Introduction to Fundamental Analysis
Understanding Fundamental Analysis: Fundamental analysis is the study of the core underlying elements that influence the economy of a particular currency. This method of study attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors. Imagine financial markets as a large clock, the gears inside this clock that move the hands, or drive the clock would be these “fundamentals”. Although you can look at the clock and know what time it is, only by looking at the fundamentals can you truly understand how it became the time it is now. By knowing this, you might better understand the movement of time and be better able to predict what time it will be in the future. As a Forex investor you can better understand why the market is where it is today and where it might be tomorrow (or at a future point) based on studying these fundamentals.
Keep in mind that Fundamental analysis is a very effective resource to forecast economic conditions, but not exact currency prices. For example, you might get a clear understanding of the health of the US economy by studying an economist’s forecast of an upcoming Employment Cost Index (ECI), but how does that translate into entry and exit points? You need to develop a method that you use to decipher this raw data into usable entry and exit points based on your personal unique trading strategy. These methods are known as forecasting models. Forecasting models are like fingerprints - unique to every trader. Every trader may look at the exact same data, yet conclude completely different scenarios on how the market will react. It is important to analyze the fundamentals and apply your findings to your model.
Fundamentals for each currency might include, but not limited to; interest rates, central bank policy, political figures/events, unemployment/employment reports, and Gross Domestic Product (GDP). These economic indicators are snippets of financial and economic data published by various agencies of the government or private sectors for each country. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, almost everyone in the financial markets religiously follows them. With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyze and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize and make trading decisions based on the data.
The Business Cycle Economic indicators are classified according to how they related to the business cycle. An economic indicator will do one of the following:
- reflect the current state of the economy as coincident
- predict future condition are leading
- confirm a turning occurred are lagging
The organization responsible for an indicator generally distributes its reports about an hour before the official release time to the financial news outlets (Reuters, CNBC, Dow Jones Newswires, and Bloomberg).
The reporters, who are literally locked in a room and not permitted to have contact with anyone outside, ask questions of the agency officials and prepare headlines and analyses of the report contents. These stories are embargoed until the official release, at which time they are transmitted over the newswires to be dissected by the Wall Street community. Most Wall Street firms employ economists to provide live broadcasts of the numbers as they run across the newswires, together with interpretation and commentary regarding likely market reaction. This is known as the hoot and “holler” or tape reading. The more an indicator deviates from Street expectations, the greater its effect on the financial markets
Major Fundamental Indicators
No single economic indicator will tell you all you need to know.
12 Indicators 1. GDP
2. Indices of Leading, Lagging, and Coincident Indicators
3. The Employment Situation
4. Industrial Production and Capacity Utilization
5. Institute for Supply Management Indices
6. Manufacturers’ Shipments, Inventories, and Orders
7. Manufacturing and Trade Inventories and Sales
8. New Residential Construction
9. Conference Board Consumers Confidence and University of Michigan Consumer Sentiment Indices
10. Advance Monthly Sales for Retail Trade and Food Services
11. Personal Income and Outlays
12. Consumer and Producer Price Indices
Gross Domestic Product (GDP)
Combination of Economics & Accounting It is the broadest, most comprehensive barometer of a country’s overall economic condition. Sum of all the market values of all final goods and services produced in a country (domestically) during a specific period using that country’s resources, regardless of the ownership of the resources.
GDP is calculated and reported on a quarterly basis as part of the National Income and Product Accounts (NIPAs). NIPAs were developed and are maintained today by the Commerce Department’s Bureau of Economic Analysis (BEA). NIPAs are the most comprehensive set of data available regarding US national output, production, and the distribution of income. Each GDP report contains data on the following:
- personal income & consumption expenditures
- corporate profits
- national income
To calculate GDP, the BEA uses the aggregate expenditure equation:
C is personal consumption expenditures
I is gross private domestic investment
G is government consumption expenditures & gross investment
X-M is the net export value of goods and services (exports - imports)
C (Personal Consumption Expenditures) The total market value of household purchases during the accounting term, including items such as beer, telephone service, golf clubs, CDs, gasoline, musical instruments and taxicab rides.
These fall into 3 categories; durable goods, nondurable goods, and services.
- Durable goods have shelf lives of three or more years
- Non durable goods are food, clothing, energy products, and items like tobacco, cosmetics, prescription drugs, and magazines.
I (Gross Private Domestic Investment) spending by businesses, expenditures on residential housing and apartments, and inventories. Inventories are valued by the BEA at the prevailing market price.
G (Government Consumption Expenditures & Gross Investment) All money laid out by federal, state and local governments for goods and services.
X-M (Net Exports of Goods & Services) The difference between the dollar value of the goods and services sent abroad and those it takes in across its borders.
The GDP report is a mother lode of information about a nations economy. The GDP is released on a quarterly basis. One commonly used strategy is calculating the output gap of the GDP. The output gap is the difference between the economy’s actual and potential levels of production. This difference yields insight into important economic conditions, such as employment and inflation.
The economy’s potential output is the amount of goods and services it would produce if it utilized all its resources. Economists estimate the rate at which the economy can expand without sparking a rise in inflation. It is not an easy calculation, and it yields as many different answers as the economists who calculate it. Luckily, a widely accepted estimate of potential output is reported relatively frequently by the Congressional Budget Office (www.cbo.gov). This website has information about methodology, underlying assumptions in computing the trend level as well as a detailed historical data.
Indices of Leading, Lagging & Coincident Indicators
Index of Leading Economic Indicators Compiled by the Conference Board and published in its monthly Business Cycle Indicators report. Released to public at 10:00 am ET four to five weeks after the end of the record month. www.conference-board.org has historical data and explanations of the methodology behind the indices.
Because the indices’ components are all released earlier than the indices themselves, the markets generally don’t react strongly to the indicator report.
Coincident Index 4 Components
(1) Nonfarm Payrolls: obtained from a survey of about 160,000 businesses, conducted by the Bureau of Labor Statistics.
(2) Personal Income Less Transfer Payments: Derived from the Personal Income and Outlays report, produced by the Bureau of Economic Analysis (BEA). The largest source is wages and salaries, transfer payments – government disbursements and food stamps.
(3) Total Industrial Production Index: published by the Federal Reserve and constructed of 295 components that are weighted according to the value they add during the production process.
(4) Manufacturing & Retail Trade Sales: Collected as part of the National Income and Product Accounts calculations. Found in the Manufacturing and Trade Inventories and Sales (MTIS) report published by the Department of Commerce.
Leading Economic Index 10 Components
(1) Average weekly hours worked in manufacturing
(2) Average weekly initial claims for unemployment insurance
(3) Manufacturers’ new orders for consumer goods and materials
(4) Slower deliveries diffusion index of vendor performance
(5) Manufacturers’ new orders for nondefense capital goods
(6) Monthly building permits for new private housing
(7) Stock prices, 500 common stocks
(8) The M2 money supply (in 1996 dollars)
(9) The interest rate spread between the 10-year Treasury bond and the federal funds rate
(10) The Index of Consumer Expectations
The individual indicators composing the Leading Economic Index differ considerably in their abilities to predict economic turning points. Some are very far seeing, others relatively near sighted. The composite index combines in such a way that the whole is designed to outperform any of its parts.
Lagging Economic Index 7 components
(1) Average duration of unemployment
(2) Ratio of manufacturing and trade inventories to sales
(3) Manufacturing labor cost per unit of output
(4) Average prime rate
(5) Commercial and industrial loans outstanding
(6) Ratio of consumer installment credit to personal income
(7) Change in the consumer price index for services
The Lagging Economic Index follows downturns in the business cycles by about three months and expansions by about fifteen. This index was designed to confirm turning points in economic activity that were identified by the leading and coincident indices have actually occurred, thus preventing the transmission of false signals.
The Employment Situation
The most important economic indicator by far is the monthly Employment Situation published by the Bureau of Labor Statistics (BLS). No other report has the potential to move the forex market like employment and no other indicator is more revealing of general economic conditions than the labor market data. Employment data is important because it reveals how firms, corporations, and others responsible for hiring decisions view the current and upcoming economic environment.
The monthly employment report is based on two separate surveys: the Current Population Survey (CPS), aka the household survey, and the Current Employment Statistics survey (CES), aka the establishment, or payrolls, survey. Supplemental to each release, the commissioner of the Bureau of Labor Statistics provides a statement to the Joint Economic Committee of the U.S. Congress. The statement, generally three pages long, highlights significant strengths and weaknesses in the monthly employment statistics.
Top billing on the employment report is generally shared by two figures; the unemployment rate and the monthly change in nonfarm payrolls. Average hourly earnings, hours worked, overtime hours worked and the monthly change in manufacturing jobs also command a great deal of traders attention.
In the employment surveys, the BLS includes only persons older than sixteen. Excluded from surveys are people in mental or penal institutions and members of the armed forces. People qualify as employed in two ways. First are those who, during a given period, have worked as paid employees in someone else’s company or in their own businesses or on their own farms or have done fifteen hours or more of unpaid labor in a family-operated enterprise. Second are those with jobs or in businesses from which they have take temporary leave, paid or unpaid, because of illness, bad weather, vacation, child-care problems, labor disputes, maternity or paternity leave or other family or personal obligations.
Unemployed people are those not working during the period in question, whether because they voluntarily terminated their employment, in which case they are classified as job leavers, or because they were involuntarily laid off, making them job losers.
Strong relationships exist between the employment data and virtually every other indicator. The growth rate of non farm payrolls is generally strongly correlated with the growth rate of GDP, industrial production and capacity utilization, consumer confidence, spending, and income.