Fundamental Analysis Chapter- I

Education - Fundamental Analysis Chapter-I

What is Fundamental Analysis?

Let me welcome You to the world of fundamental analysis. Have you ever wondered why the American dollar is weakening or gaining in value? Or why the price of gold or oil fluctuates so much? Fundamental analysis explains how economic information from all around the world affects the prices of financial instruments. I hope to show You the beauty of analyzing macroeconomic information and what benefits it gives.

According to J.C Ritchie (in his Fundamental Analysis) “the goal of fundamental analysis is monitoring and classifying financial assets according to their investment quality (as estimated risk valuation) and expected rate of return”.

Fundamental analysts try to price a financial instrument (equities, currencies, commodities, indices etc.) and to define its intrinsic value. Afterwards, comparing the valuation with the market price, they forecast the future turn of events and the possible rate of return. If analysts recognize that the financial instrument is valued lower by the market than its intrinsic value (the financial instrument is undervalued), they will recommend buying it. In the case when calculations show that market price is too high (the financial instrument is overvalued), they will recommend their clients to sell it.

Opposite to technical analysis, fundamental analysis investigates the reasons, not the effects. The main difference though is that technical analysis helps with the timing of your decision to enter the market while fundamental analysis explains why certain things happened. Pricing a financial instrument, analysts take into account many factors like: current and future macroeconomic situation of the region and the country, interest rate levels, possible development of the industry, profits and dividends forecast or cash flows of the company (in case of equities). Recommendations made after fundamental analyses are based on subjective assumptions of analysts; that is why they cannot be treated as 100% precise. Fundamental analysis is comprised of the following stages:

1. Macroeconomic analysis (Currencies, Commodities, Indices).
2. Industry sector analysis (Companies).
3. Situational analysis of the company (Companies).
4. Financial analysis of the company (Companies).
5. Valuation.

The stages described above are used when investors analyze companies and its stocks. On the forex market, one obviously needs to investigate the current global economic situation. To follow that, governments and government agencies publish several economic indicators regarding segments of the industry. Also, central bank’s decisions regarding interest rates are closely watched. All these, and many more contribute to movements of exchange rates. I will describe all the important economic indicators in the near future.

Fundamental analysis is an important step in the decision-making process. At the same time it is not perfect and has its drawbacks. The most often mentioned are:

1. The same macroeconomic information can have different effects for the same currencies – there is no rule of thumb regarding how currencies will behave when a certain set of information is released.
2. Too many economic indicators and macroeconomic data – almost every day governments publish economic reports. Political situation changes abruptly sometime. There are so many events that a fundamentalist might overlook.
3. Fundamental analysis is good only for a long-term period – fundamental analysts can forecast future economic situation but usually for a longer period of time. In the meantime, unexpected corrections or declines cannot be easily foretasted.

When analyzing the economy and future trends it is very important to take into account what information the market has already discounted. If the market expects a fast and dynamic growth or expansion, is this information already discounted by the market?

Opponents of fundamental analysis point out that there is a vast amount of risks that can affect the outcome of the analysis for example changing interest rates, changing housing and labor market trends, inflationary pressures, political risk and others.

Can you think of any other disadvantages of fundamental analysis? Or are you confident that you can completely rely on it?

As I mentioned before, fundamental analysis answers the question: what and why to buy? Whereas, it is also recommended to use technical analysis to tell us when to buy and when to sell. I have to point out that many experienced fundamental analysts, including myself, use both fundamental and technical analysis on the modern capital market with great success.