What is fundamental analysis and how do you use it for trading stocks? The very definition that is given is the following:
- Fundamental analysis is the foundation of solid investing. It helps you determine the underlying health of a company by examining the business’ core numbers: its income statements, its earnings releases, its balance sheet, and other indicators of economic health.
Fundamental analysis is also the examination of the underlying forces that affect the well being of the economy, industry groups, and companies and this can be used when deciding on when to enter and exit the markets for day trading as well.
Lets begin with fundamental analysis of the economy for the sake of avoiding confusion with the fundamental analysis of an individual company.
The underlying forces!
So what is it that drives the economy? There are many underlying forces that have an effect on the economy. Sometimes these forces help the economy and at other times they hurt the economy. For a better explanation of how the economic machine works you can watch the video below which explains supply and demand. This is crucial to understand, so that you can get a better picture of how supply and demand effect price movement on a stock or on products in an industry.
At the industry level, forecasts can be made from examination of supply and demand forces on products that are offered. The more supply there is of something the less demand there is for it. Take oil for example, from 2014 up to 2016, oil supply has exploded on a global scale. This means that there is less demand for oil because there is more oil in circulation globally.
When there is more of a product being produced, it is easier to get a hold of therefore the price of that product normally goes down. In the case of oil, in the beginning of 2014 the price was roughly 148 – 145.00 per barrel and when countries started producing more of it, like the United States with new fracking technology, there was more oil on the market driving the price down to 33.00 per barrel as of February 15th 2016.
This is a prime example of supply and demand of oil and how it effects the global market price for oil. So what could you do with this information if you are day trading? If you were wanting to day trade oil, you might consider the supply and demand of oil in this scenario. Demand is low therefore the price of any ETF or stock you might purchase that tracks oil or is a oil producing company, is more than likely going to be a bargain for you.
Knowing when a asset class is low in price is just half the battle but it’s a great place to start with fundamental analysis. Jim Rogers, has famously been quoted along with other billionaire investors stating “The price you pay for an asset, is one of the most important fundamentals to investing.” This is also true for day trading, so before you buy any asset or stock on the stock market, do yourself a favor and look into the supply and demand of the industry that you are investing in first.
(NOTE: Looking for value and the right time to buy an asset are BOTH considered a short term strategy. If you are not into day trading or short term investing, than there is no need to worry about stock fundamental analysis or market analysis until you sell your asset years later. It may not even apply at all, if you are investing through an index fund or mutual fund.)
Beware of Interest rates
Just recently in the last year or so (2015 -2016) there has been a lot of talk around interest rates. Will interest rates rise from almost 0% or will they stay the same? What effect will they have on the economy? These are good questions and unfortunately, not even the brightest minds on planet earth can predict exactly how the economy will react when interest rates do go up.
One thing is for certain though, if interest rates go up or down, there will still be a stock market and there will still be supply and demand for products. The main point to take away from interest rates is that they are controlled by Central Banks of countries and regulated by the World Bank or I.M.F. – International Monetary Fund. Anytime changes are made on interest rates for a country, a lot of times, markets will become very volatile. This means the markets for that country, will go up and down in big point swings or point drops on an index. markets don’t react the same every time so you won’t always see major market swings and corrections. Just be aware of them and their drastic effects on markets and prices of stocks.
A Good rule of thumb for interest rates:
- If you are day trading, STAY AWAY from trading on Friday’s and Monday’s.
- The reason behind not trading on Friday’s and Monday’s, is that over the weekends, Central Banks and countries will plan out new monetary policy through joint meetings. (G20 Summit, DAVOS, Federal Reserve meetings, etc…)
- You DO NOT want to be stuck in a trade on Friday and have markets open on Monday in free fall because of FEAR from a Geo political move made by a Central Bank or other organization. (TRUST ME, I LEARNED THE HARD WAY ON THIS.)
Watch the news!
I don’t know of a better habit to get into, when it comes to market analysis of the economy. I read the headlines every day from Google Finance, Seeking Alpha, Wall Street Journal and the list goes on. This is the best way in my opinion, to get a feel for how markets will start out a day or week.
A lot can be said for news and how it plays a role, in how markets react to certain situations in the market place. The biggest observation I have made in my experience with day trading and how it correlates with the news is this: When news is bad, the markets flood with sell orders and FEAR takes over. Market indexes drop significantly along with ALMOST every stock price out there. I say almost because not all of the stocks drop in price. Some actually increase in price when the markets fall.
When news is good markets rally and prices on most stocks usually go up. There are stocks or ETF’s out there that do go down when markets go up too. We can get into these ETF’s at a later time and I will explain how they work and how you can take advantage of them in down markets. 😉 For now, if you aren’t reading the news….start!
I had to train myself to do it and yes it can be boring at times but it will save you thousands of dollars LOST, if you know what to start looking for. I recommend starting with an app on your phone like Google Finance and start reading headlines first thing in the morning and reading the articles that are released. Watch how markets react to headlines. Make a habit of it and pretty soon, you will start to get a grasp on what you can expect from market volatility for the day and for the week so that you are better prepared for when to make your entries and exits on stocks for day trading.
So to recap here, watch the video on the economic machine. You should have an understanding now of how supply and demand works. We learned what to watch for with interest rates and how those effect market conditions. As for learning about fundamental analysis of individual companies such as reading income statements and price to earnings ratios…. we will cover those topics in separate articles. There is just too much to cover on that portion of fundamental analysis and for the sake of the readers I wanted to focus in on the economic fundamentals first. There is just as much $$$ to be made on day trading or playing “the economic conditions” through fundamental analysis as there is with directly investing in a single company.
If you have any strategies you would like to share or any other fundamental analysis or stock fundamentals that can be used for forecasting the economies markets, please leave comments below.