Economic analysis is a key component of fundamental analysis. This is the case because certain companies will thrive under certain economic conditions.
Certain investor follow a top-down approach to fundamental analysis, which means that they start by analysing the wider economy before analysing specific companies.
They hold the belief that they should invest in sectors that fit the current state of the economy, rather than focusing on the characteristics of individual companies.
Therefore, top-down investors spend most of their time analysing the economy, before analysing individual companies that they are going to invest in.
This fits in with the idea that the economy is a cycle and that certain industries will perform best at different stages of the cycle.
For instance, finance companies perform well when the economy is recovering from a recession. A top-down investor may therefore invest in finance companies if their analysis is telling them that the economy is moving away from a recession.
There are a host of economic indictors that are used in fundamental analysis to determine the state of the economy.
The three that we will cover in this section are Gross Domestic Product (GDP), retail sales and industrial production.
GDP provides an overview of the value of all finished goods and services provided by a country within a given period. If GDP is rising. then is suggests that the economy is in an expansion phase, while if it is declining, it suggests that the economy is a contraction phase.
Retail sales show how healthy consumer spending is within the economy, while industrial production shows the level of demand for products from businesses or consumers.
If retail sales and industrial production are falling, it suggests that the economy is in the contraction phase. On the other hand, if they are rising, it suggests that the economy is in the expansion phase.
Employment data and the consumer price index are other important economic indicators.
Employment data shows the demand for employees within the economy. If the unemployment rate is falling, then it suggests that businesses need employees as they are expecting increased demand for their products or services – which suggests that the economy is in the expansion phase.
However, if the unemployment rate is high, then it suggests that businesses do not really need staff and that perhaps certain businesses are going out of business. This suggests that the economy is in the contraction phase.
Finally, the consumer price index measures the level of inflation that exists within an economy. To be more specific, it measures the rate at which businesses have increased their prices. If the level of inflation is high, it is likely that interest rates will also increase.
This is negative for most stocks as it means that borrowing money becomes more expensive, limiting the growth rate of the businesses. The exception to this would be finance companies, who would make higher profits by lending money to companies, as well as companies that have little need for debt or have high cash reserves.
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