FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 6 Part 2
• Forecasting with Fundamental Analysis and
  Technical Analysis

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Objective for This Lecture Series

• To introduce you to two very different approaches
  to forecasting financial asset prices.
• Fundamental analysis
• Uses economic and financial data upon which to
  base the calculation of the appropriate price of
  a financial asset.
• Tries to identify undervalued assets.
• Technical analysis
• Forecasting of future financial price movements
  based on an examination of past price (and
  volume) movements.

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Forecasting Assuming Efficient Markets

• According to the Efficient Market Hypothesis,
  when new information hits the market, the news
  spreads very quickly and is incorporated into
  asset prices without delay.
• If this this the case, then any technique
  promising greater returns than the over-all
  market itself is questionable at best.
• So as we work through the following two
  forecasting approaches, we need to consider how
  efficient markets would impact upon each
  technique.

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Fundamental Analysis

• This technique attempts to identify undervalued
  financial assets, so that if purchased would
  enable the investor to achieve returns greater
  than those that could be obtained by holding a
  portfolio of the financial assets in question.
• But, if markets are efficient, financial assets
  are priced correctly, i.e., there will be no
  undervalued assets.

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Fundamental Analysis Selecting Appropriate Model

• The selection of an appropriate pricing model
  is critical to the forecast for a particular
  financial asset.
• Long-term Bonds
• Interest rate models with focus on future
  inflation.
• Foreign Exchange (short term horizon)
• Short term interest rate differential models with
  focus on central bank policies
• Foreign Exchange (longer term horizon)
• Trade (imports and exports) and capital flows
  (stock market, foreign direct investment).
• Inflation.
• Common stock
• Economic, industry and company models.

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Fundamental Analysis Common Stock

• Historically this is the approach most used by
  financial analyst.
• Popularized by Columbia University Professors
  Benjamin Graham and David Dodd (1934, Security
  Analysis).
• They argued that investors should buy stocks in
  corporations that have undervalued assets
  relative to their true market value, or
• current assets exceeding current liabilities,
• low price/earnings ratio.
• Graham and Dodd advocated searching out stocks
  which are undervalued by the market.
• Once an undervalued security is found, it's
  simply a matter of buying the stock and waiting
  for the market to realize the "more accurate"
  value of that security.

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Fundamental Analysis Common Stock

• Fundamental approach has used successfully by
  Warren Buffett who actually studied under
  Benjamin Graham at Columbia University in the
  early 1950s.
• After graduation Buffett applied for a job with
  Graham investment firm, but was initially turned
  down!
• In April 3, 1995, Warren Buffett was quoted
  (Fortune Magazine) as follows I'd be a bum in
  the street with a tin cup if the markets were
  efficient.
• For an interesting account of Warren Buffett see
• http//beginnersinvest.about.com/cs/warrenbuffett/
  a/aawarrenbio.htm
•  

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Calculating the Value of Common Stock

• There are two general approaches to valuing
  common equity 1) the discounted cash flows
  approach, and 2) the relative valuation approach.
• Discounted Cash Flow A stocks value is based on
  the present value of its future cash flows, such
  as dividends.
• Relative Valuation Approach Values a stock based
  on its current price relative to certain
  variables, such as the company's earnings,
  revenues or book value.

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Top Down Fundamental Approach

• This approach is probably the most comprehensive
  of all fundamental techniques. It can involve
  specific steps such as
• 1. Economic Forecast (global, national, regional)
• 2. Group (Industry) Selection
• Which industries are likely to do well in the
  forecasted environment.
• 3. Analysis of Companies within the Group
• Leaders, innovators, start-ups, etc.
• 4. Company Selection
• Companys Plans and Outlook
• New product development, red flags (litigation,
  etc.)
• Management
• Financial Analysis

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Technical Analysis

• This technique examines past financial asset
  prices in an attempt to predict future asset
  prices.
• However, if markets are efficient, then the quick
  flow of information will be immediately reflected
  in asset prices and tomorrow's price change will
  reflect only tomorrows news.
• But, according to the efficient market
  hypothesis, tomorrows news is unpredictable and
  thus tomorrows price changes will be
  unpredictable and random.

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Technical Analysis

• History Its origins can be traced to articles
  published by Charles H. Dow in the Wall Street
  Journal between 1900 and 1902.
• Dow suggested the use of past price behavior to
  guide investing decisions.
• Technique became popular after contributions by
  Hamilton (1922) and Rhea (1932).
• Technical analysis believes that the price of an
  asset is determined by supply and demand.
• Simply put, technical analysis uses charts which
  indicate the beginning of shifts in demand and/or
  supply and thus lead price changes.
• Recall, technical analysis is at odds with the
  random walk assumption of the Efficient Market
  Hypothesis.

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Definitions of Technical Analysis

• Robert Edwards and John Magees classic book
  (Technical Analysis of Stock Trends, 1948)
• Technical Analysis is the science of recording,
  usually in graphic form, the actual history of
  trading (price changes, volume of transactions,
  etc.) in a certain stock or in the Averages and
  then deducing from that pictured history the
  probable future trend.
• Martin J. Pring (Technical Analysis Explained,
  1979).
• "The technical approach to investing is
  essentially a reflection of the idea that prices
  move in trends which are determined by the
  changing attitudes of investors toward a variety
  of economic, monetary, political, and
  psychological forces. The art of technical
  analysis -- for it is an art -- is to identify
  trend changes at an early stage and to maintain
  an investment posture until the weight of the
  evidence indicates that the trend has reversed."

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Technical Analysis Summary

• Technical Analysis
• This approach is NOT interested in financial or
  economic data that may affect the assets price.
• Sometimes referred to as noise trading (i.e.,
  not interested in news).
• Utilizes charts of past price movements to
  estimate where prices may move in the future.
• Sometimes referred to as a chartist (or charting)
  approach.
• Assumes prices are not random
• That patterns of prices develop and can be used
  to forecast the future.
• Generally uses a short time frame intraday
  (1-minute, 5-minutes, 10-minutes, 15-minutes,
  30-minutes or hourly), daily, weekly or monthly.
• Can be applied to any financial asset whos price
  is determined by supply and demand.
• Stock, bonds, foreign exchange, key commodities.

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Examples of Technical Approaches

• Moving Average Analysis of Stocks
• Where is the individual stock (or market) in
  relation to some moving average of past prices?
• If breaking above moving average, this is a
  signal of strength.
• If breaking below moving average, this is a
  signal of weakness.
• Overbought and Oversold Analysis of Stocks
• Is the individual stock (or market) trading above
  or below its historical range?
• Above its range suggests overbought condition.
• A signal that the stock (or market) should move
  down.
• Below its range suggests oversold condition.
• A signal that the stock (or market) should move
  up.
• Head and Shoulders Reversal Pattern of Stocks
• Specific price and volume pattern which signals a
  reversal of the prior trend.

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Moving Average DJIA Over the Last 3 Months
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Moving Average Coca Cola Over the Last 3 Months
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Overbought or Oversold Level 3
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Head and Shoulders Patterns

• Head and shoulders is a reversal pattern that,
  when formed, signals the security is likely to
  move against its previous trend.
• The signal appears to be most reliable (?) in
  detecting a reversal of an uptrend.
• A Head and Shoulders pattern consists of four
  distinct parts The left shoulder, the head, the
  right shoulder, and the neckline. Each of these
  four must be present for the formation to exist.
• In addition, the volume pattern must also meet
  strict requirements. Volume must show a peak on
  the left shoulder, a lower peak at the head, and
  then an even lower level at the right shoulder.

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Head and Shoulder Formation

• Left Shoulder A high volume rally and top
  followed by a minor reaction with significantly
  less volume than during the rise and top.
• Head Another high volume rally with the top
  reaching a higher level than the left shoulder,
  followed by a another reaction on less volume
  that takes the price to a level near the bottom
  of the previous reaction.
• Right Shoulder A third rally on noticeably less
  volume that fails to reach the top of the head.
• Neckline A decline in prices from the top of the
  right shoulder which falls below the line formed
  when connecting the bottoms of the left shoulder
  and head by at least 2-3 of the stock's market
  value.

• Head and Shoulders as a Reversal Pattern in an
  Uptrend

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Head and Shoulders as a Reversal Signal in an
Uptrend Diagnostics Products, November 2001
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Use of Technical Analysis in Foreign Exchange
Markets

• During the last 15 years or so beginning with
  joint research by Mark P. Taylor and Helen Allen
  (1990, 1992) a number of studies have reported
  the results of surveys of foreign exchange market
  participants in the major trading centers
  concerning the use of technical analysis. 
• These studies concluded that technical analysis
  is in widespread use among foreign exchange
  professionals.
• As early examples see
• Allen, Helen, and Mark P. Taylor. 1990. "Charts,
  Noise and Fundamentals in the London Foreign
  Exchange Market." Economic Journal 100
  (supplement) 49-59. 
• Taylor, Mark P., and Helen Allen. 1992. "The Use
  of Technical Analysis in the Foreign Exchange
  Market." Journal of International Money and
  Finance 11 304-14.

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Technical Analysis Foreign Exchange
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Source of Technical Charts

• For a discussion of types of technical signals
  see
• http//www.tradetrek.com/education/tech_tra/tech_t
  rading_strategy03.asp
• Data for individual stocks
• http//finance.yahoo.com/q?sgoog
• For charts of individual stocks and the market
• http//finance.yahoo.com/q/bc?sgoogt1d
• For interactive charts of individual stocks and
  the market
• http//finance.yahoo.com/chartschart1symbolgoog
  range1dindicatorvolumecharttypelinecrosshai
  ronlogscaleoffsource
• Data for U.S. market and overseas markets
• http//finance.yahoo.com/intlindices?u

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Appendix 1

• Interview with Benjamin Graham

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Interview with Graham in the 1970s

• Question In selecting the common stock
  portfolio, do you advise careful study of and
  selectivity among different issues?
• Graham In general, no. I am no longer an
  advocate of elaborate techniques of security
  analysis in order to find superior value
  opportunities. This was a rewarding activity,
  say, 40 years ago, when our textbook Graham and
  Dodd was first published but the situation has
  changed a great deal since then. In the old days
  any well-trained security analyst could do a good
  professional job of selecting undervalued issues
  through detailed studies but in the light of the
  enormous amount of research now being carried on,
  I doubt whether in most cases such extensive
  efforts will generate sufficiently superior
  selections to justify their cost. To that very
  limited extent Im on the side of the efficient
  market school of thought now generally accepted
  by the professors.

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Appendix 2 Three Forms of Market Efficiency and
Forecasting

• The following two slides discuss (1) the three
  forms of market efficiency and (2) the use of
  forecasting with these three forms.

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Three Forms of The Efficient Market Hypothesis

• There are actually three stages of the EMH model
• Weak Form Current prices reflect all past price
  and past volume information.
• The fundamental information contained in the past
  sequence of prices of a security is fully
  reflected in the current market price of that
  security.
• Semi-strong Form Current prices reflect all past
  price and past volume information AND all
  publicly available information.
• Information such as interest rates, earnings,
  inflation, etc.
• Strong Form Current prices reflect all past
  price and past volume information, all publicly
  available information publicly available
  information AND all private (e.g., insider)
  information.

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Forecasting asset prices within the 3 Types of
Efficient Markets

• Weak form In this type of a market, all past
  data and prices are reflected in the current
  prices.
• Thus, Technical Analysis is not of any use.
• Semi strong form In this type of a market, all
  public information is reflected in the current
  stock prices.
• Thus, here, even Fundamental Analysis is of no
  use (as well as technical analysis)
• Strong form In this type of market, all
  information is reflected in the current stock
  prices.
• Thus, not only is any kind of analysis useless,
  even insider information is useless for
  predicting future stock market prices.