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March 8th 2011

In Defense of Fundamental Analysis!

I was inspired to write this post by a recent article published by Counting Pips, entitled “The Problem with Forex Fundamental Analysis.” While the author, Warren Seah, delivers a stinging critique of fundamental analysis, I think most of his points are pretty hollow. For the sake of debate, I’d like to present my rebuttal.

Seah’s thesis can essentially be boiled down as follows: First, by the time traders have a chance to act on fundamental developments, it is inherently too late as such developments have already been priced into the exchange rates. Second, he argues that fundamental metrics are not automatically trustworthy, since the countries presenting them often have their own agendas. Finally, he asserts that the markets’ response to fundamental news releases is often illogical, and may only serve to confuse traders that would otherwise depend on technical signals to make trading decisions.

I think Seah’s first argument is inherently self-defeating. If one were to concede that all fundamental data has already been priced into currencies, that one would have to make the same concession with regard to price data, which is the backbone of technical analysis. In the end, all traders- regardless of analytical approach – believe that efficient markets theory is flawed, and that exchange rates (and other asset prices, for that matter) are not always correctly valued. The goal of any type of analysis is to identify and exploit such inefficiencies.

I think Seah’s second point, meanwhile, is somewhat irrelevant. Regardless of whether the official economic indicators are actually correct, the market will come to its own (implicit) consensus, and the data will still form the basis for investment decisions. In other words, given that comparative inflation rates can and do drive exchange rates, it’s important to be aware of such rates, be they explicitly provided by a government agency or implicitly priced in by investors. Whether the government agency’s figures are accurate or not doesn’t mean that currency investors shouldn’t worry about inflation.

With regard to the final point, I would agree that news releases can cause exchange rates to move illogically, but as Seah concedes, these inefficiencies will usually smooth themselves out over the following trading periods. A fundamental analyst with a long-term time horizon wouldn’t be swayed by such short-term fluctuations, especially if they are illogical. Thus, I would argue that news releases are more likely to interfere with short-term technical strategies than long-term fundamental strategies.

Ultimately, both fundamental factors AND technical factors drive exchange rates, with the latter primarily dictating short-term movements and the latter bearing more heavily on the medium-term and the long-term. By way of example, consider that all else being equal, a currency backed by low inflation, high economic growth, and high interest rates should outperform a currency with high inflation, low GDP growth, and low interest rates over the long-term. Since exchange rates don’t move up and down in straight lines, there will be plenty of opportunities for technical traders to earn a profit on a minute-by-minute and even week-by-week basis. The fact that very few technical traders will look at 5 year charts and very few fundamental traders will waste their time on 1-day charts largely explains the perceived value of both types of analysis.

Ideally, I would say that all traders should be aware of and make use of both types of analysis. In reality, though, I think this is akin to trying to have one’s cake and eat it too. I think it’s much more practical for traders to decide which type of analysis is better suited to their trading style and even their personality type, and analyze accordingly. For the best analogy, consider that Warren Buffet probably doesn’t know what a stochastic is, while quantitative hedge fund managers probably couldn’t care less about value. And yet it’s possible for both to earn consistent, out-sized returns.

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Posted by Adam Kritzer | in Commentary | 2 Comments »

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2 Comments of “In Defense of Fundamental Analysis!”

  1. Javy Says:

    Hi Adam,

    Could you please explain this phrase: “Ultimately, both fundamental factors AND technical factors drive exchange rates, with the latter primarily dictating short-term movements and the latter bearing more heavily on the medium-term and the long-term”

    Thanks

  2. Zachary Says:

    Adam, Great counterpoint to Warren’s article! Couldn’t agree more with many of your points especially as we are currently seeing inflation rates as a major driver of currencies. Trading would be so much easier if we could ignore one form of analysis or the other. 🙂

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