Fundamental analysis of the financial markets

The fundamental analysis is derived from economic data to prognosticate prices, whereas the technical analysis is based on the analysis of price trends. Fundamental data is, for example, the production, consumption, disposable income, interest rate development, consumer price index, and also the profit and loss account of a company, to name but a few. Many successful traders use fundamental analysis to determine the basic market direction. To time entry and exit of the market they sometimes use the technical analysis.

Each trader has a different character and a different psyche. Since the fundamental analysis rather determines long-term trends, traders who prefer a long-term duration of a position mainly use this method of analysis. The traders, who act on a daily basis will use this analytical method to determine the basic direction or to better be able to assess false signals.

How does fundamental analysis work?

Fundamental analysis attempts to derive causal relationships between individual market-influencing factors. In the following, some factors will be named and explained. It must be noted that the consideration of the individual factors and markets is by no means complete.

The fundamental analysis can have various advantages for a trader.

  • It provides additional information to increase the likelihood of a profitable trade.
  • Fundamental developments can indicate price movements very early, long before technical signals occur. This allows an aggressive trader to enter the market much earlier, and to enter a position.
  • The knowledge of the fundamental importance of a result can help a trader remain calm during a trade, even if it does not accrue immediately.
  • The way in which the market responds to specific news can even be used as a trading instrument by a technical trader.
  • The information from the fundamental analysis can help the trader not to fall into the trap of false signals.

Market influencing factors:

In order to prognosticate a price, index value, or market price in the future, the fundamental analysis uses various different factors. These differ depending on which market is considered. In an index, for example, different factors are included than in shares. Seasonal factors also play a role. For example, at the end of the year there is the so-called window dressing effect. In the following, the fundamental analysis in the individual asset classes will be illuminated on, step by step.

The fundamental analysis to value stocks

The fundamental analysis of stocks assumes that there is a fair intrinsic value of a company. If this value deviates from the value currently being traded on the stock market, there is an undervaluation or overvaluation. The analysts then derive appropriate trading signals from this. If there is undervaluation, stocks are bought, and expected that the traded price of the shares also adapts to the intrinsic value on the stock market. In the case of an overvaluation, the product is sold or sold empty.

The following factors are used for stock analysis:

  • Revenue
  • Profit
  • Liquidity
  • Financing power
  • Order situation
  • Business concept
  • Industry

Some of the factors lead to a certain margin of valuation from the fair value of the company. The business concept regularly leads to mispricing of a company. The industry is also a reason for mispricing. For example, bad news from big companies in the respective industry can affect all the companies in said industry.

These factors are then used to derive the relevant ratios, such as the price-profit ratio. The trader can thereby see how the company is currently valued on the stock market and can apply his trade logic.

Fundamental analysis of indices

The relevance of the numerous factors that affect the value of indices may change over time. In general, the growth of the company’s profits determines the general direction of the trend of a stock market. As a result, factors also influence the company profits. However, not only the company’s future profits severely influence the current value of the index, but also the interest rates.

  • Interest rates

    The monetary policy of the central banks is crucial for the development of a stock market. If the supply of money is expanded, the equity market is generally better off since investments increase. The money can end up in many places. It can be used for the purchase of investment goods, the purchase of cars, luxury goods, but also investment in the stock market. The more liquidity is available, the better the stock market does.

    Interest rates therefore have a strong influence on the stock market:

    1. They influence the financing costs of the debt capital of companies. Thereby also affecting the profits of companies.
    2. They influence the discounting of the future profit distributions (dividends), which are included in share prices. With rising interest rates, future profits are worth less, thus also the shares.
    3. They make the competitors` investment in bonds accordingly attractive and thus also affect the stock markets.
  • Psychological factors

    The prevailing market sentiment is crucial for price formation. This sentiment is then influenced by given fundamental data. These sentiments are measurable by various sentiment indicators (for example put/call ratio), which represent these factors.

  • Economic factors

    The state of the economy is another large factor. A good economic situation has a positive impact on the profits of companies. This in turn leads to rising stock prices.

The fundamental analysis to value commodities

The influencing factors for commodity prices are very diverse and vary greatly according to which commodity is being considered. The considered factors in the crude oil market are completely different from the gold market. In the gold market, for example, one does not know the actual amount of global gold reserves. As a result, one does not know how much gold can be offered at the respective market price. The composition of the supply curve is therefore completely unknown. With crude oil, on the other hand, the stock supplies are much better known.

  • Seasonal factors

    Almost every commodity exhibits seasonal price fluctuations. For this reason, seasonal factors have to be taken into account especially in this area.

  • Supply and consumption

    In order to be able to prognosticate a commodity’s price, the supply and consumption of the raw material must be analysed. Political factors also play a role here. For example, OPEC’s behaviour plays an important role in the oil price. In addition to these two details, stock supplies are also paramount for price determination.

  • Stock supplies

    An important factor can be the stock supplies. High prices ensure that producers keep their stock supplies small and therefore offer larger quantities on the market. At low prices, they will be more likely to keep their good in stocks than to offer the commodities on the market.

  • Quality differences

    In the case of commodities, there are always differences in the quality of the goods being offered. For this reason, when regarding oil for example, it has to be ascertained which oil is being traded. There are hundreds of crude oils. Accordingly, the properties (sulphur content and weight) of the oils have to be evaluated.

Fundamental analysis of currency exchange rates

Foreign currency exchange rates are important for a country’s international competitiveness. If a currency increases in value, the country’s goods become more expensive for the buyers. Due to the price increase, less good are bought from that country. For this reason, a currency is also an important tool when taking into account the different production costs of countries.

A common theory when determining the exchange rates of two currencies is the purchasing power parity. This describes the relative purchasing power of one currency relative to the other currency. If, for example, you buy a shopping basket for €100 and then receive it for $100, the exchange ratio would be 1:1 = 1. If, however, the value of the basket in Euros would rise by 2% and the Dollar by 5%, then the Dollar should fall by 3% against the Euro in order to absorb the purchasing power loss. Accordingly, the exchange rate would be:

1.02/1.05 = 0.971

  • Interest rates

    Interest rates are an important factor in the price formation of currencies. Rising interest rates cause a higher demand for a currency. As a result, the price of this currency increases in relation to the other currencies.

  • Economic factors

    A growing economy, low unemployment rates, a good budgetary balance and a low level of national debt usually lead to an appreciation of a currency.

  • Politcal factors

    The economic, monetary, and trade politics of an economy are crucial in determining the value of a currency. These are the most difficult factors to calculate in the price formation of currencies. Countries with distinct and stable governments, sound tax policies, judicious fiscal policies, and which have a strong, independent central bank tend to receive the trust of foreign investors, rather than countries where there is unrest. As a result, the currencies of the countries that investors trust appreciate in value.

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