Having a base knowledge of the inner workings of fundamental analysis will give you an edge on investment decisions, particularly over the long-term. Based on the theory that the market price of an asset moves towards its real or intrinsic value, the goal of fundamental analysis is to determine the true value of an investment. A trader can use this value as a benchmark against the security’s current price in order to decide what position to take. If the security is believed to be underpriced, then a buy position is taken; if it is overpriced then a sell or short position is taken.
FX traders can determine a country’s economic state by examining macroeconomic indicators that include interest rates, Gross Domestic Product (GDP), consumer price index (CPI), employment indicators, retail trade, consumer confidence, balance of trade and government fiscal and monetary policy. These self same factors affect the valuation of securities in addition to company-specific determinants comprising revenues, earnings, future growth, return on equity and profit margins.
- Interest rates: central banks in a country have the power to change interest rates and any changes impact the currency directly. Usually when a country raises its interest rates, its currency will strengthen as investors will allocate their assets to that country in order to reap greater profits.
- Gross domestic product (GDP): GDP is a strong indicator of economic activity. A high GDP reading is often followed by speculations of higher interest rates, which is usually a positive indicator for currencies.
- Consumer price index (CPI): CPI is a primary indicator of inflation. It marks changes at the level of retail prices for the average consumer. An increase in CPI can also lead to an increase in interest rates, which then raises the value of a currency.
- Employment numbers: when employment increases, consumer spending follows suit which causes domestic demand to increase. If inflation increases too much, the central bank will intervene by raising interest rates in order to ease spending.
- Retail trade: the retail sales indicator is a determinant of consumer spending and performance of retail stores. This report demonstrates consumer spending patterns and helps to assess the direction of the economy.
- Consumer confidence index (CCI): this is the degree of optimism experienced by consumers as illustrated through their saving and spending activities. Data collected for the CCI is in a 5-question survey format. When confidence is up, consumers spend more money which indicates a healthier economy. When confidence is down, then consumers are spending less and saving, which is an indicator of a weak economy. Companies use the CCI readings to determine their future business decisions. For instance, if the CCI index is low then manufacturers can expect less purchases and lower their inventories to meet the change.
- Balance of trade: indicates the balance of payments received from imports vs exports. If payments received from exports exceed those from imports then the balance is positive. A surplus is a strong indicator for currency growth.
- Government fiscal and monetary policy: A fiscal policy relates to taxes and expenditures, while monetary policy is associated with financial markets and financial assets such as credit.
Fundamental analysis is about using real data to evaluate a security’s value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for almost any type of security. Many factors can influence prices in financial markets that range from the economic and political to the social and psychological.