What is fundamental analysis in trading and how can I use it?

A guide to fundamental analysis in trading

Fundamental analysis is a method used to assess the value of an asset by analysing the underlying economic and financial factors. These factors may include economic indicators like gross domestic product (GDP), inflation rates, interest rates, employment figures, and company earnings reports, among others.

In essence, fundamental analysis looks at the "big picture" to determine whether an asset is overvalued, undervalued, or fairly priced.

Fundamental vs. technical analysis

While technical analysis examines past price movements to predict future market direction, fundamental analysis delves deeper into the causes behind these movements, examining factors that could influence supply and demand in the future.

Fundamental analysis is more about the "why" behind price movements, while technical analysis is about the "what" and "when." Both methods can be valuable, and many traders combine them to form a more comprehensive strategy.

For more information on this topic, check out Pepperstone’s thorough guide on the difference between fundamental and technical analysis.  

Key components of fundamental analysis

In both forex and stock trading, there are several key components of fundamental analysis that traders need to understand:

Economic Indicators

Economic indicators are critical data points that help assess a country’s economic health. In forex trading, these include:

• GDP (Gross Domestic Product): Measures the overall economic output of a country.
• Unemployment Rate: Shows the percentage of unemployed workers, affecting consumer spending and economic growth.
• Inflation Rates (CPI, PPI): Reflects changes in prices of goods and services, influencing central bank policies and currency values.
• Interest Rates: Central banks set interest rates, which directly impact currency value by affecting capital flows.
• Trade Balance: The difference between exports and imports, indicating whether a country has a trade surplus or deficit.

Company financials (for stock trading)

In stock trading, understanding a company’s financial health is essential:

• Earnings Reports: Quarterly reports that show profitability, revenue, and expenses. In the U.S. the Securities and Exchange Commission (SEC) requires public companies to file periodic financial statements and other disclosures. Traders and investors rely on SEC filings to make informed decisions when evaluating whether to invest in a company. SEC filings can be accessed for free at EDGAR, the commission's online database.
• Price-to-Earnings (P/E) Ratio: A valuation metric that compares stock price to earnings.
• Revenue Growth: A rising revenue indicates a company’s market expansion or improved product sales.
• Debt Levels: High debt can strain a company’s finances, affecting its stock price.

Central bank policies

Central banks play a crucial role in currency valuation through monetary policy. Traders need to follow announcements from institutions like the Federal Reserve, ECB, Bank of England or Bank of Japan, as interest rate changes or quantitative easing programmes can affect currency values.

Geopolitical events

Political events, wars, natural disasters, and changes in government policies can influence currency and stock prices. Trade tensions, sanctions, or political instability in a region can significantly affect market confidence and asset valuations.

Global Events

Events such as pandemics, trade wars, and climate disasters can impact global supply chains, economic growth, and overall market confidence, affecting both stock and currency markets. During times of heightened uncertainty, investors often engage in a "flight to safety," moving capital into what are considered safe-haven currencies like the U.S. dollar, Swiss franc, or Japanese yen. These currencies tend to hold their value or even appreciate during crises, as they are perceived as more stable and reliable. This shift can further influence currency valuations and exacerbate movements in the forex market.

How economic indicators affect currency prices in forex trading

In forex trading, economic indicators are critical in determining currency movements. If a country like the United States shows robust economic growth through increasing GDP figures, lower unemployment rates, and rising consumer spending, this signals a healthy and expanding economy. In response, foreign investors might increase demand for U.S. assets, such as stocks and bonds, which could lead to higher demand for the U.S. dollar. As demand for the currency increases, the value of the dollar appreciates against other currencies, strengthening it in the global forex market.

During recessions, the scenario often reverses. A shrinking economy, rising unemployment, and declining consumer spending weaken confidence in a country's assets and currency. Foreign investors might reduce demand for these assets, which can lead to depreciation of the currency. Recessions can also trigger central banks to lower interest rates to stimulate the economy, further reducing the currency's value.

How do interest rates impact currency values?

Interest rates are perhaps the most influential factor in fundamental analysis for forex traders. When a country’s central bank raises interest rates, it can make the currency more attractive to investors seeking higher yields, thereby increasing demand for the currency and pushing up its value. Conversely, lowering interest rates can have the opposite effect, reducing a currency's attractiveness and leading to depreciation.

When The Federal Reserve raised interest rates four times in 2018, the U.S. dollar appreciated against several other currencies, as investors sought the higher yields available in USD-denominated assets.

Inflation rates and their influence on forex markets

Inflation affects the purchasing power of a currency. If a country’s inflation rate is rising too quickly, its central bank may raise interest rates to slow down the economy, which can strengthen the currency. However, if inflation is too low, the central bank may lower rates, weakening the currency to spur economic activity.

Throughout 2022, U.S. inflation soared to its highest levels in over 40 years, driven by supply chain disruptions, energy costs, and pent-up demand post-pandemic.

In response, the U.S. Federal Reserve aggressively raised interest rates to curb inflation. The expectation of higher rates in the U.S. boosted demand for the dollar, as higher interest rates attract foreign investment, driving the USD/JPY exchange rate higher. In contrast, Japan's inflation remained relatively low, and the Bank of Japan (BoJ) kept its ultra-loose monetary policy, with no rate hikes. This divergence in monetary policy between the Fed and BoJ led to a significant depreciation of the yen against the dollar. By October 2022, the USD/JPY pair had reached a 32-year high, with the yen weakening to around 150 per U.S. dollar (see chart below). This situation underscored how inflation and the central bank’s response to it can strongly impact forex pairs.

Earnings reports and their effect on stock prices

In stock trading, earnings reports are critical. A company that posts strong earnings growth will typically see its stock price rise, as investors become more confident in the company's prospects. Conversely, a company that misses earnings expectations may see its stock fall.

When Amazon (AMZN) reported its Q4 earnings in 2020, it surpassed expectations with a 44% revenue increase year-over-year. This strong performance led to a surge in its stock price, reflecting investor confidence. Conversely, In January 2022, Netflix (NFLX) sold off significantly after the company reported its Q4 earnings, which included subscriber growth that fell short of expectations. Concerns about rising inflation and tightening monetary policy also contributed to the broader tech sell-off, impacting Netflix's stock price further.

TradingView’s global earnings calendar is a valuable tool for tracking upcoming earnings reports across various markets. It helps traders anticipate potential stock price movements, providing a clear schedule of when key companies are reporting earnings, which is critical for making informed trading decisions. Pepperstone also provides insight into earnings.

Identifying overvalued and undervalued assets

Identifying overvalued or undervalued currencies and stocks involves comparing their current market prices with intrinsic or fair value.

Currencies

To assess whether a currency is overvalued or undervalued, traders can use two key concepts: Purchasing Power Parity (PPP) and the Real Effective Exchange Rate (REER):

• PPP measures how much a currency should be worth based on the cost of a basket of goods in different countries. If a currency's exchange rate is much higher than its PPP value, it might be overvalued.
• REER takes inflation and trade relationships into account, showing how competitive a currency is globally.

If a currency's market rate is high compared to both its PPP and REER, it could indicate overvaluation, while the opposite suggests undervaluation. The World Bank has a database to screen for currencies based upon REER:

Stocks

Undervalued/overvalued stocks can be found using screening sites like Finviz and TradingView (see below) by filtering for outlying price-to-earnings (P/E) ratios, high dividend yields, or specific market caps. Both platforms offer customisable screens, with the ability to identify stocks that are trading below their intrinsic value based on fundamental metrics.

Significance of trade balance in forex trading

A country’s trade balance can provide insight into its economic strength. A trade surplus (more exports than imports) is generally positive for a currency, as it signals that foreign buyers are purchasing the country’s goods, thereby increasing demand for its currency. A trade deficit, on the other hand, can weaken a currency.

For example Australia's reliance on exports, particularly commodities like iron ore and coal means that when the trade surplus grows, as seen during periods of high demand from China, the Australian dollar (AUD) strengthens due to increased demand for the currency to purchase these exports. Conversely, when demand drops, leading to a trade deficit, the AUD can weaken as foreign demand for Australian goods - and by extension, its currency - decreases. This correlation between trade balance and currency is key for traders in forex markets.

Predicting long-term trends with fundamental analysis

One of the main advantages of fundamental analysis is its ability to predict long-term market trends. By evaluating economic conditions, traders can identify undervalued or overvalued assets and position themselves accordingly. During periods of economic expansion, traders may anticipate that a country’s currency will appreciate, and during recessions, they may expect a currency to weaken.

Limitations of fundamental analysis

While fundamental analysis provides valuable insights, it has limitations. Market sentiment and unexpected events can cause short-term price movements that contradict the underlying fundamentals. Furthermore, not all companies disclose complete financial information, which can lead to misinformed decisions.

Additionally, fundamental analysis does not always provide precise entry or exit points, which is why many traders use it in conjunction with technical analysis.

How often should you review fundamental data?

The frequency with which to review fundamental data depends on the trading style. Long-term traders may only need to review economic data once a week or when major reports are released, while short-term traders might monitor data daily to capitalise on market volatility.

Developing a fundamental analysis trading strategy

An outline for developing a fundamental analysis trading strategy:

• Economic Indicators: Monitor GDP growth, inflation, and employment data to assess currency or stock market strength. Example: Rising GDP or job growth can indicate a bullish currency or stock market.

• Company Financial Health: Review earnings reports, cash flow, and debt levels. Example: Invest in companies with strong earnings growth and low debt-to-equity ratios.

• Interest Rates: Track central bank decisions on interest rates, as higher rates attract foreign investment. Example: A country raising interest rates may see its currency appreciate.
• Economic Calendars: Use calendars to follow key economic releases (e.g., Non-farm Payrolls, CPI) that influence price movements.
• News Events & Geopolitical Factors: Incorporate major news events like trade agreements or political instability into your analysis.
• Long-term Value Approach: Focus on assets that appear undervalued based on long-term data, targeting sustainable trades.
• Combine with Technical Analysis: se technical indicators (e.g., moving averages) to time entries and exits.

Finding reliable research and analysis on economic events is crucial for making informed trading and investment decisions. Here are some top sources to consider:

Financial News Websites

• Bloomberg - Offers comprehensive coverage of market news, economic data, and in-depth analysis.
• Reuters - Provides real-time updates and analysis on global markets and economic conditions.
• PiQ - Access to news feeds with timely data releases. Free aggregation platforms like PiQ offer over 100 sources of information from the likes of Reuters and Bloomberg

Expert Commentary

Expert commentary can help interpret central bank actions and predict potential market impacts. Pepperstone provides comprehensive previews to help prepare for all major market moving events. Follow Pepperstone’s senior analysts Chris Weston (@ChrisWeston_PS) and Michael Brown (@MrMBrown) on X (Twitter) for insight into the various caveats to look out for in the releases.

• Economic Research Institutions
• Federal Reserve Economic Data (FRED) - Provides a vast database of economic indicators and historical data.
• Bureau of Economic Analysis - Offers official data on GDP, personal income, and other economic indicators.
• National Bureau of Economic Research (NBER) - Provides research and reports on economic cycles and recessions.
• Office of National Statistics - The ONS is the UK's official statistical authority, providing data on the economy, population, and society.
• Eurostat - The European Union's statistical office, providing statistical information to support EU policies and decision-making.
• Financial Research Platforms
  • Morningstar - Offers detailed analysis and ratings on stocks, mutual funds, and other investments.
  • S&P Global - Provides research reports, ratings, and data on global markets and sectors.
  • FactSet - Offers financial data and analytics, including economic forecasts and market analysis.

Economic Calendars

Sites like Pepperstone provide schedules of upcoming economic events and forecasts.