Fundamental analysis (FA) refers to a way of calculating a security’s inherent value by assessing relevant economic and financial factors. Fundamental analysts carry out a study of every factor that may impact the security’s value. This could range from macroeconomic factors like the economic state and industry conditions to microeconomic factors such as the quality of a company’s management.
The ultimate aim is to come to a number that could be compared with a security’s present rate to see if the security is undervalued or overvalued.
Many believe that this analysis method is the opposite of technical analysis, which predicts price direction with the help of the direction of prices past data pertaining to price and volume.
As fundamental analysis assesses the inherent value of an investment, its use in forex includes observing the economic conditions which have a significant impact on the nation’s currency value. We discuss some of the key fundamental factors that can cause a shift in the currency’s movement below:
Economic Indicators
Economic indicators are reports that a government or an organization releases. These reports outline the nitty-gritty of the country’s economic performance. Economic reports make it possible to measure a country’s economic health. However, one should take into account the fact that there are several factors and policies that impact a nation’s economic performance.
Since the release of these reports is pre-decided, one can get a proper insight to determine whether the national economy has improved or declined. The effect of these reports can be compared to the manner in which earnings reports, SEC filings, and other releases could have an impact on securities. In forex as well as in the stock market, moving away from what is considered the norm could lead to monumental price and volume movements.
You may already be familiar with a couple of economic reports like unemployment numbers, that are public knowledge. Other factors such as housing stats do not get sufficient coverage but it helps to note that every indicator serves a unique purpose.
Gross Domestic Product (GDP)
GDP is used to measure a country’s economic performance broadly. It indicates the overall market value of all goods and services that are produced within the country annually. As the GDP figure on its own is known to be a lagging indicator, traders typically focus on reports that are made public prior to when the final GDP figures are revealed. These are the advance report and the preliminary report which if revised considerably could lead to some significant volatility in the gold market.
Retail Sales
The retail-sales report calculates the overall receipts of all retail stores of a country. This is done on the basis of a diverse set of retail stores spread across the nation. The report acts as a timely indicator of consumer spending patterns at large which can be tweaked as per seasonal variables. It helps in speculating the performance of key lagging indicators and to analyze the economy’s immediate direction. Advanced reports of retail sales could lead to some solid volatility because of revisions. The retail sales report could be looked at against the sales performance of a publicly-traded company.
Industrial Production
This report indicates a shift in the production of factories, mines, and utilities in a country. It also states facts about “capacity utilization,” to mention the degree to which every factory’s potential is being utilized. It is a good sign if a country’s production increases when it is using its industrial resources at maximum or near-maximum capacity.
Traders who work with this indicator focus on utility production which is typically as volatile as the utility industry. As a result, the trading of and demand for energy gets impacted because of weather changes. These changes could lead to major revisions in the report that would further become a cause of volatility in a country’s currency.
Consumer Price Index (CPI)
The CPI calculates the changes in the rates of consumer goods that go well over 200 different categories. If you compare this report to the nation’s exports, it can provide proper insight that can help one gauge whether the nation is making a profit or loss with the products and services produced. Make sure you also track the exports as the prices of exports tend to change often with respect to a currency’s strength or weakness.
Economic Indicators
Since economic indicators sense the state of a country’s economy, any changing conditions reported would naturally impact the price and volume of the national currency. One should bear in mind that the aforementioned indicators aren’t the only exclusive factors that can make a difference in the currency’s price. Third-party reports and technical factors are some examples of other aspects that can make a difference in the currency’s valuation. Here are some guidelines for carrying out fundamental analysis in the forex market:
- Use an economic calendar that has a list of indicators and when they are expected to be released. Do watch out for future trends. Several times, markets tend to move as they expect a particular indicator or report likely to be released in the near future.
- Stay on top of any updates and news that come about the economic indicators that capture the market’s pulse. These indicators act as catalysts that lead to the largest price and volume movements.
- Learn about the market’s expectations about data and observe when these expectations are met as this is much more significant than data. It is rare that there lies a remarkable difference between the expectations and actual results. In case it happens, you should know the possible reasons that may have resulted in this difference.
- Don’t be in a hurry to respond to the news. Many times these numbers are put out in the public and then revised. This can alter things rapidly. Keep a close watch on these revisions, since they could give you better insights into future trends.
Steps in Fundamental Analysis
To put it broadly, fundamental analysis studies individual firms by assessing their financial statements and examining different metrics. This helps in determining the company’s intrinsic value on the basis of its revenues, profit, costs, capital structure, cash flows, etc. Company metrics can be analyzed against industry peers and competitors to ultimately compare the market at the macro level.