Fundamental analysis uses economic data to forecast prices, whereas technical analysis is based on the study of past price movements. Fundamental data include economic data such as production, consumption, disposable income, interest rate trends and the consumer price index, as well as company figures such as the income statement – to name just a few examples. Many successful traders use fundamental analysis to determine the general direction of the market, and some then turn to technical analysis to time their entries and exits.
Every trader has a different character and temperament. Because fundamental analysis tends to identify long-term trends, it is used above all by traders who prefer to hold positions for longer periods. Traders who trade daily will use it at most to establish the underlying direction of the market or to better assess false signals.
How does fundamental analysis work?
Fundamental analysis tries to establish cause-and-effect relationships between the individual factors that influence a market. Some of these factors are named and explained below, although this overview of factors and markets is far from complete.
Fundamental analysis can offer a trader several advantages:
- It provides additional information that can increase the probability of a profitable trade.
- Fundamental developments can signal major price movements early, long before technical signals appear. This allows an aggressive trader to enter the market and open a position much earlier.
- Knowing the fundamental significance of an event can help a trader stay calm during a trade, even if the market does not move in the expected direction straight away.
- The way the market reacts to certain news can even be used as a trading tool by technical traders.
- Information from fundamental analysis can help a trader avoid falling for false signals.
Factors that move the markets
To forecast a future price, index level or exchange rate, fundamental analysis draws on a range of factors. These differ depending on the market being analysed: an index, for example, is driven by different factors than an individual share. Seasonal factors also play a role. One example is the window dressing effect towards the end of the year, when fund managers buy the year's best performers and sell the losers so that their portfolios look better in the annual report. The following sections look at fundamental analysis for each asset class in turn.
Fundamental analysis of shares
Fundamental analysis of shares assumes that every company has a fair intrinsic value. If this value differs from the price at which the share is currently trading on the stock exchange, the share is undervalued or overvalued, and analysts derive trading signals from this. If a share is undervalued, it is bought on the assumption that its market price will eventually move into line with its intrinsic value. If it is overvalued, it is sold or sold short.
The following factors feed into the analysis of a share:
- Revenue
- Profit
- Liquidity
- Financial strength
- Order situation
- Business model
- Industry
Some of these factors leave room for interpretation around a company's fair value. The business model, for example, regularly leads to companies being mispriced. The industry can also cause mispricing: bad news from large companies in a sector can drag down every company in that sector.
These factors are then used to derive key ratios such as the price-to-earnings ratio (P/E ratio). From these, traders can see how the market currently values the company and apply their own trading logic.
Fundamental analysis of indices
The relevance of the many factors that influence the level of an index can change over time. In general, the growth of corporate earnings determines the overall direction of a stock market's trend. The factors that affect corporate earnings therefore also come into play. However, it is not only companies' future earnings that have a strong influence on the current value of an index – interest rates do too.
Interest rates
The monetary policy of central banks is crucial for the development of a stock market. When the money supply is expanded, the stock market usually does better because investment increases. The money can end up in many places: it can be used to buy capital goods, cars or luxury goods, or it can be invested in the stock market. The more liquidity is available, the better the stock market tends to perform.
Interest rates therefore have a strong influence on the stock market:
- They affect companies' cost of borrowing and therefore also their profits.
- They affect the discounting of future profit distributions (dividends), which are reflected in share prices. When interest rates rise, future profits are worth less today – and so are the shares.
- They determine how attractive bonds are as a competing investment, which in turn also influences the stock markets.
Psychological factors
The prevailing mood in the market is crucial to how prices are formed. This sentiment is itself influenced by the available fundamental data. It can be measured using various sentiment indicators, such as the put/call ratio.
Business cycle factors
The state of the economy is another strong influence. A strong economy and a favourable business cycle have a positive effect on corporate profits, which in turn leads to rising share prices.
Fundamental analysis of commodities
The factors that influence commodity prices are very diverse and vary greatly depending on which commodity market is being analysed. The factors that matter in the crude oil market are completely different from those in the gold market. In the gold market, for example, the actual size of global gold holdings is not known. As a result, nobody knows how much gold could be offered at a given market price, so the shape of the supply curve is essentially unknown. With crude oil, by contrast, inventory levels are known much more precisely.
Seasonal influences
Almost every commodity shows seasonal price fluctuations – think of the higher demand for heating oil and natural gas in winter, or of harvest cycles for agricultural commodities. For this reason, seasonal factors need to be taken into account, especially in this area.
Supply and consumption
To forecast the price of a commodity, its supply and consumption have to be analysed. Political factors also play a role here: in the case of oil, for example, the behaviour of OPEC is highly important.
Inventories
Inventories can be an important factor. High prices lead producers to keep their stocks low and therefore to sell larger quantities on the market. When prices are low, they are more inclined to build up their inventories than to sell the commodity on the market.
Differences in quality
Commodities always vary in quality. With oil, for example, it is necessary to consider which type of oil is involved. There are hundreds of different crude oils, so their properties – sulphur content and specific gravity (density) – have to be assessed.
Fundamental analysis of exchange rates
Exchange rates are important for a country's international competitiveness. If a currency rises in value, the goods produced in that country become more expensive for foreign buyers, who therefore tend to buy fewer of them. This also makes the exchange rate an important mechanism for reflecting differences in production costs between countries.
A widely used theory for determining the exchange rate between two currencies is purchasing power parity (PPP). It describes the relative purchasing power of one currency compared with another. Suppose a basket of goods costs €100.00 in the eurozone and the same basket costs $100.00 in the United States: the exchange rate would then be 1:1. If inflation then raised the price of the basket by 2% in euros and by 5% in dollars, the dollar should fall by roughly 3% against the euro to offset its loss of purchasing power. One dollar would then be worth about 0.971 euros (1.02 divided by 1.05) – or, expressed the other way round, EUR/USD would rise to about 1.029.
Interest rates
Interest rates are an important factor in the pricing of currencies. As a rule, rising interest rates increase demand for a currency, so its value rises relative to other currencies.
Economic factors
A growing economy, low unemployment, a balanced budget and low government debt normally lead to a currency appreciating.
Political factors
A country's economic, monetary and trade policies are crucial to the value of its currency, and they are the hardest factors to build into currency pricing. Countries with clear and stable governments, sound tax policies, prudent fiscal policy and a strong, independent central bank are more likely to win the confidence of foreign investors than countries marked by unrest. As a result, the currencies of countries that investors trust tend to appreciate.