Fundamentals of Investments

1. 8 FundamentalsofInvestments C h a p t e r Stock price behavior and market efficiency Valuation & Management second edition CharlesJ.Corrado BradfordD.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2. Technical analysis • Fundamental analysis focuses mostly on the company financial information. • Technical analysis is a technique for predicting the market direction based on : • Historical price and volume behavior • Investor sentiment • Investors with a positive outlook on the market are called bulls and a rising market is called a bull market

3. Technical analysis • Pessimistic investors are called bears and a falling market is called a bear market • Technical analysts search for bearish or bullish signals meaning positive and negative indicators about the stock prices or the market direction

4. Dow Theory • Is a method of analyzing and interpreting the stock market movements that relies on the Dow Jones industrial average and the Dow Jones Transportation averages • The essence of Dow theory is that there are at all times three forces at work in the financial markets • A primary direction or a trend • A secondary reaction or a trend • Daily fluctuations

5. Dow Theory • According to the theory, the primary direction is either bullish ( up) or bearish ( down) • It reflects also the long direction of the market • However, the market can depart for limited periods of time from the primary direction • These departures are called the secondary trends , may last for several weeks or months • These are eliminated by the corrections which are the reversion back to the primary direction

6. Dow Theory • Daily fluctuations are noise and are of no real importance • The basic purpose of the Dow theory is to signal changes in the primary direction • Depends on the two stock averages • If one of these departs from the primary trend, the movement is viewed as a secondary • If a departure in one , followed by a departure in another this is viewed as confirmation

7. Dow Theory • A confirmation is a signal that the long-run trend has changed direction. • Support level : price or level below which a stock or a market as a whole is unlikely to fall • Resistance level: price or level above which a stock or a market as a whole is unlikely to rise • As a stock price falls , it reaches a point where investors believe that it can fall no further

8. Resistance and support levels • Bottom feeders picks up at that point, there by they are supporting the price • The resistance level is the same thing in the opposite direction, as a stock rises , it tops out and investors selling the picks up this selling is often referred to profit taking • Break out : occurs when a stock passes through either a support or a resistance level. The breakout interpreted to mean that the price will continue in that direction

9. Technical indicators • Technical analysts rely on a variety of so called technical indicators • Look at page 253 • The first item listed is the number of issues traded . This number is fluctuated • Advancing issues and declining ones and the number of unchanged prices, then the number of the stock prices reaching new highs and new lows

10. Technical indicators • One popular technique is the advance/decline line • Which shows the cumulative difference between advancing issues and declining issues • A downward sloping advance/decline line would be considered as a bearish signal • The upward slope is a positive sign • Advance/decline line is often used to measure the market breadth

11. Technical indicators • If the market is going up, the technical analyst view it as a good sign • The next row is the trading volume for the advancing, declining and unchanged issues • Heavy advancing volume is viewed as a bullish signal • The last three numbers , are of the interest of technicians , ( closing tick) is the difference between the number of shares that closed on an uptick and those that closed on downtick

12. continue • Closing arms (trin) is the ratio of average trading volume in declining issues to the average trading volume in advancing issues • Values greater than 1 are considered bearish because the indication is that the declining shares are heavier volume • The final piece of information is the block trades refers to trades in excess of 10,000 shares

13. Charting • Technical analyst rely heavily on charts showing the recent market activity in terms of either prices or volume • Technical analysis is called charting and technical analysts are called chartists • There are four charting techniques: • The relative strength charts • Moving average charts • Hi-lo-close and candlestick charts • Point and figure charts

14. Relative strength chart • A measure of the performance of one investment relative to another • A ratio bigger than 1.0 indicates that on relative basis , the company is outperformed • Example page 255 between ford and GM

15. Moving average charts • An average daily price calculating using a fixed number of previous day’s prices or levels updated each day • Such charts are used in an attempt to identify short and long term funds • The way we construct a 30 day moving average stock price is to take the prices from the previous 30 trading days and average them

16. Hi-lo-close and Candlestick charts • Is a bar chart showing for each day, the high price, the low price and the closing one • Candlestick chart is an extended version of hi-lo-close that provides a compact way of plotting the high, low , open and closing price through time while also showing whether the opening price was above or below the closing price

17. Hi-lo-close and Candlestick charts • The name stems from the fact that the resulting figure look like a candlestick with a wick at the both ends • Candlestick are abbreviated As HLCO • The body of the candlestick is defined by the opening and closing prices • If the closing price is higher than the opening, the body is clear or white, otherwise its black

18. Hi-lo-close and Candlestick charts • Extending above and below the body are the upper and the lower shadows, which are defined by the high and low prices for the day • Dark cloud cover: a white candle with a long body is followed by a long bodied black candle, when this occurs during a general uptrend , the possibility of a slowing or reversal in the uptrend is suggested

19. Hi-lo-close and Candlestick charts • Bearish engulfing pattern: the market opened higher than the previous day’s close, but closed lower than the previous day’s open (Bearish Indicator) • Harami: the body of the second candle lies inside that of the first day’s , the harami signals market uncertainty and the possibility of a change in a trend

20. Point and Figure charts • Technical analysis chart showing only the major price moves and their direction • Chartists believe that point and figure charts provide a better indication of important trends • The whole example in book page 259

21. Chart formation • Head and shoulders , in the eyes of the technical analysts , a bearish indicator , when the stock price “pierces the neckline” , after the right shoulder is finished , its time to sell • Technical analysts believe that the chart interpretation is a subjective art rather than an objective matter

22. Other technical indicators • Odd lot indicator: looks whether the odd lot purchases are up or down • Odd lot purchases: purchases of fewer than 100 shares • One argument is that the old lot purchases represent the activities of smaller, unsophisticated investors , so when they start buying its time to sell • Increasing the short sales are a negative signal

23. Other technical indicators • Some indicators are a little silly , there is the Hemline indicator • The idea that stock prices move in the same general direction as the hemlines of women's dresses. Short skirts in the 1920s and 1960s were considered bullish signs that stock prices would rise, whereas longer dresses in the 1930s and 1940s were considered bearish (falling) indicators.

24. Other technical indicators • Super bowl indicator: which forecasts the direction of the market based on whether the national football conference or the american football conference wins • A win by the national football conference is bullish • You might be surprised to learn that for the period 1967-1988, this indicator forecast the direction of the stock market with more than 90% accuracy !

25. Market Efficiency • Relation between the stock prices and the information available to investors , indicating whether its possible to beat the market • If the market is efficient , it is n’t possible except by luck

26. What does beat the market mean ? • Riskier investments have larger returns than less risky investment, so the fact that an investment appears to have a high or low return doesn’t tell us much • To determine if an investment is superior , we need to compare excess return which is the difference between what the investment earned and what other investments with the same risk earned

27. What does beat the market mean ? • A positive excess return means that an investment has outperformed other investment of the same risk • So earning a positive excess return is what we mean by beating the market

28. Forms of market efficiency • Weak form efficient market : a market in which past prices and volume figures are of no use in beating the market • SemiStrong form efficient market: a market in which publicly available information is of no use in beating the market • Strong form efficient market : a market in which information of any kind , public or private is of no use in beating the market

29. Why would a market be efficient? • The driving force toward market efficiency is simply competition and the profit motive • Investors try to identify superior performing investment, using the most advanced information processing tools available, investors appraise the stock values , buying those that look undervalued and selling those that look even overvalued.

30. Why would a market be efficient? • The fundamental characteristics of an efficient market is that prices are correct in the sense that they fully reflect relevant information • When new information comes to light , price may change and they may change by a lot depends on the new information.

31. Are financial markets efficient? • They are four basic reasons why market efficiency is so difficult to test: • The risk adjustment problem • The relevant information problem • The dumb luck problem • The data snooping problem

32. The risk adjustment problem • The risk adjustment problem is the most straightforward to understand • Beating the market means earning a positive excess return . To determine whether an investment has a positive excess return , we have to look at the risk associated with it • But we aren’t certain exactly what we mean by risk , much less how to measure it and adjust for it.

33. The risk adjustment problem • So , what appears to be a positive excess return may just the result of a faulty risk adjustment problem

34. The relevant information problem • Market efficiency is just meaningful only to some particular information • But we can’t know all the information that have been underlying the behavior • Suppose that we see the 10 years ago , the price of a stock shot up by 100 percent over a short period of time and then collapsed , we dig through the historical data , but we don’t find any reason for this behavior

35. The dumb luck problem • By tracking the performance of thousand of money managers over some period of time , some managers accumulate remarkable track records and a lot of publicity • Are they good or are they luck? If we could track them for many decades , we might be able to tell , but for the most part , money managers aren’t around long enough for us to accumulate enough data.

36. The data snooping problem • Ghosts in data • If we look enough and hard enough at any data, we are bound to find some patterns by sheer chance • But are they real???

37. Some implications of market efficiency • Investment process can be divided into two ways: • Asset allocation • Security selection • if all the markets are efficient , asset allocation is still important because the way that you divide your money between the various types of investment will influence the overall risk relation

38. Some implications of market efficiency • If the market is efficient , the security selection is less important and y don’t need to worry too much about overpaying and underpaying for any particular security

39. The day off the week • The weekend effect (also known as the Monday effect, the day-of-the-week effect or the Monday seasonal) refers to the tendency of stocks to exhibit relatively large returns on Fridays compared to those on Mondays. This is a particularly puzzling anomaly because, as Monday returns span three days, if anything, one would expect returns on a Monday to be higher than returns for other days of the week due to the longer period and the greater risk.

40. The amazing January effect • January effect is the tendency of stock markets to rise in the month of January. The tendency is more evident in first week of January. January effect is more evident in small-cap and mid-cap stocks and different stocks and markets are differently affected by the effect.

41. The amazing January effect • The main reason for January effect is related to Tax paying. Investors and traders sell-off their holdings to claim a capital loss or to get lower taxes before the end of the tax calendar (in December) causing the prices to fall. In first week of January these investors/traders reinvest their money and buys-back stocks, and the prices rise. For S&P January effect took place 32 times out of total 39 years from 1979. As the effect is widely expected it is difficult to profit from this effect.

42. Black Monday (1987) • Black Monday refers to Monday, October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong, spread west through international time zones to Europe, hitting the United States after other markets had already declined by a significant margin. The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1738.74

43. Performance of professional money managers • Despite the different resources , experiences , opportunities and incentives and despite the patterns that existed in the stock market. Money managers aren’t able to beat the market. • This is true for professionals as a group and as individuals