price. The development of the supply curve thus remains entirely unknown. In the case of crude oil, in contrast, stocks are much better known.
Seasonal influences
Virtually every commodity has seasonal price fluctuations. Therefore, seasonal factors must be considered in this area in particular.
Supply and consumption
In order to be able to forecast a commodity price, you have to analyse the supply and consumption of the commodity. Political factors also play a role here. The behaviour of OPEC, for example, plays a major role in the oil price.
Stocks
Stock levels can be an important factor. High prices ensure that producers keep stocks low and therefore offer larger quantities on the market. When prices are low, they will be more inclined to replenish their stocks than to offer the raw materials on the market.
Differences in quality
Where raw materials are concerned, there are always differences in the quality of the goods on offer. This is why it is important to consider what kind of oil it is, for example. There are hundreds of different crude oil types. The properties (sulphur content and specific gravity) of the oils must be assessed accordingly.
Fundamental analysis of exchange rates
Exchange rates determine a country’s international competitiveness. As a currency rises in value, the goods from that country grow more expensive for buyers. Accordingly, fewer goods tend to be bought from that country. A currency thus also is an important instrument for considering the different production costs of countries.
A common theory for determining the exchange rates of two currencies is purchasing power parity. This describes the relative purchasing power of one currency in relation to another currency. For example, if you buy a shopping basket for EUR 100.00 and then get it for USD 100.00, the exchange ratio would be 1:1=1. However, if the value of the basket of goods in EUR were to rise by 2% from inflation while the dollar rose by 5%, the dollar would fall by 3% against the EUR to compensate for the loss of purchasing power. The exchange rate then would be: 1.02/1.05 = 0.971
Interest
Interest rates are an important factor in the pricing of currencies. Rising interest rates lead to higher demand for a currency. As a result, its price rises in relation to the other currencies.
Economic factors
A growing economy, low unemployment, a balanced budget, and low government debt normally lead to an appreciation of a currency.
Political factors
The economic, monetary, and trade policies of an economy are decisive factors for currency value. These are the most difficult aspects to factor into the pricing of currencies. Countries with clear and stable governments, sound tax policies, a prudent fiscal policy, and a strong independent central bank are more likely to gain the confidence of foreign investors than countries in which there is unrest. The currencies of countries that investors trust in are gaining in value accordingly.