Fundamental analysis
THERE are generally two approaches that are employed when analysing capital markets; Fundamental analysis and technical analysis.
For example, when trading or investing on the stock market, there is need to appreciate that companies do not operate in isolation given that they operate within an industry and broader economy.
In this article, Piggy will focus on fundamental analysis and how it can be used to anticipate trends and identifying opportunities.
Fundamental analysis is a broad study of the economic and political forces that determine the price levels of an asset. This includes stock prices, exchange rates and even property prices. Like any other price, supply and demand dynamics are critical. By forecasting how these forces will change and develop over the medium term, one can forecast how price levels will move.
Supply and demand
Typically, more demand for a good or service causes its price to increase. Less demand causes the price to decline. Greater supply for something usually leads to a lower price. Less supply leads to a higher price.
Example 1
Imagine we all want the new Mercedes Benz model, but it is a limited edition. Only 500 have been made globally.
Is the price of that car likely to be high or low?
The price of that car is likely to be very high, because lots of people will be chasing after a limited amount of cars.
But what happens to the price if Mercedes Benz suddenly announces they will produce another 50 000 of the specific model? The price will probably decline, as more cars are available to the market.
Example 2
A farmer in a small village produces tomatoes. He is the only one producing tomatoes there and the village is relatively isolated.
In 2019, the weather was excellent. He managed to produce 1 000kg, more than enough to feed the whole village. He sold every kilo of tomatoes for US$1 in that year. However, in 2020, the weather was rather bad. He only produced 200kg.
What is likely to happen to the price of every kilogramme of tomatoes?
Prices will probably go up. Everyone will want tomatoes but there may not be enough of them to go around. This means that each person would be willing to pay a higher price for potatoes.
Example 3
Apple has just released its brand new iPhone 12. What will probably happen to the price of the iPhone 11?
Most likely, it will go down. This is because Apple’s cost of making an iPhone 11 did not change dramatically overnight. But the fact that people now want the iPhone 12 suggests there is less demand for the previous version. Piggy highlights that understanding the forces of supply and demand is critical when analysing markets. This is applicable even on the stock market whereby the supply and demand of shares or script is critical in understanding price trends.
The demand curve
Piggy also believes that it is critical to have an appreciation of several economic indicators when analysing markets. This includes understanding economic and industry growth rates, trade balances and inflation trends.
Growth rates
Generally, countries that grow faster are often good places to invest. The Zimbabwean economy for example has experienced recessions in 2019 and 2020, with GDP estimated to have contracted by 6% and 4,1%, respectively (Ministry of Finance).
The economic contraction has been a result of output losses in key sectors such as agriculture, mining, manufacturing, and tourism.
The recession has largely been a result of shocks such as (i) prolonged drought episodes, (ii) Cyclone Idai and (iii) the Covid-19 pandemic. The Government of Zimbabwe estimates that the economy will rebound by 7,4% in 2021 on the back of recovery in agriculture which is expected to grow by 11,3%.
Some of the implications of high GDP growth rates are as follows: l More opportunities for expansion; l Rising incomes create demand; l Overseas companies want to set up operations in these countries; and
l Foreign investors want to buy stocks of companies operating in these countries.
Overall, the above factors (normally) boost demand for the currency and cause it to appreciate.
Trade balance
Trade balance = exports–imports.
The trade balance is the amount a country receives for the export of goods and services minus the amount it pays for its import of goods and services.
Broadly speaking, countries that run persistent trade surpluses tend to have strong currencies. Conversely, nations with consistent trade deficits tend to have weaker currencies.
For example, if Zimbabwe exports more goods to Zambia, than Zambia exports to Zimbabwe, then the demand for the Zimbabwean dollar (ZW) from Zambia increases and therefore the ZW may strengthen against the Zambian Kwacha (ZMW).
Inflation
This is the rate at which the general level of prices for goods and services is rising. It is typically measured as an annual percentage change.
Another way to think of it is as a measurement of the loss in the purchasing power of every unit of currency per year. For example, if inflation is 5% annually, then theoretically a pen that costs US$1 in 2021 will cost US$1,05 in 2022.
That means that your US$1 will buy you less things in 2022 compared to 2021. That is why you may have heard your parents or grandparents say: things were so much cheaper in our time! It is true, things were a lot cheaper. That pen may have only cost US5 cents in 1980 for example. However, salaries were much lower as well.
Inflation affects different groups of people in vastly different ways. In general, high inflation hurts savers and investors. If you have US$ 100 000 in the bank and inflation unexpectedly spikes to 10%, your money now buys roughly 10% fewer things.
But it also helps borrowers. Imagine you just got a loan of US$100 000 to buy a house worth as much. If next year inflation spikes to 10%, the same house will be worth US$110 000, but you will still have to pay only US$100 000. The biggest threat to the economy, however, may be when inflation moves sharply and unpredictably from year to year. The uncertainty over what happens next makes consumers less likely to spend as their real income may fall, corporations more hesitant to invest, and so on. One of the worst instances of hyperinflation was recorded in Zimbabwe.
In 2008, inflation was estimated at 231 000 000% y-o-y. That means that a loaf of bread that cost ZW$1 in 2007 was worth 231 million just one year later. Imagine trying to plan your personal expenses, business investment, or savings, in such an environment?
Chapter 2 of the Investment 101 Handbook provides a thorough overview of inflation and other economic indicators. Download a copy of the Investor 101 Handbook from www.piggybankadvisor.com.