LEVEL: BEGINNER
The capital markets ebb and flow throughout the course of time, driven by supply and demand for specific financial instruments. There are numerous factors that drive specific instruments, and a portfolio manager’s job is to determine the future direction of certain financial instruments by analyzing a variety of factors. When it comes to analyzing the company itself and its position in the larger market, one of the most effective tools is fundamental analysis.
Fundamental Analysis: What is it?
Fundamental analysis is the process of using economic data, monetary policy, earnings releases, and political changes to determine if new information is already baked into the current price of a financial instrument or if it’s selling too cheaply or too dear. Fundamental analysts will pour over reports and releases to try to gain some insight into the future direction of the markets and an individual company.
Economic Analysis
For example, analysts will make predictions on the direction of financial instrument based on economic releases such as the US employment report. Generally, traders and analysts are looking to see if the economic release is different from expectations. Financial markets usually price in expectations of an event into a financial instrument and new information will generally alter price action to incorporate new information immediately.
A trader who uses fundamental analysis using a top-down approach will look at economic data and determine if the new information will change global flows. Better than expected news can drive stocks higher even if the current fundamentals of the company are relatively negative. Using the payroll report as an example, if expectations are for an increase in jobs of 100,000 and the release shows an increase of 300,000, there is the likelihood that equity markets globally will rally significantly. The concept that a rising tide lifts all boats is prevalent for top-down traders.
Monetary Policy Analysis
Monetary policy is the policy governing interest rates and the actions or inaction of central banks. Interest rate policy generally focuses on maximizing price stability and growth. In the US, the central banks have a dual mandate which is to maximize price stability and employment. Other central banks, such as the European Central bank, have only one mandate, which is price stability.
Central banks often spur growth and employment by reducing interest rates, making it easing for banks to lend money at reduced rates. Lower interest rates also increase liquidity, and make purchasing riskier assets a more attractive alternative than hold low interest baring government notes.
When inflation begins to erode the value of fixed income products, central banks will generally increase interest rates in an effort to cool an economy, and increase price stability.
Decreasing interest rates increase the discounted cash flows of stocks, which in turn increase the value of a stock at the present time. Increasing interest rates has the reverse affect, making the value of a riskier asset such as a stock less valuable.
The currency markets over the long term are driven by movements in interest rates and interest rate differentials. As perceptions about monetary policy change, interest rates within individual countries will change, driving a greater difference between countries’ economies.
For example, if the US central bank reduces interest rates by either lowering the benchmark interest rate or increasing its currency bond purchase program while Canada increase interest rates, money will flow into Canadian fixed rate products and out of US fixed rate products. As interest rates move in favor of Canadian products, the Canadian dollar will gain strength over the long term against the US dollar. Central Banks will not always want to strengthen the currency of their own economy, so their monetary policies will change over time and from era to era. In some cases Central Banks will promise to maintain one policy for a long time—but they can (and often do) change their minds as economic conditions change.
Earnings Releases
Individual stocks are driven by the fundamentals of individual companies. These fundamentals include earnings, revenue, expenses, cash flows, margins, etc… Individual stocks often march to the beat of their own drum, ignoring macro flows. Analysts that look at company fundamentals and somewhat ignore macro flows are called bottom-up investors.
Equity analysts will look at how a company performed over a specific quarter or what a CEO has recently stated to gain some insight into the future direction of a stock. It is important to be aware of what is happening in the world, since financial instruments like currencies, over the long term, reflect the state of the country the currency is used in. Every day there are economic releases around the world that reflect new information that determines the path that a fundamental analyst will need to examine.
Political Changes
Sovereign risks as seen with Europe during the past 3 years can create substantial volatility within the capital markets. Top down traders who focus on global macro flows with use this type of information to speculate on the direction of a market. For example, a presidential race outcome that is unexpected could change the course of an equity market.
Fundamental Trading
Fundamental trading uses market impetus’s to initial and manage risk. Most of this trading style is considered discretionary, meaning that the rules the fundamental trading analyst employs are subjective and can change based on the trader’s discretion. When a fundamental analyst examines recent news, he or she must also be able to determine if the news or events are currently priced into the market for a financial instrument. This is the unique skill set that an analyst brings to the table.
Generally, when a market is surprised by some new fundamental news, the market reaction is immediate. After participants absorb the new news, the markets will continue to move in the direction of the initial reaction over a period of time.
As the fundamental trading analyst practices investing in the financial markets, he or she will begin to understand the different fundamental news releases that are important, and those that expose the markets to noise. A fundamental analyst should keep track of how the markets move on certain economic releases. This is an import guide to performance within fundamental trading. It is very difficult to be a fundamental analyst that specializes in all markets. Each market has numerous nuances that create subtle and large changes in the direction of a financial market. Equity analysts generally stick to the fundamentals surrounding individual stocks, while global macro fundamental analysts watch monetary policy and economic data releases.