A guide to understanding fundamental analysis

When somebody talks about fundamental analysis, you might think of a sleazy loan officer at your local bank. He's the guy in the ill-fitted suit, with an unpleasant smile and a look in his eyes that suggests you're not going to get anywhere in life without his help. It’s definitely not what a forex broker in Australia has in mind when he talks about it.

The fundamental analysis comes from the term "fundamentals," where we get such words as fundamentalism and fundamental. You can also see it related to astronomy (related to things like mass and volume) and geometry (which has to do with straight lines). So when you hear somebody talking about fundamental analysis, know they are referring to the basic principles behind something, the foundation upon which everything lies. This doctrine lies at the very heart of fundamental analysis - that all things, even the markets and economies, have a foundation.

Fundamental analysis Vs. Technical analysis

The first thing we need to know about fundamental analysis is what it isn't: It's not technical analysis. The technical analysis concerns itself with price patterns and charts, and other such phenomena.

Fundamental analysis looks at interest rates and earnings and balance sheets and all sorts of boring-sounding data nobody needs to know until they've already made their fortunes. New investors or small business owners might heed this advice for one simple reason: A focus on fundamentals makes making investment decisions less stressful. Technical analysts are always nervous because they are constantly second-guessing themselves with market swings. Still, those who make decisions based on the big picture view never have to stress whether an investment will work out.

If you're in business and you do everything right, your business will succeed. So if you look at fundamental analysis to understand how the market works and plan your investments accordingly, then it's something that benefits everybody.

The foundation of fundamental analysis is the economy. Economists like Ben Bernanke and Paul Krugman can develop all sorts of theories about interest rates and government spending and productivity (and they do). Still, their ability to affect the real world is limited to their effect on GDP growth or consumer price index (don't ask). The economy itself does not follow neatly laid plans; it follows Adam Smith's invisible hand, which guides producers toward creating what consumers demand without any such guidance from central planners.

Fundamental analysis and inflation

The second thing we have to understand about fundamental analysis is how an economy works as a whole. In markets, there are two sectors: Those who supply goods and services and those who demand them. When somebody requires a good or service, they give up money to get it. The producers respond by increasing prices until they can cover their costs - that's what we call inflation (if prices go up too fast, you end up with hyperinflation).

When somebody decides to buy one product instead of another (or none at all), it has consequences for everybody else. If consumers spend more on cars than clothes, car manufacturers can produce more vehicles and clothing retailers sell fewer items; if consumers spend more on houses than cars, the opposite occurs. This process is called an indirect exchange, which means that each decision to buy or sell a product has repercussions for everybody else in the market. In other words, any decision by a consumer will affect somebody else's decision about whether to produce another good or service.

The third thing we need to understand about fundamental analysis is that pro-business and pro-market are different. A free market does not mean prices can change at random or producers cut corners by hiring illegal immigrants and paying no taxes. That's what we call crony capitalism, and it's not just wrong because it's unfair; it undermines social trust (especially when people find out their neighbours are getting richer off of illegal activities).

Aside from loads of practice on demo accounts while testing your knowledge and understanding of fundamental analysis, is to choose the right broker in Australia.

This article does not necessarily reflect the opinions of the editors or the management of EconoTimes