What is Fundamental Analysis?

Fundamental analysis is an approach to evaluating markets that uses various sources of information to determine the true value of an asset. Unlike technical analysis, which focuses solely on price movements, fundamental analysis creates a comprehensive picture of the strengths and weaknesses of a particular security.

Fundamental analysis is often mentioned as a way to find stocks to buy. However, traders use it across various asset classes.

For example, in forex trading, a fundamental trader would analyze data that could have a significant impact on the price of a currency pair, such as economic data, political factors, or even the effects of natural disasters.

But fundamental traders do not take this data into account randomly. They try to determine the intrinsic value of the market to find out if the asset is underpriced or overpriced relative to its current price.

Fundamental analysis and intrinsic value

Fundamental analysis is based on the belief that every asset has its true value. Although markets may temporarily overestimate or underestimate an asset, ultimately, the price should return to this true value.

Imagine that you are analyzing a company and decide that its value is higher than what its current stock price indicates. In this case, you might buy its shares and later sell them when the price reaches the level you assigned to it.

There are many different factors you can consider when determining the true value of a currency. You can look at economic reports, central bank activities, retail consumption, and other factors that may influence its value.

Disadvantages of fundamental analysis

Fundamental analysis is a great tool for gaining insights into selected asset classes and sectors, and it can help you identify profitable opportunities. However, there are two main issues you should be aware of.

The first problem is that there is no guarantee that the market will follow the intrinsic value you have determined, even after thorough analysis. External factors, such as natural disasters or scandals, can lead to unexpected changes in the price of an asset and cause the estimated value to not materialize.

Another possibility is that the market may remain irrational and mispriced longer than you can keep your position open.

The second problem is the vast amount of data that must be considered when analyzing global markets. With so many different factors, it can be difficult to decide what is important and what is not.

One solution to this problem is a top-down approach. Start by focusing on the overall economy, and then identify markets that may be overvalued or undervalued. Afterward, look at specific factors that influence individual assets so you can determine where to take a position.

Key factors in fundamental analysis

As we’ve already mentioned, fundamental traders have access to a wide and diverse range of information. However, there are several factors that are more significant than others:

Central Bank Announcements

Central banks are often responsible for significant volatility in most markets. Their main activity is raising or lowering interest rates, which can greatly impact currencies, stocks, indexes, and other assets.
Fundamental analysts also watch for new monetary policies (such as hints that a central bank might change its stance), asset purchases, currency revaluations, personnel changes, and other factors that could influence the markets.

Economic Data

Almost every asset is influenced by the broader economic situation, so traders using fundamental analysis look for signals that suggest economic growth or decline.

GDP (Gross Domestic Product) is one of the key indicators of economic growth as it expresses the value of all goods and services produced within a country. Besides GDP, data on employment and manufacturing activities are also important.

Inflation

Inflation is another key economic factor that affects the markets. Inflation occurs when the purchasing power of a currency decreases. Central banks usually try to keep inflation under control to prevent deflation.

Inflation doesn’t only affect forex, but it also impacts bonds, commodities, stocks, and indexes, which may experience volatility.

Politics

Political changes within a country can influence financial markets. For example, a new president might change legislation or may support larger investments in infrastructure, which could affect the economic situation.

Geopolitical factors can have a similar effect. For instance, increased conflict in the Middle East can create pressure on global oil supplies and raise its price. This could negatively affect businesses that rely on oil for their production processes.

Natural disasters and seasonality

These two factors can act as invisible triggers of market volatility.

Natural disasters can affect businesses and economies, disrupt supply chains, and cause fluctuations in commodity prices. Seasonal weather issues can have a similar effect, as adverse conditions may impact the production and availability of certain commodities.