Fundamental analysis involves examining actual and anticipated demand and supply data to forecast the direction and magnitude of future price movements in the market. This article draws primarily on Van Tharp’s book Trade Your Way to Financial Freedom.

 

Introduction to Fundamental Analysis

Fundamental analysis serves many purposes. It helps investors estimate the ‘fair value’ of a financial asset. By comparing this fair value to the current market price, investors can gauge how attractive an investment is. Additionally, fundamental analysis aids in setting price targets by providing a general sense of where the market might head—whether you should seek quick profits or hold an asset for a much higher price objective.

• Fundamental analysis is the key tool for determining ‘fair value.’

• It generally predicts the direction and magnitude of future price movements.

• Expert fundamental analysts often forecast price trends more reliably than most other market analysts.

• However, fundamental analysis cannot pinpoint exactly when price movements will start or end.

• Combining fundamental and technical analysis offers advantages for building a comprehensive trading framework.

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Spotting Demand-Driven Markets

Strong demand is the primary driver behind sustained uptrends. Therefore, one of fundamental analysis’s main goals is to identify markets with rising demand.

• Demand-driven markets typically offer trades with higher probability and profitability.

• Markets can also rise due to supply shortages, but such supply-driven trends usually last shorter than demand-driven trends.

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Fundamentals vs. Technicals

Many traders rely solely on either fundamental or technical analysis, which can be a mistake.

• Fundamental analysis better determines price objectives but is less effective for timing entries.

• Technical analysis excels in market timing.

• Combining both approaches provides a competitive edge.

• Note: Most technical indicators don’t predict the magnitude of price moves well, but Fibonacci retracements and extensions can sometimes provide useful price targets.

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Fundamentals and News

It’s important to distinguish between news releases and fundamental analysis.

• Fundamental analysis aims to predict price direction, while news often follows price moves.

• Most news is already priced into the market.

• Anticipated news (“the rumor”) usually causes bigger moves than the actual news release (“the news”), hence the saying “Buy the rumor, sell the news.”

• Avoid judging a report’s bullishness or bearishness by the initial market reaction; first reactions are often wrong.

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Assessing Basic Market Data

Demand and Supply Changes

Predicting price movement fundamentally means forecasting changes in demand and supply levels. Price must find a new equilibrium whenever these forces shift.

• If demand increases and/or supply decreases → Price rises.

• If both demand and supply increase → Price generally remains stable.

• If demand decreases and/or supply increases → Price falls.

• If both demand and supply decrease → Price generally remains stable.

Strong trends usually stem from steadily rising demand or significant supply shortages. Demand-driven trends are generally more important and longer-lasting than supply-driven ones.

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Volume Data

Volume provides valuable market insight and supports all forms of analysis.

• Market volume reflects liquidity conditions, which are critical for trading.

• Rising volume can confirm increasing demand or supply.

• It may indicate large institutional activity.

• According to Wyckoff, price changes result from specific “efforts,” measurable by volume. Discrepancies between price and volume can warn of tricky conditions ahead.

For stocks, additional tools like the Arms Index (TRIN) analyze the ratio of advancing vs. declining stocks relative to their volume:

• A 5-day moving average above 1.2 may signal a potential bottom.

• A reading below 0.8 may signal a potential top.

• These signals typically represent short-term trades lasting 1–3 days.

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Market Volatility

Volatility measures the degree of price fluctuation over time and is crucial for assessing risk.

• It helps calculate optimal position sizing.

• Affects risk/reward ratios and market timing decisions (e.g., identifying the end of accumulation or distribution phases).

• Can be used in trade setups; for example, spotting narrow-range consolidations after strong trends to anticipate breakouts.

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Fundamental Data and Seasonal Patterns

Annual demand and supply cycles in physical markets can create seasonal price patterns in financial assets. Although seasonal trends can be consistent, they should be traded with caution, supported by technical indicators and current fundamental data.

• Seasonal patterns imply some predictability but are not foolproof.

• Certain fundamental factors recur annually, such as:

  • Weather affecting energy demand (e.g., heating oil).

  • US monetary liquidity fluctuations linked to tax payments and Federal Reserve actions.

  • The US presidential election cycle’s impact on stock performance.

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Business Fundamentals and Top Investors’ Advice

Successful investors often base setups on business fundamentals, such as financial statements and management quality. Consistent, capable management is a key factor.

 

Warren Buffett’s Fundamental Setup

According to researcher Robert Hagstrom, Buffett applies 12 criteria before buying a company—9 for setups and 3 for entry timing. He views investments as lifetime holdings and largely ignores timing. Some criteria include:

• Understanding the business model simply.

• A consistent operating history without major upheavals.

• Market dominance with pricing power.

• Strong historical returns on equity with limited debt.

• A focus on cutting costs and improving profit margins.

Management-related criteria:

• Honesty and transparency.

• Avoiding conformist managers who follow the crowd.

• Rational capital allocation, avoiding reinvestments that earn less than the company’s cost of capital.

Learn more about Buffett’s approach here: TradingCenter Buffett Indicators

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William Gallacher’s Fundamental Method

In Winner Take All, Gallacher shows how simple fundamental approaches can yield profits in global markets:

• Select markets based on value propositions.

• Focus on buying cheap markets and selling when expensive.

• Develop a critical eye for which fundamentals matter.

• Recognize that important fundamentals can change over time.

• Fundamentals provide an educated bias (bullish or bearish), not precise setups.

• Combine your fundamental view with price-based entry signals, sound position sizing, disciplined loss limits, and systematic profit-taking.

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■ Exploring Fundamental Data and the Advice of Guru Fundamentalist Investors

G.P. for ExpertSignal.com (c)

December 19th, 2024

Main Source: “Van Tharp - Trade Your Way to Financial Freedom”