As I discussed in our very first lesson, there are two ways that traders analyze the markets which are known as technical analysis and fundamental analysis. As I also mentioned in that lesson while most people who buy and sell over the short term focus on technical analysis and most people who buy and sell over the long term focus on fundamental analysis, in my opinion both technical traders, fundamental traders, and investors can all benefit from at least having an understanding of both types of analysis even if they prefer one or the other as their primary tool they use to make their trading decisions.
While technical analysis focuses solely on the analysis of historical price action, fundamental analysis focuses on everything else including things such as the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, currency or commodity using fundamental analysis there are two basic approaches one can use which are known as bottom up analysis and top down analysis. Bottom up analysis very simply means looking at the details such, as earnings if we are talking about a stock, first and then working one’s way up to the larger picture by looking at things such as the industry of the company who’s stock you are trading and then finally the overall economic picture. Top down analysis on the other hand means looking at the big picture things such as the economy first and then working one’s way down to the details such as earnings if we are talking about a stock.
While there is some debate about which method is best my personal preference is for Top Down analysis and since by starting this way we can start with the things that apply to all markets and not just the stock market this is how we will start.
The first thing that it is important to understand from a fundamental standpoint is what the economic situation is as it affects the financial instrument you are trading. As I am based in the US and the US is the World’s largest economy this is what I am going to talk about, however most of the things I discuss here apply in a broad sense to any economy. When we begin to discuss the foreign exchange market in later lessons we will go into specific details of the other major and emerging market economies from around the world.
According to Investopedia.com the definition of an economy is “the large set of inter-related economic production and consumption activities which aid in determining how scarce resources are allocated. The economy encompasses everything relating to the production and consumption of goods and services in an area.”
People often refer to the US economy as a capitalist or free market economy. A capitalist or free market economy in its most basic sense is one in which the production and distribution of goods and services is done primarily by private (non-government) companies and the price for those goods is set by the free market. This is in contrast to a socialist or planned economy where production and distribution of goods and services as well as the pricing of those goods and services is handled by the government.
While, as I state above, most people refer to the US Economy as a capitalist economy it is really more of a blended economy as the government does handle some things on behalf of the population such as the military, road building, and education.
So why is this important for a trader to know? Very simply moves towards capitalism and free market ideas are normally seen by the market as pro business and growth while moves towards more socialist ideas are normally seen by the market as anti-business and growth. With this in mind whenever there is a move towards capitalism by an economy all else being equal you will normally see markets rally on this news and whenever there is a move away from capitalism you will normally see markets sell off on this news.