Fundamental analysis — what it is and how to use it in trading

Fundamental analysis allows traders and investors to analyse a financial instrument to identify its intrinsic or true value. 

This form of analysis involves examining macro and microeconomic data to determine whether an instrument is undervalued, overvalued, or fairly valued.

With macroeconomic data, traders and investors could look at certain factors, such as the health of the economy, including interest rates, political and economic events, and the conditions of the financial instruments industry or sector. 

Whereas, with microeconomic data, they could look at factors such as earnings reports or the health of a company if they were trading stocks, for example, or if they were trading commodities, for instance, in the agricultural sector, they could look at weather reports.

Together with the economic data, they could also examine market sentiment using different tools, such as the VIX (volatility index), which could assist them in making more informed trading decisions. This, along with all the other publicly available information gathered, could also help them make more informed trading decisions.

When executing fundamental analysis, traders and investors could take two different approaches: top-down analysis and bottom-up analysis.

Let’s take a closer look at the difference between these two approaches in more detail below.

Top-down analysis

With the top-down approach, a trader or investor will start by analysing the overall health of the economy of a specific country; the financial instrument they’re interested in is most prevalent, looking at various data factors such as the GDP, interest rate, and inflation levels.

They try to identify the direction the economy might take and then examine the different sectors and industries they believe are showcasing the most growth.

Once they’ve done that, they could analyse the various financial instruments within these sectors and industries they believe could provide potential trading opportunities.

Bottom-up analysis

With the bottom-up approach, traders and investors will generally focus most of their time on analysing the microeconomic factors concerning a particular financial instrument to better understand its operations. 

For example, if they were looking at stocks, they could look at a company’s earnings reports and prospective growth over a certain period of time.

Traders and investors using this approach tend to believe that certain individual financial instruments perform better than the overall industry they are categorised in.

For some traders and investors, fundamental analysis could be seen as too broad of a term. The reason for this is that it could refer to anything directly related to a financial instrument.

All of the information involved could appear overwhelming. Therefore, to better understand what to look for, analysts have classified fundamental analysis into two categories: quantitative and qualitative.

• Quantitative analysis: Let’s say a trader or investor is looking at shares; quantitative analysis involves examining numerous factors such as earnings per share, financial ratios, interest rate policies, and market capitalisation to identify a company's overall health.
• Qualitative analysis: This form of analysis involves looking at more subjective factors, such as management quality, the company’s executive team, proprietary technology (if applicable), and brand recognition.

Qualitative fundamentals are more difficult to quantify compared to quantitative fundamentals; however, neither one is superior to the other as traders, as well as investors generally tend to use both when analysing the overall trading opportunities for financial assets.

Various factors could affect a trader’s or investor’s overall financial instrument analysis, so we’ve compiled a list of some essential factors traders and investors might want to consider when doing their analysis.

Supply and demand

One of the most fundamental aspects that influence the value of a financial instrument comes down to supply and demand. 

An imbalance between supply and demand causes the price of financial assets to either rise or fall. For example, if there is more demand for gold, but the supply starts decreasing, the price of gold will begin to rise.

The same could be said when looking at stocks; if a company releases a new groundbreaking technology, the demand for that company will increase, and with only a limited number of shares available, the value of its share price will increase.

The opposite is also true; if the supply outweighs the demand, the price of an asset will start to fall.

Interest rate

The interest rate is linked to most financial instruments. However, commodity and forex traders are more inclined to keep a close eye on the interest rate for different countries, which could directly affect the price movement of the assets they might be looking to trade.

A country’s central bank determines interest rates. The participation and actions of these central banks will significantly influence a currency’s exchange rate.

Another factor to consider regarding interest rates is quantitative easing - when central banks inject more money into a country’s economy. Many traders and investors view this as unfavourable, causing a currency's value to drop.

Inflation

Inflation is another factor linked to a country’s currency. If inflation becomes too high, it shifts the supply-demand balance, favouring supply. 

This could cause the currency to devalue since the supply of the currency is more than the demand for the currency.

Conversely, deflation is the opposite; when a country experiences deflation, the currency’s value increases because demand overtakes supply.

GDP

Gross Domestic Product (GDP) is used to assess all commodities and services generated within an economy over a certain period of time. GDP is regarded as one of the best indicators of a country’s overall economic health.

A country with a strong GDP growth indicates a strong economy. However, the link between how well a country’s economy is doing or not doing and the value of the currency itself is not that simple. 

If a country is only experiencing constant growth, it could increase inflation, which, as we’ve seen in the previous section, can hurt the currency’s overall value.

Company-related factors

It goes without saying that if a firm has publicly traded shares, anything that happens within the company will directly influence the share price. A company’s stock price will likely grow with successful product launches, greater revenue, decreased debt, and increased investors’ capital.

However, suppose the company is losing money, having product failures, or amassing debt. In that case, most shareholders will see this as unfavourable and could start to sell their shares, lowering the overall share price.

Changes in management, mergers, and acquisitions are two more reasons that could cause the price of a share to rise or fall, depending on the shareholder’s initial view on the matter.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures a country’s pricing for goods and services. If the CPI increases to a level above the central bank’s CPI benchmark, the central bank could start raising interest rates to reduce inflation and potentially try stabilising the country’s economic growth rate.

Retail Sales

The retail sales figures of a country provide an accurate picture of how people are spending and the health of the country’s economy on the most basic level. If a country’s CPI statistics are strong, it indicates that the domestic economy is in good health, which could indicate potential future growth rates.

Political and economic events

A country’s political and economic situation could directly impact various financial markets, such as the currencies, commodities, and stock markets.

Political instability and impaired economic performance could impact a currency’s value and increase the price of certain commodities.

Politically stable nations with a steady and predictable economic performance are typically more desirable to international investors. As a result, these countries attract investment away from countries with more economic unrest.

These more desirable investment countries will see their currency increase in value as well as see an increase in investment in other financial sectors within the country.

Other political events, such as presidential elections, will see high volatility within a currency, causing prices to fluctuate quicker and more often. Depending on the outlook of traders and investors, this could have a negative or positive effect on the country’s financial sector.

The scale of an economic news event could also influence a currency’s price, depending on its intensity, either on a short - or long-term basis.

It’s safe to say that a positive news event could increase a currency’s value and, in turn, potentially increase investments within other sectors. In contrast, a negative news event could decrease a currency’s value.

Different news events could include employment data, manufacturing data, GDP updates, etc.

Natural catastrophes and seasonality

For many traders and investors, this might seem disconnected from the markets. However, it could generate levels across various assets. 

Natural catastrophes such as earthquakes and floods could disrupt commodity supply systems and cause problems for companies and economies, causing corporations to experience significant losses and damage to infrastructure.

As a result, this could then hurt the manufacturing and transportation of goods, affecting a company’s sales, which could then possibly affect the company’s stock price if it’s a publicly traded company or the price of commodities if it forms part of that financial sector.

Seasonal weather patterns might have the same effect; this is more prevalent in the commodities market. For example, if a country is experiencing an extreme weather pattern, it could affect the price of certain agricultural products, pushing the price higher as demand outweighs supply.

There are various advantages to using fundamental analysis; below is a breakdown of some of them.

• Most fundamental traders have a longer-term outlook of the market, and using fundamental analysis provides them with a broader picture of what is currently happening.
• Fundamental analysis assists traders and investors in identifying the true value of a financial instrument.
• It can help traders and investors better understand a company’s or economy’s overall health.
• Following a reputable and official news source could provide a more accurate signal on the potential price movements of various financial instruments.
• Looking at a company’s earnings reports could provide traders and investors with the necessary insights into the company’s potential growth and, in turn, offer the opportunity to invest in those companies with greater growth expectations.
• This form of analysis can be used to analyse various financial markets, such as stocks, indices, commodities, and forex.

There are also some disadvantages when using fundamental analysis; below is a breakdown of some disadvantages a trader and investor might want to keep in mind.

• Fundamental analysis could become time-consuming, as traders and investors would need more time to gather the necessary information about the financial instrument they might be interested in.
• This form of analysis doesn’t necessarily consider how market sentiment from other traders and investors could affect the price of financial assets, which means missed opportunities could exist.
• There aren’t clear entry and exit signals with fundamental analysis compared to technical analysis, which focuses more on providing possible clearer signals.
• Fundamental traders might need to have a greater understanding of a country’s overall economic health, the specific industry in which their financial instrument is situated, and the various competitors involved within the industry.
• The qualitative factors are often subjective, meaning each trader and investor might have a different opinion on what is positive or negative.

As previously mentioned, fundamental analysis involves identifying an asset’s intrinsic value by examining various factors, such as company earnings reports, macro and microeconomic data, and the overall health of the economy through information such as interest rates, political and economic events, and the condition of the financial instruments sector or industry.

Traders and investors also use this information to identify whether an asset might be overvalued or undervalued.

If they believe an asset is undervalued, they could buy it. Conversely, if they believe an asset is overvalued, they could sell it.

If we look at an example of someone trading forex, they could examine macroeconomic data such as a country’s GDP figures and inflation rate. Meanwhile, if someone is trading shares, they could examine a company’s earnings reports and the condition of the industry in which the shares are situated.

Traders and investors utilising fundamental analysis tend to have a longer-term approach to the market.

Technical analysis, on the other hand, is the complete opposite. It involves predicting future price movements and identifying possible trading opportunities by examining historical price data.

By identifying past trends and patterns, traders could find potential future trading opportunities as they believe what happens in the market isn’t random and certain trends and patterns tend to repeat themselves.

They tend to use a variety of technical indicators such as moving averages, Fibonacci retracement, or relative strength index (RSI) with a combination of price action trading such as candlestick patterns and charts patterns to look for potential trading opportunities and entry and exit points.

Traders utilising this form of analysis tend to be chart-focused and have a shorter-term approach to the market.

Fundamental analysis is essential for evaluating the intrinsic value of a financial instrument by looking at various fundamental aspects which could influence the price movements of said financial instruments.

By looking at these fundamental aspects, such as a company’s earnings reports, a company’s revenue, a country’s GDP levels, inflation rates, interest rates, and debt levels, a trader could find possible trading opportunities that technical traders could possibly miss out on.

It assists traders and investors in determining whether a financial instrument is possibly overvalued or undervalued while providing information on the instrument’s potential future growth, which also provides a longer-term perspective.

With both quantitative and qualitative analysis, traders and investors could better understand a company’s overall growth patterns, which could, in turn, assist in making potential long-term trading decisions in the stock market.