Fundamental Analysis

Understanding Fundamental Analysis
Fundamental analysis is the study of the core underlying elements that influence the economy of a particular currency. This method of study attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors. Imagine financial markets as a large clock, the gears inside this clock that move the hands, or drive the clock would be these "fundamentals". Although you can look at the clock and know what time it is, only by looking at the fundamentals can you truly understand how it became the time it is now. By knowing this, you might better understand the movement of time and be better able to predict what time it will be in the future. As a Forex investor you can better understand why the market is where it is today and where it might be tomorrow (or at a future point) based on studying these fundamentals.

Keep in mind that Fundamental analysis is a very effective resource to forecast economic conditions, but not exact currency prices. For example, you might get a clear understanding of the health of the US economy by studying an economist's forecast of an upcoming Employment Cost Index (ECI), but how does that translate into entry and exit points? You need to develop a method that you use to decipher this raw data into usable entry and exit points based on your personal unique trading strategy. These methods are known as forecasting models. Forecasting models are like fingerprints - unique to every trader. Every trader may look at the exact same data, yet conclude completely different scenarios on how the market will react. It is important to analyze the fundamentals and apply your findings to your model.

Fundamentals for each currency might include, but not limited to; interest rates, central bank policy, political figures/events, unemployment/employment reports, and Gross Domestic Product (GDP). These economic indicators are snippets of financial and economic data published by various agencies of the government or private sectors for each country. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, almost everyone in the financial markets religiously follows them. With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyze and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize and make trading decisions based on the data.

Fundamental analysis is the study of the core underlying elements that influence the economy of a particular currency. This method of study attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors. Imagine financial markets as a large clock, the gears inside this clock that move the hands, or drive the clock would be these "fundamentals". Although you can look at the clock and know what time it is, only by looking at the fundamentals can you truly understand how it became the time it is now. By knowing this, you might better understand the movement of time and be better able to predict what time it will be in the future. As a Forex investor you can better understand why the market is where it is today and where it might be tomorrow (or at a future point) based on studying these fundamentals.

iled by the Conference Board and published in its monthly Business Cycle Indicators report. Released to public at 10:00 am ET four to five weeks after the end of the record month. www.conference-board.org has historical data and explanations of the methodology behind the indices.

Because the indicesâ€™ components are all released earlier than the indices themselves, the markets generally donâ€™t react strongly to the indicator report.

Coincident Index

Four Components:
1. Nonfarm Payrolls: obtained from a survey of about 160,000 businesses, conducted by the Bureau of Labor Statistics.
2. Personal Income Less Transfer Payments: Derived from the Personal Income and Outlays report, produced by the Bureau of Economic Analysis (BEA). The largest source is wages and salaries, transfer payments â€“ government disbursements and food stamps.
3. Total Industrial Production Index: published by the Federal Reserve and constructed of 295 components that are weighted according to the value they add during the production process.
4. Manufacturing & Retail Trade Sales: Collected as part of the National Income and Product Accounts calculations. Found in the Manufacturing and Trade Inventories and Sales (MTIS) report published by the Department of Commerce.

Leading Economic Index

Ten Components:
1. Average weekly hours worked in manufacturing
2. Average weekly initial claims for unemployment insurance
3. Manufacturersâ€™ new orders for consumer goods and materials
4. Slower deliveries diffusion index of vendor performance
5. Manufacturersâ€™ new orders for nondefense capital goods
6. Monthly building permits for new private housing
7. Stock prices, 500 common stocks
8. The M2 money supply (in 1996 dollars)
9. The interest rate spread between the 10-year Treasury bond and the federal funds rate
10. The Index of Consumer Expectations

The individual indicators composing the Leading Economic Index differ considerably in their abilities to predict economic turning points. Some are very far seeing, others relatively near sighted. The composite index combines in such a way that the whole is designed to outperform any of its parts.

Lagging Economic Index

Seven Components:
1. Average duration of unemployment
2. Ratio of manufacturing and trade inventories to sales
3. Manufacturing labor cost per unit of output
4. Average prime rate
5. Commercial and industrial loans outstanding
6. Ratio of consumer installment credit to personal income
7. Change in the consumer price index for services

The Lagging Economic Index follows downturns in the business cycles by about three months and expansions by about fifteen. This index was designed to confirm turning points in economic activity that were identified by the leading and coincident indices have actually occurred, thus preventing the transmission of false signals

CompThe most important economic indicator by far is the monthly Employment Situation published by the Bureau of Labor Statistics (BLS). No other report has the potential to move the forex market like employment and no other indicator is more revealing of general economic conditions than the labor market data. Employment data is important because it reveals how firms, corporations, and others responsible for hiring decisions view the current and upcoming economic environment.

The monthly employment report is based on two separate surveys: the Current Population Survey (CPS), aka the household survey, and the Current Employment Statistics survey (CES), aka the establishment, or payrolls, survey. Supplemental to each release, the commissioner of the Bureau of Labor Statistics provides a statement to the Joint Economic Committee of the U.S. Congress. The statement, generally three pages long, highlights significant strengths and weaknesses in the monthly employment statistics.

Top billing on the employment report is generally shared by two figures; the unemployment rate and the monthly change in nonfarm payrolls. Average hourly earnings, hours worked, overtime hours worked and the monthly change in manufacturing jobs also command a great deal of traders attention.

In the employment surveys, the BLS includes only persons older than sixteen. Excluded from surveys are people in mental or penal institutions and members of the armed forces. People qualify as employed in two ways. First are those who, during a given period, have worked as paid employees in someone elseâ€™s company or in their own businesses or on their own farms or have done fifteen hours or more of unpaid labor in a family-operated enterprise. Second are those with jobs or in businesses from which they have take temporary leave, paid or unpaid, because of illness, bad weather, vacation, child-care problems, labor disputes, maternity or paternity leave or other family or personal obligations.

Unemployed people are those not working during the period in question, whether because they voluntarily terminated their employment, in which case they are classified as job leavers, or because they were involuntarily laid off, making them job losers.

Strong relationships exist between the employment data and virtually every other indicator. The growth rate of non farm payrolls is generally strongly correlated with the growth rate of GDP, industrial production and capacity utilization, consumer confidence, spending, and income.

The Industrial Production and Capacity Utilization report is assembled and released around the fifteenth of each month by the Board of Governors of the Federal Reserve System. It presents the data on the output of the nationâ€™s manufacturing, mining, and utility sectors. Also known as the Federal Reserveâ€™s G17 report, it organizes this data into industrial production and capacity utilization indices. The former measures the physical volume of the output of various industries and markets, the later shows what portion of the nationâ€™s production capacity was involved in creating that output. The Industrial Production and Capacity Utilization release, along with the historical data, is available on the Federal Reserveâ€™s website, www.federalreserve.gov

The Industrial Production and Capacity Utilization report is an assemblage of fifteen tables arranged over nineteen or twenty pages. They display the current monthâ€™s values for the various industrial-production and capacity-utilization indices, revisions to the previous monthsâ€™ values, month to month percentage changes in the indices, and their quarterly and annual rates of growth.

The industrial production indices measure quantity of output, not dollar volume, relative to a base year, currently 1997, whose value is set at 100. The Federal Reserve obtains the production data it uses to construct these indices both directly and indirectly. Direct sources include trade associations such as the American Forest and Paper Association, the U.S. Geological Survey, the Internal Revenue Service, and the Tannerâ€™s Council of America. Actual production data, however, is available at different times for different industries. When hard figures arenâ€™t available the Federal Reserve estimates output based on the number of production-worker hours in the Bureau of Labor Statisticsâ€™ monthly Employment Situation report or on electric power use by industry.

Capacity utilization is a measure of how close the nationâ€™s manufacturing sector is to running at full capacity. The Fed defines full capacity as sustainable practical capacity, or the greatest level of output that a plant can maintain within the framework of a realistic work schedule, taking into account normal downtime and assuming sufficient availability or inputs to operate the machinery and equipment in place.

The report contains capacity and capacity utilization rates for eighty-five industries, including the following major categories:

â€¢ Semiconductors and related electronic components
â€¢ Motor vehicles and parts
â€¢ Apparel and leather
â€¢ Paper
â€¢ Chemicals
â€¢ Wood products
â€¢ Electric utilities

The Purchasing Managersâ€™ Index (PMI) garners quite a lot of attention and it has been said that it was former Federal Reserve chairman Alan Greenspanâ€™s Desert Island Statistic â€“ the one he would need to conduct policy if he were stranded on a desert island and only had access to one economic indicator. The PMI is the headline index of the Manufacturing ISM Report on Business. This report is created by the Tempe, Arizona based Institute for Supply Management (ISM), a not for profit professional association and is made available on ISMâ€™s website at www.ism.ws on the first business day of every month, after 10 a.m. ET.

The Report on Business discusses the current readings of ten seasonally adjusted diffusion indices constructed by the ISM from the responses to a survey of approximately 400 purchasing managers across the United States. The survey polls participants about their opinions on prices of materials paid in the production process, production levels, new orders, order backlog, the speed of supplier deliveries, inventories, customer inventories, employment, new export orders, and imports. The PMI is a weighted composite of the following five indices:

1.New orders
2.Production
3.Employment
4.Vendor performance
5.Inventories

The ISM manufacturing report is valued not only for the diffusion indices but also for the accompanying discussion and comments made by the purchasing and supply executives participating in the survey. Together, the indices and executivesâ€™ anecdotal insights form a fairly detailed picture of the state of the manufacturing sector

The Manufacturersâ€™ Shipments, Inventories, and Orders, or M3, survey is one of the most respected economic indicators. Published monthly by the U.S. Department of Commerceâ€™s Census Bureau, the report measures current activity and future commitments in the U.S. manufacturing sector. Using data supplied by approximately 4,700 reporting units of businesses in eighty-nine industry categories, it provides statistics on the value of factoriesâ€™ shipments, new orders, unfilled orders, and inventories.

The M3 survey is published in two parts. The Advance Report on Durable Goods is released about four weeks after the reference month, on approximately the eighteenth business day of the month. The revised and more comprehensive Manufacturersâ€™ Shipments, Inventories, and Orders appears about a week later and supplies greater detail about production, by industry group, as well as including information about nondurable and durable goods.

Manufacturing orders are considered to be a leading economic indicator because they reflect decisions about optimal inventory levels given the demand businesses anticipate based on their economic forecasts. The Census Bureau obtains its data on domestic manufacturing through surveys of manufacturing companies with annual shipments totaling $500 million or more. Participation is voluntary and responses are sent via the Internet, telephone or fax. The reports contain both seasonally adjusted and non adjusted figures for the record month and for the previous three months, together with percentage changes from month to month. All the values are nominal, given in constant-dollar terms.

The M3 report is considered a gold mine of economic information. The durable new orders data is touted as a particularly rich lode due to the insight provided into a large component of personal consumption and capital expenditures.

Business inventories are â€œwaiting roomâ€‌ goods â€“ products that have been manufactured, processed, or mined by have not yet been sold to the final user. As such, they are a key component of the GDP calculation. GDP is the total amount of final goods and services produced in an economy in a given period. That includes goods that havenâ€™t been acquired by a final purchaser, otherwise known as inventory.

However, inventoriesâ€™ role in the GDP calculation is not the sole reason economists monitor them carefully.

Failure to balance inventories against demand can, and has, hurt businesses and destabilized the economy. Companies that overstock their shelves in anticipation of orders that do not materialize find themselves in a hole, forced to cut production and lay off workers. It has been hypothesized by prominent economists that the Great Crash of 1929 was provoked in part by the misalignment of inventory positions. On the other hand, businesses whose inventories are too lean miss potential profit during a boom.

The MTIS report compiles sales data previously reported in the Census Bureauâ€™s Advance Monthly Sales for Retail Trade and Food Services report together with inventory and sales information from its Wholesale Trade Survey and its Manufacturersâ€™ Shipments, Inventories, and Orders survey.

Low inventory positions may signal an impending acceleration in production and manufacturing activity, while high inventories may portend a recession and widespread layoffs.

The American Dream of home ownership is one of the primary drivers of the US economy. Housing activity affects the investment (I) component of the aggregate expenditure formula for calculating gross domestic product: C+I+G+(X-M). The construction of new, privately owned residential structures, particularly single-family homes, is very telling regarding consumer sentiment and the health of the economy.

While new housing only accounts for 3 percent of GDP it can have a profound effect on the economy due to the multiplier effect of related spending and other indirect contributions. Once a home is bought, it must be furnished and decorated.

All of this activity means new jobs for construction workers, retail salespeople, and manufacturers; increased tax revenues for local and state municipalities; and greater spending on goods such as carpeting, furniture, and appliances.

There are several important housing indicators, including the Census Bureauâ€™s new home sales and the National Association of Realtorsâ€™ existing home sales. The most influential, however, is new-housing starts and building permits. These numbers are contained in New Residential Construction, which is released jointly by the U.S. Department of Commerceâ€™s Census Bureau and the U.S. Department of Housing and Urban Development at 8:30am ET on approximately the fifteenth day of the month following the reference month.

Many different surveys of consumer confidence and sentiment exist. Some research institutions and investment firms have even created their own. The best known and most respected are the Conference Boardâ€™s Consumer Confidence Index and the University of Michiganâ€™s Index of Consumer Sentiment. However, all the various surveys share one characteristic: They ask everyday people from different walks of life easy to answer questions that probe their feelings about the current and future state of the economy, inflation, and their plans for vehicle and home purchases.

The Conference Boardâ€™s confidence index is generally released on the last Tuesday of each month and a basic version made available on the Conference Boardâ€™s website. A more detailed version and the history is available by subscription directly from the Conference Board.

The University of Michigan usually issues its sentiment index on the second to last Friday of each month, followed by the revised final estimate two weeks later. This survey is available by subscription only.

The differences in the methodologies used by the Conference Board and the University of Michiganâ€™s Survey Research Center are small but important enough to produce indices with somewhat divergent characteristics and strengths. Some feel that the larger pool sampled in the NFO survey makes the Conference Boardâ€™s indices more significant statistically. They also feel that eliciting expectations for the next six months, as the NFO survey does, is more realistic than the Michigan surveyâ€™s five year perspective. On the other hand, the longer history and twice-monthly reporting of the sentiment indices garner favor for the University of Michiganâ€™s report.

The Census Bureau of the U.S. Department of Commerce releases the Advance Monthly Sales for Retail Trade and Food Services report, aka the retail sales report, about two weeks after the end of the record month at 8:30 am ET. The report presents preliminary estimates for the nominal dollar value of sales for the retail sector, as well as the month to month change in that value.

The reason for the interest in the retail sales report is that retail spending provides a great deal of insight into personal consumption expenditures, the largest contributor to gross domestic product.

The Census Bureau compiles the Advance Monthly Sales for Retail Trade and Food Services report from responses to a survey it mails out to approximately 5,000 companies about five working days before the end of the reporting month. The 5,000 are a subsample of the 13,000 or so companies polled for the later Monthly Retail Trade report. The replies are weighted and benchmarked to give an accurate representation of the more than 3 million retail and food services companies in the United States and indicates what these companies earned during the record month from sales and for providing services that are â€œincidental to the sale of the merchandise.â€‌