The basics of the fundamentals

The Basics of the Fundamentals

Fundamental analysis is a method of evaluating an asset; it attempts to measure its intrinsic value by examining the underlying forces that could affect the asset.

Fundamental Analysis includes;

  • Company or industry-specific factors – such as mergers or acquisitions
  • Geo-Political factors – such as interest rates and other government policies
  • Macroeconomic factors – such as the level of unemployment

Why is it useful?

So why is Fundamental Analysis used so widely, and what does it help us achieve and understand?

  • Fundamental Analysis helps us to measure an asset's intrinsic value. The idea behind the fundamental analysis is that each asset has a “correct” price which means we can determine if the current market price is overvalued or undervalued. Keeping in mind that the price will always revert back to what is “correct”, knowing whether the asset is under or overvalued gives us an indication as to whether to buy or sell.
  • Through fundamental analysis, we are able to determine the overall health of an economy to give us a mid to long-term outlook as to the direction of the markets

Major Industrialized Nations Central Banks

Below is a list of a few major industrialized nations and their central banks:

  • USA - The Federal Reserve (FOMC - Federal Open market Committee)
  • UK - Bank of England (BoE (MPC - Monetary Policy Committee))
  • Europe - European Central Bank (ECB)
  • Japan - Bank of Japan (BoJ)

Central banks make decisions that affect the economy, and decisions that affect the economy are decisions that will affect your trading so whenever a statement is released from these banks you should pay attention.

Interest rates

Every time the chairman of the FOMC, gives a speech everybody is playing the guessing game trying to figure out what’s going to happen with the interest rates.

Interest rate can be defined as;

'The cost of borrowing money expressed as a % of loan value'

Understanding Interest rates are important when talking about factors such as the money supply or inflation because central banks use the manipulation of interest rates to control the money supply and combat inflation.

You might be wondering why this is important to you, well; changes in interest rate cause changes in the economy and changes in the economy affect your trading.

Example: Increasing the interest rates

This effectively makes borrowing money less easy and as a result, the amount that people spend goes down. The decrease in expenditure means that the demand for many goods goes down, and as a result, their price will also decrease.

The central bank will often increase interest rates when they fear the economy is “inflamed” – they make borrowing less easy to reduce expenditure and cool the economy down in order to avoid inflation.

Example: Decreasing the interest rates

This effectively allows us to borrow money more easily and as a result, the amount that people spend goes up. The increased expenditure means that there is also an increase in the demand for many goods, and as the demand for these goods increases so too will their prices.

The central bank will lower interest rates when they feel as though the economy is facing a potential recession, interest rates will be reduced to encourage spending and promote the growth of the economy.

Money supply

The main role of any central bank is to control a country’s money supply.

The money supply is a measure of the entire amount of bills, notes, coins, loans, credit and other liquid instruments in circulation within a country’s economy.

By decreasing borrowing costs, central banks are effectively increasing the money supply.

Money supply is measured by M0, M1, M2 and M3, with M0 being the narrowest measure of money (cash and liquid assets), and M3 being the broadest.

The money supply is an important factor to keep an eye on, especially if you want to trade Forex.

Increased money supply demonstrates early signs of inflation – if the supply of money exceeds the supply of goods prices are likely to rise – and you get inflation.

What is inflation?

Put simply inflation is 'Rising prices'. It can also be described as the sustained increase in the prices of goods and services.

What does inflation do?

Inflation causes what we call an erosion of the purchasing power of your money.

It means that your money is worthless, you can buy less with your dollars (or pound or euro) and it's all because of inflation.

What causes inflation?

There are two main causes of Inflation:

1.Demand-Pull Inflation; this form of inflation occurs when aggregate demand outweighs aggregate supply. When there is more demand than there is supply, prices increase = inflation.

2.Cost-Push Inflation; this form of inflation occurs as a result of an increase in say the prices of wages and or of raw materials. These increased costs cause supply to decrease and consequently, the amount of demand will outweigh supply. Again, where there is more demand than there is supply, prices increase = inflation.

What are the different types of inflation?

  • Hyper-Inflation - Extremely rapid or out of control rising inflation
  • Deflation - Falling prices - The opposite of Inflation
  • Stagflation - Sluggish economic growth accompanied by rising inflation
  • Disinflation - Slowing of the Inflation rate

Economic release

Every given period of time, each country around the world will have what is called an economic release.

A data release is the periodic publication of economic data and or news of a qualitative and quantitative nature.

These data or news releases help paint a picture of the overall health of a company or country’s economy.

A stronger outlook for a company or country’s economy should be reflected by a higher company stock price or stronger domestic currency.

This data/news can have both a short and long-term impact on prices and traders will look to benefit from any movement created by these economic data releases.

This means that investors will make investment decisions based on their interpretation of the economic data which has been released.

Key Points of Economic Data

  • The strength of importance of the data will also be a factor in determining the strength of price moves.
  • The key to trading data is to look at the outcome of the data/news release in relation to the expected forecast.
  • The larger the difference between the actual figure and the forecast figure, the greater the likely hood of a larger change in prices.