By Brandon Wendell, Online Trading Academy Senior Instructor and Trader Mentor
Last week, I responded to the claim that technical analysis was akin to reading tea leaves and held no place in proper financial analysis. Anyone who has used technical analysis knows the value of it in order to identify the most probable direction and timing of market moves. In the same spirit, I do not want to downplay the usefulness of fundamental analysis either.
I treat fundamental analysis much like I do a weather report. Since I am in Mumbai, India currently in the monsoon season, this is especially appropriate! Imagine if you were to view a weather report prior to leaving your house in the morning. The weatherperson mentions that there is an 80% chance of rain that day. As a smart person, you would most likely carry an umbrella with you when you leave the house. You are now prepared for the environment in which you are going to be operating in.
However, did the weatherperson give you the exact timing as to when you will need to open that umbrella? Of course not; they may try to narrow it down to an hour, but that is as exact as they can be for their forecast. The same can be said for fundamental analysis; it will inform you as to the environment your stock, sector or market is in, but can never give you the exact timing for changes in trend or pace. We need to rely on technical analysis for the timing.
Practicing proper risk management requires much more than simply setting stops on your positions. It requires you to be aware of the market and sector's environment and trend. If you are aware of the environment, you can avoid risky ones, or take positions that have lower risk and higher probability for profit. Taking only high quality trades and managing risk when dangers appear is critical to ensure consistent profitability that all traders strive for.
So what are the things we should be looking for fundamentally in our research? We can start by understanding some economic data releases and their impact on the investor's psyche. Remember, markets move due to people's actions that are driven by emotions and perceptions. These perceptions are fueled by data released in standard reports and of course, the media and guru's analysis of that data. It is not necessary to hold a degree in finance or economics to understand the impact of that data. In the Online Trading Academy Professional Trader course, we show you where to find the data and sources that explain the data's most probable impact on the markets.
Economies routinely move through cycles of expansion, topping, recession, and bottoming. The sectors also go through a cycle that predicts the economic future of the country. This applies to any country. Traders and investors will place their funds into sectors that should outperform in the upcoming economic cycle. For this reason, the markets then tend to lead the economy by a few months. In an expansionary period, investment dollars are driven toward growth industries such as technology, and infrastructure such as industrials and materials. We will also see consumer spending drive up profits in the discretionary sectors.
Figure 1 Expansion of an economy will require higher demand of energy and thus drive up profits in that sector. Commodity demand will typically increase and inflation will start to be a problem that the government will look to combat. Energy sector stocks leading the market are a macro-economic indicator of a possible peak. With the Central Banks raising rates to fight inflation, investor and trader money runs to safety of the consumer staples and healthcare sectors. This is a warning sign of potential economic contraction in the future through the eyes of investors.
Figure 2 Should that contraction or even outright recession become a reality, then the Central Banks usually intervene and lower rates to assist in recovery. The dropping rates will help interest rate sensitive sectors like utilities that operate in a highly leveraged manner. They can re-issue corporate debt at lower rates to rework their balance sheets. Many investors will have already been in those stocks as they offer a good dividend yield during bear markets. A sign of potential bottoming in the markets and economy would be the outperformance of the banking and financial sector. Low interest rate environments usually drive borrowing and investment. This helps the financials as their business picks up. However, these cycles can be disrupted by government intervention and of course lack of lending as we are currently seeing.
Figure 3 
Figure 4 Overall, a good grasp of both fundamental and technical analysis techniques is required for any trader to become successful and maintain their consistent profits in the markets. If you are lacking in your knowledge of one or both, come visit one of Online Trading Academy's Learning Centers located near you. Until next week, trade safe and trade well!
Have a great day.
- Brandon Wendell bwendell@tradingacademy.com
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