Many forex traders are technical traders, but there is a school of thought that says fundamental analysis is the best route. Fundamental analysis is the process of analyzing the market using both qualitative and quantitative factors that take into account economic and political factors.
Fundamental traders are concerned more with how the economy and political landscape shapes the world and affects trading activity. In forex, fundamental traders look at the macro and micro economic factors that affect a nation’s currency to determine the value of that currency relative to another currency. Since fundamental indicators don’t always result in instant market reactions, fundamental traders tend to have a more long-term view of the market.
While there is no shortage of trading software and tools for the technical analyst, fundamental analysts often find that they must put in more manual labor to realize a profit. Is it worth the effort?
The Benefits of Fundamental Analysis
There is a certain kind of romanticism surrounding fundamental analysis. The idea that politics and the economy drive financial decisions means that there’s more than just numbers that move the world along. This lends an artistic element to the process of analysis. Still, fundamental traders do look at numbers including:
- the measure of overall economic growth for a country.
- trade and current account balances.
- interest rates and investment (i.e. bond) yields.
- political stability.
The measure of economic growth for a nation is often measured by its GDP, but traders will often look at unemployment rates as well. Any decrease in the employment rate is seen as a weakening of the economy. When economies weaken, central banks have a history of lowering interest rates to spur growth. For traders, this means inflation. Inflation destroys the value of a currency causing traders to bet against that currency. If enough traders have the same view of a weak nation, that nation’s currency value could drop.
Trade balance can dramatically affect a nation’s currency. When a country has a trade deficit, it will generally result in a weak currency since that country will have continuous commercial selling of its money.
GDP, or Gross Domestic Product, can foretell a strong or weak nation. If GDP rises, there is an expectation of higher interest rates. These higher rates may be positive for a country. As interest rates rise, borrowers must pay more for their debt. Some businesses will default. Even so, the rising rates curb inflation by reducing the incentive to borrow. By curbing inflation, a currency grows stronger because it is not being devalued as much. Taken to the extreme, a deflationary environment would make a currency grow (sometimes rapidly) in value as fewer currency units become available in the marketplace.
An economy can still grow under high interest rate environments. This growth would be good for the economy, thus signaling a buying opportunity for forex investors.
The Disadvantages of Fundamental Analysis
Some critics of fundamental analysis point out that:
- fundamental analysis requires a background knowledge of economics and is difficult to understand.
- fundamental analysis is time consuming.
- the information unearthed by fundamental analysis is already priced into the market.
- it fails to give traders objective trading signals.
Economics is not an easy subject to master. There are two basic competing theories of economics: the Keynesian school of economics and the Austrian school. Keynesians believe that economic growth can be achieved through government stimulus. When an economy is sluggish, the central bank can “grease the grooves” by providing an infusion of capital to the market. The market then invests this money thus contributing to a recovery.
The Austrian school holds the opposite view. Instead of government stimulus helping the economy, it plants the seeds of its own destruction. The boom created by an influx of capital is really just a sign of malinvestment waiting to crash. This, according to the Austrians, is why central bank-induced boom periods are always followed by busts.
Many economists study just one theory for their entire life and still never master it enough to predict market trends. For traders, they must be able to pick the correct economic theory and know how it will impact the markets – a tough job at best.
Because of the nature of fundamental analysis, it’s time consuming. While some calculations can be done to assess the health of an economy, much of the analysis is qualitative. In other words, the trader has to know how to interpret the news and political speeches. This could take years of practice not to mention the fact that economic and political news may or may not have an immediate effect on the currency markets.
Many technical traders argue that markets are perfect and that this means that all of the fundamental indicators are already priced into the marketplace. This line of thinking is closely related to the efficient market hypothesis which states that financial markets are not over or undervalued. All relevant information is instantaneously priced into the markets. If that’s true, then fundamental analysis is a waste of time.
Technical traders also believe that fundamental analysis does not give investors the ability to make objective trading goals. Since much of the work is qualitative in nature, fundamental analysts are often perpetual “buy and hold” investors that seek gains over a long period of time. Because there’s no software that tracks historical trends, there’s no data mining. It’s this lack of historical data that accounts for this criticism of fundamental analysis.
Making a Choice
One option that you have open to you is to blend both technical and fundamental analysis into a new trading strategy. You don’t have to choose just one. In fact, an increasing number of traders use technical analysis to spot trends, then use fundamental analysis to confirm the validity of the trend before investing. A combination of the two methods might yield good results and provide flexibility in your trading strategy.
Guest post contributed by Stacy Pruitt, a freelance forex strategy and finance writer. Stacy writes about advanced trading. Learn more about forex trading.