Introduction to fundamental analysis
In this course, we’ll explore all the essential aspects of fundamental analysis—one of the two primary methods, along with technical analysis, used to research investment opportunities.
What is fundamental analysis?
Fundamental analysis is an approach to market evaluation that uses various data sources to determine an asset’s intrinsic value. Unlike technical analysis, which focuses solely on price movements, fundamental analysis aims to create a comprehensive picture of a security’s strengths and weaknesses.
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While fundamental analysis is often associated with identifying stocks to buy, it is, in fact, widely used across multiple asset classes. In forex trading, for instance, a fundamental analyst would examine any factors that could significantly influence a currency pair's value—such as economic data, political events, or even the impact of natural disasters.
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However, fundamental traders don’t examine data randomly. They work to estimate a market’s fair value to determine if it’s currently undervalued or overvalued.
Fundamental analysis and fair value
Fundamental analysis operates on the principle that each asset has an inherent fair value. While markets may temporarily drive an asset’s price above or below this value, it is expected that, over time, the price will eventually realign with its true worth.
If, after analyzing a company, you determine that its value exceeds its current share price, you could buy its stock and later sell it when the price aligns with your estimated value.
When evaluating a currency’s fair value, there are numerous factors to consider. You might examine economic data releases, central bank policies, retail spending, and other key indicators.
Drawbacks of fundamental analysis
Fundamental analysis is an excellent way to gain insight into your selected asset classes and sectors, potentially uncovering profitable opportunities. However, there are two main challenges to keep in mind.
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The first challenge is that there is no assurance your chosen market will move toward its fair value, even with thorough research. Unforeseen events—like natural disasters or scandals—can disrupt your asset's price and affect your fair value assessment. Additionally, the market might behave irrationally for a longer period than you can maintain your position.
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The second challenge is the overwhelming amount of data available in global markets. With so much information to sift through, it can be difficult to determine what is relevant and what isn’t.
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One strategy to tackle this issue is to adopt a top-down approach. Begin by analyzing the overall economy, then identify which markets might be overvalued or undervalued. Finally, focus on the specific factors affecting a select few assets to inform your investment decisions.
Important factos in fundamental analysis
As we’ve discussed, fundamental traders have access to a wide range of sources. However, some sources are more crucial than others:
Central bank announcements
Central banks can generate considerable volatility across various asset classes. One of their key actions is adjusting interest rates, which can significantly influence currencies, stocks, indices, and more.
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Additionally, fundamental analysts pay close attention to new monetary policies—indications that a central bank may alter its stance in the near future—along with asset purchases, currency revaluations, personnel changes, and other relevant factors.
Economic data
Nearly all assets are influenced by the broader economy, so fundamental traders seek indicators of economic expansion or contraction.
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The primary measure of economic growth is gross domestic product (GDP), which reflects the total value of goods and services produced within an economy. Employment figures and production reports are also essential indicators.
Inflation
Inflation is another crucial economic factor. It occurs when a currency’s purchasing power declines, and central banks are typically tasked with managing it—while also aiming to prevent deflation.
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Inflation impacts not only forex markets but also bonds, commodities, stocks, and indices, often leading to increased volatility across these asset classes.
Politics
Inflation is another crucial economic factor. It occurs when a currency’s purchasing power declines, and central banks are typically tasked with managing it—while also aiming to prevent deflation.
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Inflation impacts not only forex markets but also bonds, commodities, stocks, and indices, often leading to increased volatility across these asset classes.
Natural disasters and seasonality
These two factors might appear unrelated to the markets, but they frequently drive volatility
across various assets.
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Natural disasters can create challenges for businesses and economies, impacting supply chains for multiple commodities. Similarly, seasonal weather patterns can have comparable effects.