Fundamental vs Technical Analysis use in Trading

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Introduction

When trading and investing, two primary schools of thought guide decision-making: fundamental analysis and technical analysis. While both offer valuable perspectives, they differ significantly in their approach and application. This article examines the differences between these two methodologies, and emphasises how macro-economic fundamental analysis should be used by traders actively trading stock index futures, bond futures, foreign exchange (FX) currency instruments as well as commodities, and their CFD (contracts for difference) equivalents.

Our focus will be on the economic statistical releases and commodity supply and demand releases – such as oil inventories, which often form the backbone of fundamental analysis when trading these products. While we will touch upon the fundamental analysis of stocks’ valuation metrics, our primary emphasis will not be on the micro-economic corporate investment analysis which chartered financial analysts (CFA) tend to focus on. Instead, we aim to shed light on the importance of fundamental macro-economic releases such as Consumer Price Index (CPI) data, Gross Domestic Product (GDP), Non-farm Payrolls, ADP employment, German IFO, and central bankers’ rate decisions and their commentary. These elements are often the lifeblood of day trading, providing the timely information traders need to make informed decisions.

Join us as we navigate the intricate landscape of fundamental vs technical analysis, equipping you with the knowledge to enhance your trading strategies and outcomes.

Understanding Fundamental and Technical Analysis

As mentioned in our introduction, two primary methodologies guide decision-making: fundamental analysis and technical analysis. Each approach offers unique insights and can cater to different trading styles and timeframes. This section aims to provide a clear understanding of these two types of analysis and highlight their differences.

Fundamental Analysis involves evaluating an asset’s intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. For long-term investors, such as those involved in selecting shares for a portfolio, this could mean studying everything from a company’s earnings reports to its management quality, industry position, environmental, social and governance (ESG) approaches and even broader macroeconomic or regulatory implications. The goal is to determine an asset’s true inherent value and compare it with the current market price to identify if it’s undervalued or overvalued, providing a basis for investment decisions.

When it comes to trading instruments like stock index futures, sovereign debt futures, forex trading, and CFD trading; fundamental analysis takes on a different form. Here, the focus shifts towards economic statistical releases and commodity supply and demand announcements. These high-impact data releases, freely available on real-time economic calendars, alongside events and speeches from central bankers to OPEC, can cause significant market movements often within in a matter of seconds of the data becoming available. Traders (and their bots) closely watch these fundamental releases to make rapid trading decisions, capitalizing on the market volatility that often occurs in the wake of them.

Technical Analysis, differentiates itself by being less concerned with an asset’s intrinsic value and being more focused on statistical trends derived from market activity, such as price movements and volume. Technical analysts use chart patterns, indicators, and other tools to identify patterns that can suggest future activity.

If you are a short term technical trader in particular, never ignore the impact risk of fundamental releases too. For example, you might conclude volatility is low from a technical perspective but perhaps it’s only low because the market is awaiting a fundamental release which will skyrocket volatility shortly. When we talk about fundamental vs technical analysis it’s not a case of picking sides but more about understanding how to combine them into your risk management strategy and maximising your profit potential.

Brief Overview of Fundamental Analysis of Stocks

Fundamental analysis at a corporate level delves more into the realm of microeconomics, as opposed to the macroeconomic focus of the trading instruments other than individual stocks and shares that we’ve discussed so far. When you hear a fund referred to as a ‘macro fund’, it means that the fund’s strategy is based on a macroeconomic perspective, focusing on broader economic and political events and trends rather than individual company analysis. A macro fund will tend to be focused on ‘FICC’ products, those being fixed income (debt), currencies and commodities.

Some examples of microeconomic measures a Chartered Financial Analyst (CFA) might consider when assessing a publicly traded company’s stock for investment would be:

1. Earnings per Share (EPS): This is a measure of a company’s profitability. It is calculated by dividing net income by the number of outstanding shares. It helps in understanding the company’s ability to generate profits for its shareholders.

EPS = \frac{Net\, Income}{Number\,of\,Outstanding\,Shares}

2. Price-to-Earnings Ratio (P/E): This is a valuation ratio, calculated by dividing the market value per share by the earnings per share. A high P/E ratio could mean that a stock’s price is high relative to earnings and possibly overvalued, whereas a low P/E ratio might indicate that the current stock price is low relative to earnings.

P/E = \frac{Market\, Value\, per\, Share}{Earnings\, per\, Share}

3. Return on Equity (ROE): This is a measure of financial performance, calculated by dividing net income by shareholder’s equity. It’s a measure of how effectively management is using a company’s assets to create profits.

ROE = \frac{Net\, Income}{Shareholder's\, Equity}

4. Current Ratio: This is a liquidity ratio that measures a company’s ability to pay short-term obligations. It is calculated by dividing a company’s current assets by its current liabilities.

Current\, Ratio = \frac{Current\, Assets}{Current\, Liabilities}

5. Debt-to-Equity Ratio (D/E): This ratio is used to measure a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. A high D/E ratio generally means that a company has been aggressive in financing its growth with debt.

D/E = \frac{Total\, Liabilities}{Shareholder's\, Equity}

6. Dividend Yield: This is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price. The dividend yield is the return on investment for a stock.

Dividend\, Yield = \frac{Annual\, Dividends\, per\, Share}{Price\, per\, Share}

When analyzing individual stocks, fundamental analysis involves a deep dive into a company’s financial health, industry position, and overall economic environment. It’s a micro-level approach that scrutinizes company-specific factors such as earnings, revenue, profit margins, and other financial metrics. It also considers qualitative aspects like the quality of company management, competitive positioning, and industry health.

If you want to be a stock picker or uncover the latest books being cooked and short the stock like Hindenburg does, you focus on microeconomic fundamentals. Whereas if you want to be a sovereign debt derivatives trader (as I have been for 20 years) or a forex trader you would focus on the macroeconomics side.

Key Differences: Fundamental vs Technical Analysis

Let’s look at a summary of the the different types of analysis:

Each analysis type has a unique primary focus, utilizes different types of data, has distinctive characteristics, and aims to achieve specific goals in trading and investment decisions.

The Strategic Advantage of Fundamental Analysis in Trading

While both fundamental and technical analysis have their merits, the application of fundamental analysis in trading stock index futures, bond futures, FX trading, commodities, and their CFD equivalents offers a strategic advantage. This advantage stems from the ability to anticipate market movements based on the interpretation of high-impact economic data.

The world of trading is dynamic and fast-paced. Economic indicators and commodity supply and demand figures are released at scheduled times, but their content remains secret and protected (or should in theory) until the moment of release. This uncertainty creates a unique market environment where traders must be ready to react swiftly and decisively to new information. Such information is immensely valuable so protecting the information from leaks is a serious game. (There was one notable investment bank that worked with a macro fund to bug the waiters serving European Central Bank (ECB) policy makers before their rate announcements but that’s another story – the fund has now grown to have tens of billions under management and nobody is any the wiser.)

For instance, a surprise rate hike decision by a central bank can send shockwaves through the financial markets. Bond prices might fall as yields rise to align with the new rate, while stock index futures might also react as higher interest rates can impact corporate borrowing costs and profitability. FX markets are also sensitive to interest rate changes as higher rates can attract foreign capital, boosting the value of a country’s currency.

In these situations, traders who have a solid understanding of fundamental analysis can quickly interpret the new data, understand its potential impact on various markets, and make informed trading decisions. They can adjust their trading positions to either capitalize on the expected market movement or mitigate potential losses.

Moreover, by focusing on fundamental analysis, traders can gain a deeper understanding of the economic factors that drive market movements. This knowledge can enhance their trading strategy, allowing them to anticipate market trends rather than merely reacting to them. It’s this proactive approach that can give traders an edge, enabling them to navigate the markets with greater confidence and precision.

Key Economic Indicators in Fundamental Analysis

In the context of trading, certain economic indicators hold significantly more weight than others. These indicators can cause substantial market movements and provide traders with valuable insights into economic health and potential future market trends and opportunities to make serious money. In no particular order here are some key economic indicators that traders should be monitoring:

1. Consumer Price Index (CPI): The CPI measures changes in the price level of a weighted average basket of consumer goods and services. It’s a key indicator of inflation, which can influence central bank monetary policy and, consequently, interest rates.
2. Gross Domestic Product (GDP): GDP represents the total value of all goods and services produced over a specific time period. It’s a comprehensive measure of an economy’s overall production and health. Significant deviations from GDP forecasts can lead to market volatility.
3. Non-Farm Payrolls (NFP): This monthly report published on the first Friday of each month by the U.S. Bureau of Labor Statistics, measures the change in the number of employed people in the U.S., excluding the farming industry. It’s a critical indicator of the country’s economic health and can significantly impact the U.S. dollar, bond and equity markets and viewed alongside the unemployment rate released at the same time.
4. ADP Employment Report: This report is a measure of non-governmental private sector employment, which can serve as a precursor to the broader Non-Farm Payrolls report.
5. German IFO Business Climate Index: This index measures the monthly survey of business sentiment in Germany. As the largest economy in the Eurozone, German business sentiment can have a substantial impact on European markets and the euro.
6. Central Bank Rate Decisions: Central banks’ decisions on interest rates can cause significant market movements. Higher interest rates can attract foreign investors looking for better returns, strengthening the currency, while lower rates can lead to currency depreciation.
7. ISM Manufacturing Index: The Institute for Supply Management (ISM) Manufacturing Index measures the general direction of manufacturing within the U.S. A reading above 50 indicates expansion in the manufacturing sector, while a reading below 50 suggests contraction. This data can influence the U.S. dollar and equity markets.
8. Producer Price Index (PPI): The PPI measures the average changes in selling prices received by domestic producers for their output. It’s a significant indicator of inflation, similar to the CPI, but from the perspective of producers rather than consumers.
9. Initial Jobless Claims: This weekly report measures the number of individuals who filed for unemployment insurance for the first time. A rising trend suggests a deteriorating labor market, which can influence the U.S. dollar and equity markets.
10. Purchasing Managers’ Index (PMI): The PMI is a measure of the prevailing direction of economic trends in the manufacturing and service sectors. It’s a significant indicator of economic health and can impact currency and equity markets.
11. Retail Sales: This monthly report measures the total receipts of retail stores. Changes in Retail Sales are widely followed as an indicator of consumer spending, which drives a significant portion of economic activity.
12. Consumer Confidence Index: This index measures how optimistic or pessimistic consumers are about the economy. High consumer confidence can lead to increased spending and potentially signal economic growth, influencing equity and currency markets.
13. University of Michigan Consumer Sentiment Index: Similar to the Consumer Confidence Index, this index measures the level of consumer confidence in the economy. It’s based on a monthly survey of 500 households and can impact equity and currency markets.
14. Industrial Production: This report measures the change in the total inflation-adjusted value of output produced by manufacturers, mines, and utilities. It’s a powerful indicator of the state of the economy and can influence equity and currency markets.
15. New Home Sales: This report measures the annualized number of new single-family homes sold during the previous month. It’s a leading indicator of economic health because new home buyers are likely to buy other household items, stimulating economic activity.
16. Oil Inventories: The Weekly Petroleum Status Report provides information on U.S. commercial crude oil inventories. Changes in oil inventories can influence the price of oil, impacting energy stocks and currencies of oil-exporting nations.
17. World Agricultural Supply and Demand Estimates (WASDE) Report: This monthly report provides the U.S. Department of Agriculture’s comprehensive forecasts of supply and demand for major crops and livestock. The report can significantly impact commodity prices, affecting commodity futures markets.
18. Caixin Manufacturing PMI: The Caixin Manufacturing PMI is a composite indicator designed to provide a single-figure snapshot of the health of the Chinese manufacturing sector. Released by Caixin Media and IHS Markit, it’s based on data compiled from monthly replies to questionnaires sent to purchasing executives in over 400 manufacturing companies. A reading above 50 indicates expansion in the manufacturing sector, while a reading below 50 suggests contraction. Given China’s significant role in the global economy, this data can influence global equity and currency markets.
19. S&P/Case-Shiller Home Price Indices: These indices measure changes in residential home prices across the U.S., providing a reliable benchmark for housing market trends. Significant changes in these indices can indicate shifts in the U.S. housing market, influencing related stocks and sectors.
20. ZEW Economic Sentiment: The ZEW Economic Sentiment is a monthly economic survey. It’s an aggregation of the sentiments of approximately 350 economists and analysts, providing a forecast of Germany’s economic situation over the next six months. As Germany is the largest economy in the Eurozone, this data can have a substantial impact on European markets and the euro.

Understanding these indicators and their potential impact on the markets is crucial for traders. By keeping a close eye on these data releases, traders can make informed decisions and adjust their trading strategies accordingly.

Maturity of Data in Economic Releases

Many economic indicators are released in different stages, often categorized as ‘preliminary’ (or ‘prelim’), ‘revised’, and ‘final’. Each stage represents a different level of data maturity and can have varying impacts on the market.

1. Preliminary: This is the first release of the data, based on the initial set of responses or information available. Given that it’s the first glimpse into a particular economic condition for that period, preliminary data can cause significant market movements. However, it’s important to note that these figures are subject to revision as more data becomes available.
2. Revised: As more complete data becomes available, the preliminary figures are often revised. These revisions can provide a more accurate picture of the economic condition but may also lead to market volatility if the revised figures significantly deviate from the preliminary data.
3. Final: The final figures are typically the most accurate representation of the economic condition for the given period as they are based on the most comprehensive set of data. While they can still cause market movements, especially if they differ significantly from the preliminary and revised figures, their impact is often less pronounced because much of the information they contain has already been priced into the market.

So in terms of market impact, the preliminary figures often cause the most significant market movements because they provide the market with new information. However, if the revised or final figures significantly deviate from the preliminary data, they can also lead to substantial market volatility. Traders need to monitor all these releases and be prepared to adjust their trading strategies accordingly.

Survey of Analysts’ Expectations

Economist expectations or consensus estimates play a crucial role in the financial markets. Services like Refinitiv Eikon or Bloomberg, survey well regarded economists and analysts at major banks and respected research houses in the days approaching the release, to derive an average ‘expected’ number for various economic indicators. These consensus estimates are widely quoted in the media and serve as a benchmark against which the data, released subsequently, is measured against.

You can often tell how important a piece of data is by the number of submitted economists’ forecasts ahead of it. If there is no expectation or only a junior analyst’s single submission you can be pretty confident it’s not going to be a market moving release.

When the actual data is released, if it comes close to the consensus estimate, the market reaction may be relatively muted. This is because the expected data is already priced into the market, meaning that traders have already adjusted their positions based on the anticipated information.

However, if the actual data deviates significantly from the consensus estimate, or is outside the entire high to low range of estimates, it can cause substantial market volatility. This is known as a upside or downside ‘surprise’. For instance, if the Non-Farm Payrolls report shows significantly more jobs added than economists predicted, it could signal a stronger economy than expected, potentially leading to a rise in the U.S. dollar and U.S. equities (or weigh on bond yields and drop equities in the peak of a hiking cycle). Conversely, if the report shows fewer jobs added than expected, it could signal a weaker economy, potentially leading to reverse reactions in these markets.

These ‘surprises’ can create trading opportunities, but they also increase risk. Traders need to be aware of the consensus estimates for key economic indicators, understand how deviations from these estimates can impact the markets, and be prepared to adjust their trading strategies accordingly. If running a trading journal note the reaction down to refer back to in coming months.

Often a multitude of figures are released at the same time with differing implications, possibly along with revisions for the prior figures. You will often find the market will thrash up and down as this is all absorbed by both humans and algos in the seconds after the release before a more general movement ensues.

In the next section, we’ll discuss how central bankers’ remarks can also influence the markets.

Central Bankers’ Remarks and Their Impact on Trading

In the markets it’s not only economic indicators that matter, so do the words of central bankers. The heads of central banks, such as the Federal Reserve in the U.S., the European Central Bank in the Eurozone, and the Bank of England in the U.K., among others, hold significant sway over financial markets. Their public remarks can provide valuable insights into the current and future state of monetary policy, which can influence interest rates, inflation, and economic growth.

Central bankers often use public speeches, press conferences, and interviews to communicate with the market. They may provide their views on the economy, discuss potential policy changes, or hint at future actions. These remarks are closely watched by traders and can cause significant market movements, prepared speech contents is also often released on the wires in one go as the person making it only utters their first word.

For instance, if a monetary policy (setting interest rates) voting member at central bank hints at a potential interest rate hike in the near future, it could lead to a rise in the country’s currency and bond yields as higher interest rates can attract foreign investors looking for better returns. Conversely, if they suggest that a rate cut or other easing measures might be on the horizon, it could lead to a drop in sovereign debt yields and the currency as lower interest rates can discourage foreign investment.

However, interpreting central bankers’ remarks can be challenging, you also need to weigh their comments against whether they are a hawk or dove in their general policy stance. They often use carefully chosen language and may be deliberately vague to avoid causing unnecessary market volatility. Traders need to be able to ‘read between the lines’ and understand the implications of these remarks to make informed trading decisions.

A hawk is a policymaker who is generally more concerned about inflation and less concerned about unemployment. Hawks tend to favour higher interest rates to keep inflation in check. If a known hawkish member of a central bank makes a comment suggesting a potential rate hike, traders might see this as a neutral signal, given that it aligns with their usual stance. However, if a hawkish member hints at keeping rates steady or even cutting them, it could be seen as an even stronger signal of a potential shift in monetary policy, as it deviates from their typical stance.

At the opposite end of the scale, a dove is a policymaker who tends to prioritize economic growth and lower unemployment over controlling inflation. Doves typically favour lower interest rates to stimulate economic growth. If a dovish member suggests a potential rate cut, it might not move the markets much, as it aligns with their usual stance. However, if a dovish member hints at a potential rate hike, it could cause significant market movement, as it suggests a major shift in their outlook, ‘Even the doves want to tame inflation now!’

How to Use Fundamental Analysis in Trading

Now that we’ve explored the key aspects of fundamental analysis and its application in different trading scenarios, let’s discuss how you can use this approach in your trading decisions. Here’s a step-by-step guide:

1. Stay Informed: Keep up-to-date with the economic calendar. Know when key economic indicators are due to be released. Services like Bloomberg and Reuters provide comprehensive economic calendars that list these release dates and times.
2. Understand Expectations: Before the release of an economic report, understand what the market is expecting. As we discussed earlier, services like Eikon or Bloomberg survey economists to derive a consensus estimate. If the actual data deviates significantly from the consensus, it can cause substantial market volatility.
3. Monitor Market Reactions: Watch how the markets react to economic data releases. If a report comes in close to expectations, the market reaction may be relatively muted. However, if there’s a significant deviation from the consensus, it can lead to substantial market movements. Also consider what’s important at the time, there was a good decade plus, where CPI inflation number releases became non-events having previously moved the markets massively, a couple of years ago they started picking up relevance again and in 2023 are now the most important numbers in the markets moving them violently upon release.
4. Interpret Central Bankers’ Remarks: Pay close attention to public speeches, press conferences, and interviews by central bankers. Understand whether a central banker is typically hawkish or dovish, and interpret their remarks in this context.
5. Apply Your Knowledge: Use your understanding of economic indicators and central bankers’ remarks to inform your trading decisions. For instance, if a central bank starts hinting at a potential rate hike after a cutting cycle, you might consider going long on that country’s currency.
6. Manage Your Risk: Always remember that while fundamental analysis can provide valuable insights, it’s not a guarantee of future market movements. Ensure you have a robust risk management strategy in place to protect your capital.

Remember, the goal of fundamental analysis in trading is not to predict the future with certainty but to make informed (often lightning fast) decisions based on the best available information.

Mastering the macro game as an independent trader can significantly enhance your profitability and protect your capital. As a successful bond futures proprietary trader, I’ve had the privilege of working alongside some truly exceptional macro traders on proprietary trading floors over the past two decades in London, Singapore and Dubai. These individuals have elevated their trading strategies to extraordinary heights, achieving remarkable success in the process.

Some of these traders have even attained a sort of celebrity status within the trading community due to their impressive trades. In one notable instance, a trader’s exceptional macro trading skills caught the attention of one of the most renowned hedge fund traders in the industry, leading to an exclusive opportunity to work with them.

The takeaway here is clear: honing your skills in macro trading can open doors to significant opportunities and success in the trading world.

Key Takeaways:

• Fundamental and technical analysis are two main methodologies in financial markets.
• Fundamental analysis involves understanding the intrinsic value of a security by examining a variety of economic and financial factors. These factors can be economy-wide like inflation, interest rates, and international trade, or specific to an individual company like financial statements, earnings, etc. It can also be applied to forex markets and government debt.
• Technical analysis primarily focuses on statistical trends gathered from trading activity, such as price movement and volume, to understand market sentiments and psychology.
• Both methods have their own strengths and weaknesses. While fundamental analysis provides a deep insight into the ‘health’ of an economy or a company, it can be time-consuming. On the other hand, technical analysis can sometimes overlook broader economic factors.
• Many investors and traders use a combination of both methods to gain a comprehensive understanding of the market’s performance.

FAQs:

1. What is fundamental analysis? Fundamental analysis is a method used to estimate the intrinsic value of a security by examining a range of economic and financial factors. These factors can be related to a specific company, an industry or an entire economy and in that case be intrinsic to things like forex market behaviour.
2. What is technical analysis? Technical analysis is a method where traders and investors study statistical trends from trading activity, such as price movement and volume, to understand the market’s sentiments and psychology.
3. How do fundamental and technical analysis differ? Fundamental analysis involves an in-depth review of economic and financial indicators to estimate a security’s intrinsic value, while technical analysis focuses on statistical trends in price movement and volume to predict future market behaviour, usually involving the application of visual indicators to charts to find signals.
4. What are some strengths and weaknesses of fundamental and technical analysis? Fundamental analysis provides a deep insight into the ‘health’ of an economy or a company, but can be time-consuming. Technical analysis, while efficient, may sometimes overlook broader economic factors.
5. Can fundamental and technical analysis be used together? Yes, many traders and investors combine both methods to get a comprehensive view of the market’s performance and make informed investment decisions.

We hope you found this article on fundamental vs technical analysis useful. If you are looking for something more focussed on the technical side, we have a whole host of articles being released in our technical analysis category for you to explore too.