The functions of supply and demand allow for the movement of financial market prices. These are a reflection of market sentiment and are influenced by several key factors, which have an influence over a trader’s analysis of the market over both the short and the long term.
The two principal forms of analysis employed by traders in their analysis of a financial instrument are fundamental and technical analysis. These form two different, although interlinked, understandings of what influences movements in price and each technique can be employed either individually or together in the analysis of a financial instrument. They each form two very important roles in market analysis and it is important that traders recognize the differences in order to be able to apply these analytical techniques to their own trading. This article shall introduce the basics of fundamental analysis.
Fundamental analysis uses broad macroeconomic, financial and political news and news-events to speculate on the future price movements of a financial market. It can involve the analysis of reports, earnings analysis, economic data and news releases as a basis for making predictions on the direction of price in both the short and medium term. Sometimes referred to as the ‘bigger picture’ of financial analysis, important news such as a country’s GDP or rate decisions from Central Banks form the backbone of broad fundamental analysis. For fundamental equity investors, newsworthy events such as the replacements of a CEO, quarterly company earnings reports and sector reports offer an insight into future price direction. Due to the amount of key influential data and news information generated on a daily and weekly basis it is important for investors to be aware of such events and world-wide developments. Currencies, for example, base their long-term value on the general economic and political wellbeing of the areas where they are employed and they are incredibly price-sensitive to short term changes in the fundamental status quo of the countries where they are used.
Fundamental analysis is largely subjective and much of the interpretation of information is discretionary. Traders interpret news and data and then apply this to their investment strategies, making subjective decisions on whether this may already be priced into the market or if it will have an effect on price which has not yet been applied to its current level. This interpretation of news and information is a skill that takes a certain degree of practice and experience. This includes analysing whether, for example, a small shock in economic data can influence price over the short, medium or long term. Data that is consistently reported, such as monthly employment figures, may not have an impact on the long-term trend of a currency with the release of surprising figures, but may have a very definitive short-term effect on price. Markets tend to overreact instantly to news that is unplanned before returning to their original direction if the information is not considered fundamental to the long-term value of the financial instrument.
Practice and experience are key to making decisions relating to fundamental analysis. The discretionary understanding fundamental analysis of which news and data can be considered important can be developed to suit a traders long- or short-term market perspective. The information considered as market noise can be avoided as non-fundamental to price and, similarly, that which has already been factored into the market price can be disregarded. All markets respond differently to changes in fundamental information ; therefore, the skill of applying this to trading often lies in knowing a market well enough to understand its nuances and subtleties in its reaction to fundamental news and data.