Trading and Analysis – Fundamental Analysis

Market fundamentals are the backbone factors influencing the price of the underlying asset upon which a futures contract is based. A fundamental analyst looks at two issues—supply and demand. Supply is the amount of an asset produced, stored or stockpiled. Demand is the amount of an asset consumed.

There are three conditions fundamentalists look for in markets, deficit, surplus and equilibrium. 

Deficit
Demand exceeds supply- generally considered bullish- higher prices

Surplus
Supply exceeds demand- generally considered bearish- lower prices

Equilibrium
Demand = Supply- generally considered neutral- stable prices

The fundamental analyst carefully analyzes supply and demand data. In physical commodity markets, such as crude oil or gold, that could be estimates of production and usage. In financial markets, such as stock indexes or interest rates, it could be weekly and monthly U.S. employment reports.

If you want to be a fundamental trader, your primary task is to understand the forces of supply and demand that will yield an equilibrium point (price) at which the asset’s supply matches the asset’s demand. The ultimate goal is to understand current market prices and predict the market’s future price based on these fundamental data inputs. Analyzing market fundamentals can be an extraordinarily difficult task.

Challenges of fundamental analysis include:

Skill set

You must understand your chosen market and economic theory at a very high level.

Data Collection

Fundamental data is vast and can be hard to come by. Adjusting for the probability of data revisions into a model may make that model ineffective or useless.

Variables

The number of variables in estimating supply and demand can be overwhelming. For example, the cost of energy is a key input in the production of aluminum. Thus, in order to build a fundamental model for aluminum, you must also watch the fundamentals of the energy market.

Supply/demand elasticity

You must understand how one asset can be substituted for another based on the level of price. For example, a producer might curtail or stop production when prices are below the cost of production, which may eventually create a supply deficit. On the other side of the equation, a consumer might substitute one product for another if prices get too high, which might decrease demand and create a surplus.

Dynamic data

Fundamentals are ubiquitous and dynamic. There is no way to isolate each and every pertinent fact in order to construct a clear fundamental snapshot of a market at a specific moment in time.

Timing

In some markets, e.g. grains, market fundamentals can change from one crop year to the next. Meanwhile, in other markets, such as energy, fundamental trends and changes can take years to emerge.

Dynamic prices

Markets tend to be in a constant state of disequilibrium.