In trading and investing, there are two schools of thought on making buy and sell decisions: fundamental analysis and technical analysis. Out of these two philosophies, technical analysis is the most popular, and used by the majority of traders and investors.
In this article, we will look at fundamental analysis. We will look at technical analysis in part II.
At their core, both schools believe that prices for goods in a freely traded market eventually reflect supply and demand. For example, the share price of IBM will increase when the demand for IBM shares increases relative to the supply of IBM stock. For a commodity like corn, the price will rise when demand for corn increases relative to the available supply.
The difference between the two methods, then, is in how they determine changes in supply and demand.
In fundamental analysis, traders and investors study economic data to forecast supply and demand. For example, with stocks, an analyst might look at earnings reports, inflation rates, unemployment numbers, etc. For corn, the analyst might look at weather, crop forecasts, sales projections for breakfast cereals, etc.
The advantage of fundamental analysis is that, if you do a great job of analysis, you can avoid getting tangled in sideways markets, and can catch important, long term trends for huge profits. Since most traders focus on technical analysis, a good fundamental forecast can get you into the market at a better price.
The disadvantages of fundamental analysis are:
1. It is very hard to create a fundamental model a generate a forecast. Not only do you have to study data, but you have to determine how the majority of traders and investors will interpret the information. You also have to determine how much weight they will put on each piece of information, and how the information differs from what was expected.
For example, if an unemployment report comes out, and it is what the market expected, then the market may not move much. On the other hand, if unemployment is less than expected, it signals a strong market. At the start of an economic recovery, this can be good news, and send stocks soaring. In the later stages of a bull market, however, this could cause stocks to go down because traders are worried about inflation.
2. Fundamental analysts are typically limited to only trading a few industries or commodities. It is very hard to become an expert in many areas.
3. Fundamental analysis typically gives an early buy signal. A fundamental trade can eventually make great money because the trader / investor got in before technical traders but, until the supply/demand shift occurs, they may have to ride their losses and, hence, need to be well-capitalized.