Fundamental Analysis Explained

The truth about forex trading is that all of us are “fundamentalists.” We are all trading the news and the underlying economics of currencies, especially supply and demand. Although there is an acknowledged schism between fundamental traders and those that rely on technical analysis, the difference relates more to how each type of analysis is employed, and not the foundations. Technical analysts believe-without any sense of irony-that fundamentals are already included in the price as well as reflected by indicators.

Fundamental Analysis is a broad term that describes the act of trading based purely on global aspects that influence supply and demand of currencies, commodities, and equities. Many traders will use both fundamental and technical methods to determine when and where to place trades, but they also tend to favor one over the other. However, if you would like to use only fundamental analysis, there are a variety of sources to base your opinion.

Central Banks

Central banks are likely one of the most volatile sources for fundamental trading. The list of actions they can take is vast; they can raise interest rates, lower them (even into negative territory), keep them the same, suggest their stance will change soon, introduce non-traditional policies, intervene for themselves or others, or even revalue their currency. Fundamental analysis of central banks is often a process of poring through statements and speeches by central bankers along with attempting to think like them to predict their next move.

Economic Releases

Trading economic releases can be a very tenuous and unpredictable challenge. Many of the greatest minds at the major investment banks around the world have a difficult time predicting exactly what an economic release will ultimately end up being. They have models that take many different aspects into account, but can still be embarrassingly wrong in their predictions; hence the reason that markets move so violently after important economic releases. Many investors tend to go with the “consensus” of those experts, and typically markets will move in the direction of the consensus prediction before the release. If the consensus fails to predict the final result, the market then usually moves in the direction of the actual result – meaning that if it was better than consensus, a positive reaction unfolds and vice versa for a less-than-consensus result. The trick to trading the fundamental aspect of economic releases is to determine when you want to make your commitment. Do you trade before or after the figure is released? Both have their merits and their detractions. If you trade well before the release, you can try to take advantage of the flow toward the consensus expectation, but other fundamental events around the world can impact the market more than the consensus read. Trading moments before the economic release means that you have an opinion on whether the actual release will be better or worse than the consensus, but you could be dreadfully wrong and risk large losses on essentially a coin flip. Trading moments after the economic release means that you will be trying to establish a position in a low-volume market which presents the challenge of getting your desired price.

Geopolitical Tensions

Like it or not, some countries around the world don’t get along very nicely with each other or the global community and conflicts or wars are sometimes imminent. These tensions or conflicts can have an adverse impact on tradable goods by changing the supply or even the demand for certain products. For instance, increased conflict in the Middle East can put a strain on the supply of oil which then makes the price increase. Conversely, a relative calm in that part of the world can decrease the price of oil as supply isn’t threatened. Being able to properly predict how these events will conclude may be a way to get ahead of the market with your fundamental perspective.

Weather

There are a variety of weather-related events that can cause prices to fluctuate. The easiest example is the propensity for winter to create massive snow storms that can drive up the cost of natural gas, which is used to heat homes. However, there are a variety of other weather situations that can change the value of tradable goods such as hurricanes, droughts, floods, and even tornados. While some of these events are very unpredictable, sometimes it can help to break out the old Farmer’s Almanac or pay close attention to the Weather Channel to see how weather patterns might unfold.

Seasonality

The seasonality as related to weather is something that makes sense as the natural gas example pointed out above, but there are other seasonal factors that aren’t related to weather as well. For instance, at the end of the calendar year many investors will sell equities that have declined throughout the year in order to claim capital losses on their taxes. Sometimes it may be beneficial to exit positions before the year-end selloff begins. On the other side of that equation, investors typically come back to equities in droves in January, a phenomenon called “The January Effect.” The end of a month can be rather active as well as businesses that sell products in multiple nations look to offset their currency hedges, a practice termed “Month-End Rebalancing.”

Some fundamental factors are more long-lasting while others are more immediate, but trading them can be both difficult and rewarding for those who have the intestinal fortitude to trade them. Also, the fundamental factors listed above are just the start to a list that is much longer in length as new fundamental methods of trading are created every day. So keep your eyes open for new situations that arise and maybe you could be fundamentally ahead of the curve!

Fundamental analysts have a different focus than that of technical traders. In truth, they both have their advantages, as well as their blind spots. The endless debate about which is better, is beside the point. Neither is incorrect, and both are complimentary with each other. In his book “The Disciplined Trader,” Mark Douglas made a telling reference to the methodology of unsuccessful traders whom he said were, “Focusing on price and the monetary value of a trade, instead of the potential for the market to move based on its behavior and structure.” This is the sine qua non of fundamental analysis. The fundamental analyst asks not only what the price of something is, but what the intrinsic value is. Some other aspects of this analysis are: 

Fundamentals drive markets

You may have to use “enhanced interrogation techniques” to get technical traders to admit it, but if technical indicators are a proxy for fundamentals, then one can draw the obvious conclusion; prices are the fundamentals. Currencies are reflections of the nations-or groups of nations in the case of the EUR-that issue them. Economic events, trade, growth, inflation,  employment, interest rates, investment, fiscal policies, national debt, as well as overall prosperity and political conditions, determine the basis for fundamentals. So can wars and natural disasters as the latest U.S. GDP figure for the fourth quarter of 2012 may have indicated. Fundamental analysis seeks to measure and quantify these, to come up with probable values of currencies related to other instruments. Unlike technical analysis, it does not seek exact levels or precise measurements, only sentiment and direction. It is more of a “big picture” impression rather than a microscopic measurement.

Valuation, not prices

Most fundamental analysts talk about price levels or areas rather than specific prices. They factor in market noise, liquidity as well as the irrationality of the market over the short term, with the belief that the market corrects itself over longer periods. Their trading matches this, and they give wide berth to price movement with entries and exits based more upon confluences in the environment mirrored by convergence and divergence. Many fundamental traders are contrarians by nature as well as habit. Examples include George Soros and Jim Rogers whom  have made careers of defying expectations, bucking common assumptions and predictions. Their main abilities were not only in economic forecasting based upon fundamental analysis, but in devising strategies for a wide variety of economic conditions.

Technicals are snapshots of fundamentals

Fundamental analysts get a fair amount of good natured ribbing from the technical analysts. The major point of contention seems to be that fundamental analysis is imprecise and subjective and not especially useful for certain types of trading. Fundamental analysts and traders retort that technical traders are promoting science where there is none, and at best, technical indicators give traders a temporary picture amidst the fluidity of the marketplace. Most traders fall somewhere in between and use technicals to help with entries and exits, and fundamentals to decide whether those entries and exits are right to begin with. The technical traders are correct about one thing though: fundamentals are reflected in the prices at some point. However, it can take long periods of “irrational markets” and extended volatility before prices accurately reflect those fundamentals. The best traders want to be in the market BEFORE everyone else realizes this, and out of trades when they do. This is akin to selling into strength and buying into weakness.

Forecasting and Reviews

While technical traders will rely on historical patterns vis-à-vischarts, fundamental analysts will put more stock in comparisons of economic data and historical outcomes. The fundamental trader is seeking to grasp the undercurrent of the market as defined by trends, which tend to last longer than many traders realize. This is the edge of the fundamental trader whom is not psyched out of the market by temporary swings or price spikes.

Long Term traders

Fundamental analysts tend to be long term traders as real trends take longer to form after periods of consolidation. This can be a disadvantage for those that prefer to trade shorter time frames which are more conducive to technical indicators such as support and resistance.

Key indicators versus secondary indicators

Inflation and interest rates. These are the crucial components of value due to their reflection of supply and demand.  They can be reflected in both currency values as well as sovereign bond prices. GDP is another key fundamental indicator since it reflects housing, industrial production, consumer activity and trade. Secondary indicators would be bank deposit rates and equity indexes.   

Using Economic Indicators

Since economic indicators gauge a country’s economic state, changes in the conditions reported will therefore directly affect the price and volume of a country’s currency. It is important to keep in mind, however, that the indicators discussed above are not the only things that affect a currency’s price. Third-party reports, technical factors, and many other things also can drastically affect a currency’s valuation. When conducting fundamental analysis in the forex market:

  • Keep an economic calendar on hand that lists the indicators and when they are due to be released. Also, keep an eye on the future; often markets will move in anticipation of a certain indicator or report due to be released at a later time. 
  • Be informed about the economic indicators that are capturing most of the market’s attention at any given time. Such indicators are catalysts for the largest price and volume movements. For example, when the U.S. dollar is weak, inflation is often one of the most-watched indicators.
  • Know the market expectations for the data, and then pay attention to whether the expectations are met. That is far more important than the data itself. Occasionally, there is a drastic difference between the expectations and actual results. If so, be aware of the possible justifications for this difference.
  • Don’t react too quickly to the news. Often numbers are released and then revised, and things can change quickly. Pay attention to these revisions, as they may be a useful tool for seeing the trends and reacting more accurately to future reports.

Which is the best analysis method?

The answer is both! 

Good technical analysis will tell you ‘when’, good fundamental analysis will tell you ‘why’.

On the Forex markets, traders usually rely on technical analysis to time their entry and exit from the market, while still keeping an eye on the economic calendar – top-down fundamental analysis – to keep abreast of news that can affect market volatility and trigger potential trading opportunities.

The Bottom Line

There are many economic indicators, and even more private reports, that can be used to evaluate forex fundamentals. It’s important to take the time to not only look at the numbers but also understand what they mean and how they affect a nation’s economy. When properly used, these indicators can be an invaluable resource for any currency trader.

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