→ Intro 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
1 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
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.
→ Manufacturer’s Shipments,Inventories, and Orders
The Manufacturers’ Shipments, Inventories, and Orders, or M3, survey is one of the most respected economic indicators. Published monthly by the U.S. Department of Commerce’s Census Bureau, the report measures current activity and future commitments in the U.S. manufacturing sector. Using data supplied by approximately 4,700 reporting units of businesses in eighty-nine industry categories, it provides statistics on the value of factories’ shipments, new orders, unfilled orders, and inventories.
The M3 survey is published in two parts. The Advance Report on Durable Goods is released about four weeks after the reference month, on approximately the eighteenth business day of the month. The revised and more comprehensive Manufacturers’ Shipments, Inventories, and Orders appears about a week later and supplies greater detail about production, by industry group, as well as including information about nondurable and durable goods.
Manufacturing orders are considered to be a leading economic indicator because they reflect decisions about optimal inventory levels given the demand businesses anticipate based on their economic forecasts. The Census Bureau obtains its data on domestic manufacturing through surveys of manufacturing companies with annual shipments totaling $500 million or more. Participation is voluntary and responses are sent via the Internet, telephone or fax. The reports contain both seasonally adjusted and non adjusted figures for the record month and for the previous three months, together with percentage changes from month to month. All the values are nominal, given in constant-dollar terms.
The M3 report is considered a gold mine of economic information. The durable new orders data is touted as a particularly rich lode due to the insight provided into a large component of personal consumption and capital expenditures.
→ Personal Income and Outlays
The monthly Personal Income and Outlays report is produced by the Bureau of Economic Analysis and contains great detail on income related measures as well as spending data for almost every imaginable good and service. The Personal Income and Outlays report is released about four weeks after the record month, on the first business day following the release of the Gross Domestic Product report at 8:30am ET. It is available on the BEA’s website.
The BEA uses the spending data in the report in compiling the consumption expenditures portion of the GDP report. Consumer spending accounts for approximately 70 percent of all economic activity in the U.S. Strong spending is touted as a sign of an expansionary climate; slower spending signals softer economic conditions and income data is thought to provide insight into future spending and thus future economic activity.
The BEA calculates personal income by adding together income from seven major sources and then subtracting personal contributions for unemployment, disability, hospital, and old age survivors insurance. Then, by subtracting personal tax and no tax payments such as donations, fees, and fines they arrive at disposable personal income. This is thought to be more useful than personal income because it represents the money that households have available to spend or to save.
Personal consumption expenditures is defined as the goods and services individuals buy, the operating expenses of non profit institutions serving individuals, and the value of food, fuel, clothing, rentals and financial services that individuals receive in kind.