The ultimate goal of fundamental analysis is to help a trader identify individual companies that are performing well as a business in the belief that their share price will rise over time. That being said, there are many factors outside the specific performance of a given company that can affect its fundamental outlook.
The phrase “a rising tide lifts all boats” is often used to describe the effect that a bull market has on the majority of stocks. The majority of companies are far more likely to witness growth in their business when the economy is booming than when it is contracting.
When companies and the general public perceive the economy to be strong, they are much more comfortable spending money. This spending in turn creates more demand for new and existing products and services. Companies will adjust to this by ramping up production in order to meet the increased demand. This may include hiring more workers and/or manufacturing more inventory, which in turn can serve to prolong a growth cycle. In general, it is lot easier for a typical company to grow its sales when consumer and business spending is strong than when it is weak.
On the other hand, when there is doubt about the future direction of the economy, businesses and individuals will be more hesitant to spend money, preferring to “play it safe” until a brighter picture emerges. This can result in higher unemployment and less production. Companies often find they have overestimated their production needs and find they must cut back sharply as the economy slows. This serves to further act as a brake on overall economic growth.
So what are some economic factors traders can watch? Let’s consider a handful of key factors.
Interest rate trends
Typically, low and/or declining interest rates are considered a positive trend for business overall. Lower interest rates allow companies to borrow money to expand their business more cheaply and/or to refinance their existing debts at lower rates, which means they have lower interest payments and more money to spend on company operations.
High and/or sharply rising interest rates typically result in less borrowing by businesses overall which results in less expansion of operations. Likewise, any business that relies on a customers’ ability to borrow money in order to drive sales (for example autos and real estate) can be positively or negatively impacted by changes in interest rates.
"Inflation” refers to the tendency of the price of goods and services to rise over time. A little bit of inflation is common and is to be expected. In fact, a low level of inflation can actually be healthy for the economy. A predictable decrease in purchasing power encourages businesses and consumers to spend money now rather than to save it, as do lower interest rates. The two dangers here are high and/or sharply rising inflation and the opposite of inflation which is referred to as “deflation.”
Strongly rising and/or high inflation results in sharp price increases for goods and services. While this may be mitigated to some extent over time by rising wages, such wage hikes tend to lag price increases. As a result, during a period of rising inflation, consumers and businesses reduce their purchases as they simply do not have enough money to buy everything they could when prices were lower. In a nutshell, inflation reduces buying power. As a result, a very high rate of inflation can have a negative impact on economic growth
On the other end of the spectrum we have “deflation” – which refers to an overall declining trend in the prices of goods and services. With deflation, businesses and consumers no longer have an incentive to spend cash when they have it, as they’re rewarded just for holding it by an increase in purchasing power.
Deflation can ultimately have an even more negative economic impact than high inflation if it persists for any length of time. This is counterintuitive to many individuals who instinctively long for lower prices which will effectively allow them to buy more goods and services for the same amount of money. But deflation – if unchecked – can lead to a downward economic spiral. This is basically what happened in the late 1920’s and throughout much of the 1930’s when the U.S. and much of the industrialized world experienced the Great Depression.
As deflation progresses, companies receive less and less for their products and in turn begin to produce less. This decline in production can cause companies to cut their workforce, meaning fewer people have the income to buy products & services. This can lead to another round of production cuts until the process becomes a self-fulfilling prophecy as the economy essentially implodes.
In summary, a low level of inflation is typically an economic positive. On the other hand, sharply rising or very high inflation rates are an economic negative. Deflation also has broad economic repercussions and should be monitored and taken seriously should it persist. Typically deflation is the result of a recession or contraction, not the cause of it. However deflation can proceed a recession as it incentivizes people to spend money later rather than right now.
GDP and broad economic growth
GDP stands for “Gross Domestic Product” and represents the total value of goods produced and services provided in a country during one year. In the U.S., GDP is reported on a quarterly basis by the U.S. Department of Commerce. Estimates for the previous quarter may be reported early in the following quarter; however, there is typically a three month lag in reporting the final data. In other words, the official GDP number for the 4th quarter of a given year is typically released in late March of the following year.
While there is a raw GDP number reported – which represents the dollar value of all U.S. goods and services, the more important number is the annualized rate-of-change. While it is theoretically possible for the economy to become “overheated” and experience growth at an unsustainable level – thereby setting the stage for the next economic contraction – in most cases the higher the annualized rate-of-change the better. The percent change in GDP can fluctuate widely from quarter-to-quarter. For stock investors a positive change in the range of 2% to 4% is typically considered to be ideal as it reflects meaningful growth without being unsustainable.
The bottom line is that sustained – and sustainable – growth in GDP signals a favorable environment for businesses, while a negative and/or declining trend in GDP can signal an unfavorable environment.
U.S.corporate earnings (actual and forecast)
The sum of U.S. corporate profits can be tracked and presents a clear picture of overall business prosperity. The one potential problem with announced earnings is that the data is released after the fact and tends to lag movements in the stock market as the stock market tends to discount future earnings trends. So by the time actual reported earnings reach a peak or a valley, chances are the stock market has already moved on to anticipating the next significant move in earnings. As a result, many traders pay close attention to forecasted trends for future earnings.
Many brokerage firms and ratings services offer earnings forecasts for individual companies industries as well as a stock market aggregate. The downside to analyzing this data is that analysts’ earnings predictions are sometimes inaccurate. Therefore there can be times when the majority of analysts will forecast strong earnings growth over the next year or the next quarter, but the anticipated growth will not pan out. Still, a fundamental analyst prefers to see that earnings forecasts are favorable as a potentially positive sign for the stock market moving forward.
Analyzing the macro-economic factors alone does not tell a trader what to buy or sell, nor when to buy or sell. However, even a cursory analysis of the macro economic trends that affect the business environment can help a trader assess whether the current environment is friendly or unfriendly.