Security analysis is the analysis of tradeable financial instruments called securities. It deals with finding the proper value of individual securities.

Security Analysis involves a systematic analysis of the “Risk-Return” profiles of various securities which is to help a rational investor to estimate a value for a company from all the price sensitive information/data so that the investor can decide whether to “Buy”, “Sell” or “Hold” a security and thereby earn a reasonable rate of return.

• Investment decision depends on securities to be bought, held or sold.
• Buying security is based on
  • highest return per unit of risk or
  • lowest risk per unit of return.
• A security considered for buying today may not be attractive tomorrow due to management policy changes in the company or economic policy changes adopted by the government.

Therefore, analysis of the security on a continuous basis is a must.

Approaches for Security analysis

Security analysis is broadly classified into:

1. Fundamental Analysis
2. Technical Analysis

In fundamental analysis, factors affecting risk-return characteristics of securities are looked into while in technical analysis, demand/ supply position of the securities along with prevalent share price trends are examined.

Fundamental Analysis

Fundamental analysis is a method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial, and other qualitative and quantitative factors.

Fundamental analysis, is the analysis of a business’s financial statements (usually to analyze the business’s assets, liabilities, and earnings); health; and its competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management.

Fundamental analysis is based on the assumption that the share prices depend upon the future dividends expected by the shareholders. The present value of the future dividends can be calculated by discounting the cash flows at an appropriate discount rate and is known as the ‘intrinsic value of the share’. The intrinsic value of a share, according to a fundamental analyst, depicts the true value of a share. A share that is priced below the intrinsic value must be bought, while a share quoting above the intrinsic value must be sold.

Thus, it can be said that the price the shareholders are prepared to pay for a share is nothing but the present value of the dividends they expect to receive on the share and this is the price at which they expect to sell it in the future.

Components of Fundamental Analysis

1. Economic Analysis
2. Industry Analysis
3. Company Analysis

Economic Analysis

Economic Analysis is the study of forces that determine the distribution of scarce resources. Economic analysis provides insight into how markets operate, and offers methods for attempting to predict future market behavior in response to events, trends, and cycles.

Economic Analysis is a systematic approach to determining the optimum use of scarce resources, involving comparison of two or more alternatives in achieving a specific objective under the given assumptions and constraints. Economic analysis takes into account the opportunity costs of resources employed and attempts to measure in monetary terms the private and social costs and benefits of a project to the community or economy.

Macro- economic factors e. g. historical performance of the economy in the past/ present and expectations in future, growth of different sectors of the economy in future with signs of stagnation/degradation at present to be assessed while analyzing the overall economy. Trends in peoples’ income and expenditure reflect the growth of a particular industry/company in future. Consumption affects corporate profits, dividends and share prices in the market.

Factors Affecting Economic Analysis

1. Growth Rate of Gross Domestic Product (GDP)

An economy’s overall economic activity is summarized by a measure of aggregate output. As the production or output of goods and services generates income, any aggregate output measure is closely associated with an aggregate income measure. The GDP is a measure of all currently produced goods and services valued at market prices. One should notice several features of the GDP measure. First, only currently produced goods (produced during the relevant year) are included. Secondly, only final goods and services are counted. In order to avoid double counting, intermediate goods—goods used in the production of other goods and services—do not enter the GDP. For example, steel used in the production of automobiles is not valued separately. Finally, all goods and services included in the GDP are evaluated at market prices. Thus, these prices reflect the prices consumers pay at the retail level, including indirect taxes such as local sales taxes.

2. Savings and investment

Growth of an economy requires proper amount of investments which in turn is dependent upon amount of domestic savings. The amount of savings is favorably related to investment in a country. The level of investment in the economy and the proportion of investment in capital market is major area of concern for investment analysts.

Stock market is an important channel to mobilize savings, from the individuals who have excess of it, to the individual or corporate, who have deficit of it. Savings are distributed over various assets like equity shares, bonds, small savings schemes, bank deposits, mutual fund units, real estates, bullion etc. The demand for corporate securities has an important bearing on stock prices movements. Greater the allocation of equity in investment, favorable impact it have on stock prices.

3. Industry Growth Rate

The GDP growth rate represents the average of the growth rate of agricultural sector, industrial sector and the service sector. Publicly listed company play a major role in the industrial sector. The stock market analysts focus on the overall growth of different industries contributing in economic development. The higher the growth rate of the industrial sector, other things being equal, the more favorable it is for the stock market.

4. Price Level and Inflation

The inflation rate is defined as the rate of change in the price level. Most economies face positive rates of inflation year after year. The price level, in turn, is measured by a price index, which measures the level of prices of goods and services at given time. The numbers of items included in a price index vary depending on the objective of the index. Usually three kinds of price indexes, having particular advantages and uses are periodically reported by government sources.

• The first index is called the consumer price index (CPI), which measures the average retail prices paid by consumers for goods and services bought by them.
• A second price index used to measure the inflation rate is called the producer price index (PPI). It is a much broader measure than the consumer price index.
• The third and broadest measure of inflation is the called the implicit GDP price deflator. This index measures the prices of all goods and services included in the calculation of the current output of goods and services in the economy, the GDP.

5. Agriculture and Monsoons

Agriculture is directly and indirectly linked with the industries. Hence increase or decrease in agricultural production has a significant impact on the industrial production and corporate performance. Companies using agricultural raw materials as inputs or supplying inputs to agriculture are directly affected by change in agriculture production. For example- Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw material. Fertilizer and insecticides industries are supplying inputs to agriculture. A good monsoon leads to higher demand for inputs and results in bumper crops. This would lead to buoyancy in stock market. If the monsoon is bad, agriculture production suffers and cast a shadow on the share market.

6. Interest Rate

The concept of interest rates used by economists is the same as the one widely used by ordinary people. The interest rate is invariably quoted in nominal terms—that is, it is not adjusted for inflation. Thus, the commonly followed interest rate is actually the nominal interest rate.

One should note that the nominal interest rate does not represent the real cost of borrowing or the real return on lending. To understand the real cost or return, one must consider the inflation-adjusted nominal rate, called the real interest rate. Tax and other considerations also influence the real cost or return. Nevertheless, the real interest rate is a very important concept in understanding the main incentives behind borrowing or lending.

7. Government Budget and Deficit

Government plays an important role in the growth of any economy. The government prepares a central budget which provides complete information on revenue, expenditure and deficit of the government for a given period. Government revenue come from various direct and indirect taxes and government made expenditure on various developmental activities. The excess of expenditure over revenue leads to budget deficit. For financing the deficit the government goes for external and internal borrowings. Thus, the deficit budget may lead to high rate of inflation and adversely affects the cost of production and surplus budget may results in deflation. Hence, balanced budget is highly favorable to the stock market.

8. The Tax Structure

The business community eagerly awaits the government announcements regarding the tax policy every year. The type of tax exemption has impact on the profitability of the industries. Concession and incentives given to certain industry encourages investment in that industry and have favorable impact on stock market.

9. Balance of Payment, Forex Reserves and Exchange Rate

Balance of payment is the record of all the receipts and payment of a country with the rest of the world. This difference in receipt and payment may be surplus or deficit. Balance of payment is a measure of strength of rupee on external account. The surplus balance of payment augments forex reserves of the country and has a favorable impact on the exchange rates; on the other hand if deficit increases, the forex reserve depletes and has an adverse impact on the exchange rates. The industries involved in export and import are considerably affected by changes in foreign exchange rates. The volatility in foreign exchange rates affects the investment of foreign institutional investors in Indian Stock Market. Thus, favorable balance of payment renders favorable impact on stock market.

10. Infrastructural Facilities and Arrangements

Infrastructure facilities and arrangements play an important role in growth of industry and agriculture sector. A wide network of communication system, regular supply or power, a well-developed transportation system (railways, transportation, road network, inland waterways, port facilities, air links and telecommunication system) boost the industrial production and improves the growth of the economy. Banking and financial sector should be sound enough to provide adequate support to industry and agriculture. The government has liberalized its policy regarding the communication, transport and power sector for foreign investment. Thus, good infrastructure facilities affect the stock market favorable.

11. Demographic factors

The demographic data details about the population by age, occupation, literacy and geographic location. These factors are studied to forecast the demand for the consumer goods. The data related to population indicates the availability of work force. The cheap labor force in India has encouraged many multinationals to start their ventures. Population, by providing labor and demand for products, affects the industry and stock market.

12. Sentiments

The sentiments of consumers and business can have an important bearing on economic performance. Higher consumer confidence leads to higher expenditure and higher business confidence leads to greater business investments. All this ultimately leads to economic growth. Thus, sentiments influence consumption and investment decisions and have a bearing on the aggregate demand for goods and services.

Techniques Used in Economic Analysis

1. Anticipatory Surveys

Some elements of the future are known with reasonable accuracy. Government spending is reflected in existing budgets. These budgets indicate how much will be spent and how much money will be extracted from the stream of private spending by taxation. Similar information is available on some parts of the private economy. Periodic surveys  conducted both by government and by private organizations measure business plans to invest in new plants and equipment. Increasingly, attempts are made to probe the mood and intentions of consumers concerning the possible purchase of automobiles, houses, appliances, and other durable goods. In general, such information obtained from the various surveys of investment plans, spending plans, and attitudes has been highly useful to economic forecasters. Such information helps to limit the range of possibility.

2. Barometric or Indicator Approach

When the estimation on certain time series is done through observation (indicators) on another time series, then that method is known as barometric method of demand forecasting.  This is the method that makes use of various indicators to predict the future. What is meant by economic indicators? Economic indicators refer to the statistical data or information relating to various economic areas. We understand that the business cycle goes through various ups and downs. The analysis or understanding of the business cycles in extremely important because it would show where exactly the economy is heading to. These indicators help in understanding how the economy is performing and also gives a sense of how the performance would be in the upcoming times.

These indicators can be grouped into three types on the basis of their timings with respect to the happening of the events.

• Leading indicators:

These indicators as the name suggest move ahead of the happening. In other words when an even that has already happened is used to predict the future event, then the already happened even would act as a leading indicator. For instance the data relating to working women would act as a leading indicator for the demand of working women hostels.

Though such leading indicators provide a way to understand the future demand, their major drawback is that they may not be always precise. What are the prominent examples of leading economic indicators? They would be data related to mean week hours of work put in by the workers, producers’ fresh orders for consumer goods, consumer expectations index, producers’ fresh orders of capital goods etc.

• Coincident indicators:

These are those indicators that take place simultaneously to the happening. These coincident indicators would include data relating to people employed in non-agricultural sectors, production of the industrial sector, personal income etc. These indicators too depict the state of the economy. For instance if the data related to industrial production show strong numbers, then it shows that the economy is performing well. On the other hand disappointing industrial production numbers would reflect poor state of the economy.

• Lagging indicators:

These indicators are those which take place after the happening. These indicators are essential to understand how the economy would shape up in the future because these follow the economic cycle. In other words these indicators show the way to the future. Hence lagging indicators are those which are the most important ones and are extremely useful in predicting the future economic events. Inflation and data relating to unemployment levels are the top indicators that help in understanding or analysing the performance of the economy.

3. Econometric Model Building:

Economists frequently use mathematical equations to express the normal relations between various economic factors. As a simple example, a given increase in consumer income will ordinarily produce a certain increase in sales, saving, and tax revenue, and these developments can be expressed mathematically. With a sufficient number of equations, all the important interactions within the economy can be simulated in a mathematical model. With the advent of computers able to make millions of calculations in a few moments, economists began to construct more and more complex sets of equations, called econometric models. These models, some of which include hundreds of equations, can be used to forecast overall economic activity (macroeconomic forecasting) or developments in particular parts of the economy (microeconomic forecasting). The success of econometric forecasting has so far been limited because the exact nature of economic relations is not fully known, and also because of the inadequacies of existing statistics. Nevertheless, the improvement of these techniques represents the greatest hope for more accurate economic forecasting in the future.

Industry Analysis

Industry analysis is a market assessment tool used by businesses and analysts to understand the competitive dynamics of an industry. It helps them get a sense of what is happening in an industry, i.e., demand-supply statistics, degree of competition within the industry, state of competition of the industry with other emerging industries, future prospects of the industry taking into account technological changes, credit system within the industry, and the influence of external factors on the industry.

Industry analysis, for an entrepreneur or a company, is a method that helps it to understand its position relative to other participants in the industry. It helps them to identify both the opportunities and threats coming their way and gives them a strong idea of the present and future scenario of the industry. The key to surviving in this ever-changing business environment is to understand the differences between yourself and your competitors in the industry and using it to your full advantage.

When an economy grows, it is very unlikely that all industries in the economy would grow at the same rate. So it is necessary to examine industry specific factors, in addition to economy-wide factors.

First of all, an assessment has to be made regarding all the conditions and factors relating to demand of the particular product, cost structure of the industry and other economic and Government constraints on the same. Since the basic profitability of any company depends upon the economic prospects of the industry to which it belongs, an appraisal of the particular industry’s prospects is essential.

Factors Affecting Industry Analysis

1. Product Life-Cycle

An industry usually exhibits high profitability in the initial and growth stages, medium but steady profitability in the maturity stage and a sharp decline in profitability in the last stage of growth.

2. Demand Supply Gap

Excess supply reduces the profitability of the industry because of the decline in the unit price realization, while insufficient supply tends to improve the profitability because of higher unit price realization.

3. Barriers to Entry

Any industry with high profitability would attract fresh investments. The potential entrants to the industry, however, face different types of barriers to entry. Some of these barriers are innate to the product and the technology of production, while other barriers are created by existing firms in the industry.

4. Government Attitude

The attitude of the government towards an industry is a crucial determinant of its prospects.

5. State of Competition in the Industry

Factors to be noted are- firms with leadership capability and the nature of competition amongst them in foreign and domestic market, type  of products manufactured viz. homogeneous or highly differentiated, demand prospects through classification viz customer-wise/area-wise, changes in demand patterns in the long/immediate/ short run, type of industry the firm is placed viz. growth, cyclical, defensive  or decline.

6. Cost Conditions and Profitability

The price of a share depends on its return, which in turn depends on profitability of the firm. Profitability depends on the state of competition in the industry, cost control measures adopted by its units and growth in demand for its products.

Factors to be considered are:

• Cost allocation among various heads
• Product price.
• Production capacity in terms of installation, idle and operating.
• Level of capital expenditure required

7. Technology and Research

They play a vital role in the growth and survival of a particular industry. Technology is subject to change very fast leading to obsolescence. Industries which update themselves have a competitive advantage over others in  terms of quality, price  etc.

Things to be probed in this regard are:

• Nature and type of technology used.
• Expected changes in technology for new products.
• Relationship of capital expenditure and sales over time.
• Money spent in research and development.
• Assessment of industry in terms of sales and profitability in short, immediate and long run.

Types of Industry Analysis

There are three commonly used and important methods of performing industry analysis.  The three methods are:

1. Porter’s 5 Forces
2. PEST Analysis
3. SWOT Analysis

Porter’s 5 Forces

One of the most famous models ever developed for industry analysis, famously known as Porter’s 5 Forces, was introduced by Michael Porter in his 1980 book “Competitive Strategy: Techniques for Analyzing Industries and Competitors.”

According to Porter, analysis of the following five forces gives an accurate impression of the industry and makes analysis easier.

1. Ease of Entry

This indicates the ease with which new firms can enter the market of a particular industry. If it is easy to enter an industry, companies face the constant risk of new competitors. If the entry is difficult, whichever company enjoys little competitive advantage reaps the benefits for a longer period. Also, under difficult entry circumstances, companies face a constant set of competitors.

2. Power of Suppliers

This refers to the bargaining power of suppliers. If the industry relies on a small number of suppliers, they enjoy a considerable amount of bargaining power. This can affect small businesses because it directly influences the quality and the price of the final product.

3. Power of Buyers

The complete opposite happens when the bargaining power lies with the customers. If consumers/buyers enjoy market power, they are in a position to negotiate lower prices, better quality or additional services and discounts. This is the case in an industry with more competitors but a single buyer constituting a large share of the industry’s sales.

4. Availability of Substitutes

The industry is always competing with another industry in producing a similar substitute product. Hence, all firms in an industry have potential competitors from other industries. This takes a toll on their profitability because they are unable to charge exorbitant prices. Substitutes can take two forms – products with the same function/quality but lesser price or products of the same price but of better quality or providing more utility.

5. Competitors

The number of participants in the industry and their respective market shares are a direct representation of the competitiveness of the industry. These are directly affected by all the factors mentioned above. Lack of differentiation in products tends to add to the intensity of competition. High exit costs like high fixed assets, government restrictions, labor unions, etc. also make the competitors fight the battle a little harder.

PEST Analysis

PEST Analysis stands for Political, Economic, Social and Technological.  PEST analysis is a useful framework for analyzing the external environment.

To use PEST as a form of industry analysis, an analyst will analyze each of the 4 components of the model.  These components include:

1. Political

Political factors that impact an industry include specific policies and regulations related to things like taxes, environmental regulation, tariffs, trade policies, labor laws, ease of doing business, and the overall political stability.

2. Economic

The economic forces that have an impact include inflation, exchange rates (FX), interest rates, GDP growth rates, conditions in the capital markets (ability to access capital) etc.

3. Social

The social impact on an industry refers to trends among people and includes things such as population growth, demographics (age, gender, etc), and trends in behavior such as health, fashion, and social movements.

4. Technological

The technological aspect of PEST analysis incorporates factors such as advancements and developments that change that way business operates and the ways which people live their lives (i.e. advent of the internet).

SWOT Analysis

SWOT Analysis stands for Strengths, Weaknesses, Opportunities, and Threats.  It can be a great way of summarizing various industry analysis methods and determining their implications for the business in question.

Company Analysis

Economic and industry framework provides the investor with proper background against which shares of a particular company are purchased. This requires careful examination of the company’s quantitative and qualitative fundamentals.

1. Net Worth and Book Value

Net Worth is sum of equity share capital, preference share capital and free reserves less intangible assets and any carry forward of  losses. The  total net worth divided by the number of shares is the much talked about book value of a share. Though the book value is often seen as an indication of the intrinsic worth of the share, this may not be so for two major reasons. First, the market price of the share reflects the future earnings potential of the firm which may have no relationship with the value of its assets. Second, the book value is based upon the historical costs of the assets of the firm and these may be gross underestimates of the cost of the replacement or resale  values  of  these assets.

2. Sources and Uses of Funds

The identification of sources and uses of funds is known as Funds Flow Analysis. One of the major uses of funds flow analysis is to find out whether the firm has used short-term sources of funds to finance long-term investments. Such methods of financing increases the risk of liquidity crunch for the firm, as long-term investments, because of the gestation period involved may not generate enough surpluses in time to meet the short-term liabilities incurred by the firm. Many a firm has come to grief because of this mismatch between the maturity periods of sources and uses of funds.

3. Cross-Sectional and Time Series Analysis

One of the main purposes of examining financial statements is to compare two firms, compare a firm against some benchmark figures for its industry and to analyze the performance of a firm over time. The techniques that are used to do such proper comparative analysis are: common-sized statement, and financial ratio analysis.

4. Size and Ranking

A rough idea regarding the size and ranking of the company within the economy, in general, and the industry, in particular, would help the investment manager in assessing the risk associated with the company. In this regard the net capital employed, the net profits, the return on investment and the sales figures of the company under consideration may be compared with similar data of other companies in the same industry group. It may also be useful to assess the position of the company in terms of technical know-how, research and development activity and price leadership.

5. Growth Record

The growth in sales, net income, net capital employed and earnings per share of the company in the past few years should be examined. The following three growth indicators may be particularly looked into:

• Price earnings ratio,
• Percentage growth rate of earnings per annum, and
• Percentage growth rate of net block.

Economic and industry framework provides the investor with proper background against which shares of a particular company are purchased. This requires careful examination of the company’s quantitative and qualitative fundamentals.

6. Financial Analysis

An analysis of its financial statements for the past few  years  would help  the investment manager in understanding the financial solvency and liquidity, the efficiency with which the funds are used, the profitability, the operating efficiency and the financial and operating leverages of the company. For this purpose, certain fundamental ratios have to be calculated.

From the investment point of view, the most important figures are earnings  per  share,  price earning ratios, yield, book value and the intrinsic value of the share. These five elements may be calculated for the past 10 years or so and compared with similar ratios computed from the financial accounts of other companies in the industry and with the average ratios for the  industry  as  a whole. The yield and the asset backing of a share are important considerations in a decision regarding whether the particular market price of the share is proper or not.

Various other ratios to measure profitability, operating efficiency and turnover efficiency of the company may also be calculated. The return on owners’ investment, capital turnover ratio and the cost structure ratios may also be worked out.

To examine the financial solvency or liquidity of the company, the investment manager may work out current ratio, liquidity ratio, debt-equity ratio, etc. These ratios will provide an  overall view of   the company to the investment analyst. He can analyse its strengths and weaknesses and see whether it is worth the risk or not.

7. Competitive Advantage

Another business consideration for investors is competitive advantage. A company’s long-term success is driven largely by its ability to  maintain  its  competitive advantage. Powerful competitive advantages, such as Apple’s brand name and Samsung’s domination of the mobile market, create a shield around a business that allows it to keep competitors at a distance.

8. Quality of Management

This is an intangible factor. Yet it has a very important bearing on the value of the shares. Every investment manager knows that the shares of certain business houses command a higher premium than those of similar companies managed by other business houses. This is because of the quality of management, the confidence that investors have in a particular business house, its policy vis-a-vis its relationship with the investors, dividend and financial performance record of other companies in the same group, etc. This is perhaps the reason that an investment manager always gives a close look to the management of a company in whose shares he is to invest. Quality of management has to be seen with reference to the experience, skills and integrity of the persons at the helm of affairs of the company. The policy of the management regarding relationship with the shareholders is an important factor since certain business houses believe in very generous dividend and bonus distributions while others are rather conservative.

9. Corporate Governance

Following factors are to be kept in mind while judging the effectiveness of corporate governance of an organization:

• Whether company is complying with all aspects of clause 49.
• How well corporate governance policies serve stakeholders?
• Quality and timeliness of company financial disclosures.
• Whether quality independent directors are inducted.

10. Regulation

Regulations plays an important role in maintaining the sanctity of the corporate form of organization. In Indian listed companies, Companies Act, Securities Contract and Regulation Act and SEBI Act basically look after regulatory aspects of a company. A  listed  company is also continuously monitored by SEBI which through its guidelines and regulations protect the interest of investors.

Further, a company which is dealing with companies outside India, needs to comply with Foreign Exchange Management Act (FEMA) also. In this scenario, the Reserve Bank of India (RBI) does a continuous monitoring.

11. Location and Labour-Management Relations

The locations of the company’s manufacturing facilities determines its economic viability which depends on the availability of crucial inputs like power, skilled labour and raw-materials, etc. Nearness to markets is also a  factor  to  be  considered.

In the past few years, the investment manager has begun looking into the state of labour- management relations in the company under consideration and the area where it is located.

12. Pattern of Existing Stock Holding

An analysis of the pattern of existing stock holdings of the company would also be relevant. This would show the stake of various parties in the company. An interesting case in this regard is that of the Punjab National Bank in which the Life Insurance Corporation and other financial institutions had substantial holdings. When the bank was nationalised, the residual company proposed a scheme whereby those shareholders, who wish to opt out, could receive a certain amount as compensation in cash. It was only at the instance and the bargaining strength, of institutional investors that the compensation offered  to  the shareholders, who wished to opt out of the company, was raised considerably.

13. Marketability of the Shares:

Another important consideration for an investment manager is  the marketability of the shares of the company. Mere listing of a share on the stock exchange does not automatically mean that the share can be sold or purchased at will. There are many shares which remain inactive for long periods with no transactions being effected. To purchase or  sell such scrips is a difficult task. In this regard, dispersal of shareholding with special reference to the extent of public holding should be seen. The other relevant factors are the speculative interest in the particular scrip, the particular stock exchange where it is traded and the volume of trading.

Technical Analysis

Technical analysis is a trading tool employed to evaluate securities and identify trading opportunities by analyzing statistics gathered from trading activity, such as price movement and volume. Unlike fundamental analysts who attempt to evaluate a security’s intrinsic value, technical analysts focus on charts of price movement and various analytical tools to evaluate a security’s strength or weakness.

Technical analysts believe past trading activity and price changes of a security are better indicators of the security’s likely future price movements than the intrinsic value of the security. Technical analysis was formed out of basic concepts gleaned from Dow Theory, a theory about trading market movements that came from the early writings of Charles Dow. Two basic assumptions of Dow Theory that underlie all of technical analysis are 1) market price discounts every factor that may influence a security’s price and 2) market price movements are not purely random but move in identifiable patterns and trends that repeat over time.

The assumption that price discounts everything essentially means the market price of a security at any given point in time accurately reflects all available information, and therefore represents the true fair value of the security. This assumption is based on the idea the market price always reflects the sum total knowledge of all market participants.

The second basic assumption underlying technical analysis, the notion that price changes are not random, leads to the belief of technical analysts that market trends, both short term and long term, can be identified, enabling market traders to profit from investing according to the existing trend.

Technical analysis is used to attempt to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, technical analysis can be viewed as simply the study of supply and demand forces as reflected in the market price movements of a security. It is most commonly applied to price changes, but some analysts may additionally track numbers other than just price, such as trading volume or open interest figures.

Over the years, numerous technical indicators have been developed by analysts in attempts to accurately forecast future price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators include trend lines, moving averages and momentum indicators such as the moving average convergence divergence (MACD) indicator.

Technical analysts apply technical indicators to charts of various timeframes. Short-term traders may use charts ranging from one-minute timeframes to hourly or four-hour timeframes, while traders analyzing longer-term price movement scrutinize daily, weekly or monthly charts.

Theories of Technical Analysis

1. The Dow Theory
2. Elliot Wave Theory
3. Random Walk Theory

The Dow Theory

Any attempt to trace the origins of technical analysis would inevitably lead to Dow Theory. While more than 100 years old, Dow Theory remains the foundation of much of what we know today as technical analysis.

Dow Theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment.

Dow believed that the stock market as a whole was a reliable measure of overall business conditions within the economy and that by analyzing the overall market, one could accurately gauge those conditions and identify the direction of major market trends and the likely direction of individual stocks.

Dow first used his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index (now Transportation Index), which were originally compiled by Dow for The Wall Street Journal. Dow created these indexes because he felt they were an accurate reflection of the business conditions within the economy because they covered two major economic segments: industrial and rail (transportation). While these indexes have changed over the last 100 years, the theory still applies to current market indexes.

Much of what we know today as technical analysis has its roots in Dow’s work. For this reason, all traders using technical analysis should get to know the six basic tenets of Dow Theory. Let’s explore them.

The first basic premise of Dow Theory suggests that all information – past, current and even future – is discounted into the markets and reflected in the prices of stocks and indexes.

That information includes everything from the emotions of investors to inflation and interest-rate data, along with pending earnings announcements to be made by companies after the close. Based on this tenet, the only information excluded is that which is unknowable, such as a massive earthquake. But even then the risks of such an event are priced into the market.

It’s important to note that this is not to suggest that market participants, or even the market itself, are all knowing, with the ability to predict future events. Rather, it means that over any period of time, all factors – those that have happened, are expected to happen and could happen – are priced into the market.

As things change, such as market risks, the market adjusts along with the prices, reflecting that new information. In fundamental terms, this idea is related to the work of Eugene Fama, which originated in the 1960s and is known as the efficient market hypothesis. While Dow Theory differs in that it is used to predict future trends, the idea that all market information is priced in is what is comparable.

An important part of Dow Theory is distinguishing the overall direction of the market. To do this, the theory uses trend analysis.

Before we can get into the specifics of Dow Theory trend analysis, we need to understand trends. First, it’s important to note that while the market tends to move in a general direction, or trend, it doesn’t do so in a straight line. The market will rally up to a high (peak) and then sell off to a low (trough), but will generally move in one direction.

An upward trend is broken up into several rallies, where each rally has a high and a low. For a market to be considered in an uptrend, each peak in the rally must reach a higher level than the previous rally’s peak, and each low in the rally must be higher than the previous rally’s low.

A downward trend is broken up into several drops, in which each sell-off also has a high and a low. To be considered a downtrend in Dow terms, each new low in the drop must be lower than the previous drop’s low and the peak in the drop must be lower than the peak in the previous drop.

Dow Theory identifies three trends within the market: primary, secondary and minor. A primary trend is the largest trend lasting for more than a year, while a secondary trend is an intermediate trend that lasts three weeks to three months and is often associated with a movement against the primary trend. Finally, the minor trend often lasts less than three weeks and is associated with the movements in the intermediate trend.

Primary Trend

In Dow Theory, the primary trend is the major trend of the market, which makes it the most important one to determine. This is because the overriding trend is the one that affects the movements in stock prices. The primary trend will also impact the secondary and minor trends within the market.

Secondary (Intermediate) Trend

In Dow theory, a primary trend is the main direction in which the market is moving. Conversely, a secondary trend moves in the opposite direction of the primary trend, or as a correction to the primary trend.

For example, an upward primary trend will be composed of secondary downward trends. This is the movement from a consecutively higher high to a consecutively lower high. In a primary downward trend the secondary trend will be an upward move, or a rally. This is the movement from a consecutively lower low to a consecutively higher low.

In general, a secondary, or intermediate, trend typically lasts between three weeks and three months, while the retracement of the secondary trend generally ranges between one-third to two-thirds of the primary trend’s movement.

Minor Trend or Daily Fluctuations

The last of the three trend types in Dow Theory is the minor trend, which is defined as a market movement lasting less than three weeks. The minor trend is generally the corrective moves within a secondary move, or those moves that go against the direction of the secondary trend.

Due to its short-term nature and the longer-term focus of Dow Theory, the minor trend is not of major concern to Dow Theory followers. But this doesn’t mean it is completely irrelevant; the minor trend is watched with the large picture in mind, as these short-term price movements are a part of both the primary and secondary trends.

Most proponents of Dow Theory focus their attention on the primary and secondary trends, as minor trends tend to include a considerable amount of noise. If too much focus is placed on minor trends, it can to lead to irrational trading, as traders get distracted by short-term volatility and lose sight of the bigger picture.

Three Phases of the Primary Upward Trend as per Dow Theory

Since the most vital trend to understand is the primary trend, this leads into the third tenet of Dow theory, which states that there are three phases to every primary trend:

• Accumulation phase,
• Public participation phase
• Distribution phase (Beginning of downward trend)

1. Accumulation Phase

The first stage of a bull market is referred to as the accumulation phase, which is the start of the upward trend. This is also considered the point at which informed investors start to enter the market.

The accumulation phase typically comes at the end of a downtrend, when everything is seemingly at its worst. But this is also the time when the price of the market is at its most attractive level because by this point most of the bad news is priced into the market, thereby limiting downside risk and offering attractive valuations.

However, the accumulation phase can be the most difficult one to spot because it comes at the end of a downward move, which could be nothing more than a secondary move in a primary downward trend – instead of being the start of a new uptrend. This phase will also be characterized by persistent market pessimism, with many investors thinking things will only get worse.

2. Public participation Phase

When informed investors entered the market during the accumulation phase, they did so with the assumption that the worst was over and a recovery lay ahead. As this starts to materialize, the new primary trend moves into what is known as the public participation phase.

During this phase, negative sentiment starts to dissipate as business conditions – marked by earnings growth and strong economic data – improve. As the good news starts to permeate the market, more and more investors move back in, sending prices higher.

This phase tends not only to be the longest lasting, but also the one with the largest price movement. It’s also the phase in which most technical and trend traders start to take long positions, as the new upward primary trend has confirmed itself – a sign these participants have waited for.

3. Distribution phase

As the market has made a strong move higher on the improved business conditions and buying by market participants to move starts to age, we begin to move into the excess phase. At this point, the market is hot again for all investors.

The last stage in the upward trend, the excess phase, is the one in which the smart money starts to scale back its positions, selling them off to those now entering the market.

This is also usually the time when the last of the buyers start to enter the market – after large gains have been achieved. Like lambs to the slaughter, the late entrants hope that recent returns will continue. Unfortunately for them, they are buying near the top.

During this phase, a lot of attention should be placed on signs of weakness in the trend, such as strengthening downward moves. Also, if the upward moves start to show weakness, it could be another sign that the trend may be near the start of a primary downtrend.

Six Components of the Dow Theory

1. The market has three movements
2. Market trends have three phases
3. The stock market discounts all news
4. Stock market averages must confirm each other
5. Trends are confirmed by volume
6. Trends exist until definitive signals prove that they have ended

Elliot Wave Theory

Elliott Wave Theory is named after Ralph Nelson Elliott (28 July 1871 – 15 January 1948). He was an American accountant and author. Inspired by the Dow Theory and by observations found throughout nature, Elliott concluded that the movement of the stock market could be predicted by observing and identifying a repetitive pattern of waves.

Elliott was able to analyze markets in greater depth, identifying the specific characteristics of wave patterns and making detailed market predictions based on the patterns. Elliott based part his work on the Dow Theory, which also defines price movement in terms of waves, but Elliott discovered the fractal nature of market action. Elliott first published his theory of the market patterns in the book titled The Wave Principle in 1938.

Basic Principle of the 1930’s Elliott Wave Theory

Elliott Wave theory is one of the most accepted and widely used forms of technical analysis. It describes the natural rhythm of crowd psychology in the market, which manifests itself in waves. The essence of Elliott waves is that prices alternate between impulsive phases that establish the trend and corrective phases that retrace the trend. In their most basic and straightforward form, impulses contain 5 lower degree waves and corrections contain 3 lower degree waves.

Elliott Wave is fractal and the underlying pattern remains constant. The 5 + 3 waves define a complete cycle. They can form different patterns such as ending diagonals, expanded flats, zigzag corrections and triangles. Fifteen different degrees of waves can be identified with each of the 5 smart drawing tools, allowing users to visually identify different degrees of waves on a chart. The key to trading Elliott waves successfully is counting them correctly for which there are rules and guidelines.

Simply put, movement in the direction of the trend is unfolding in 5 waves (called motive wave or impulsive wave) while any correction against the trend is in three waves (called corrective wave). The movement in the direction of the trend is labelled as 1, 2, 3, 4, and 5. The three wave correction is labelled as a, b, and c. These patterns can be seen in long term as well as short term charts.

Ideally, smaller patterns can be identified within bigger patterns. In this sense, Elliott Waves are like a piece of broccoli, where the smaller piece, if broken off from the bigger piece, does, in fact, look like the big piece. This information (about smaller patterns fitting into bigger patterns), coupled with the Fibonacci relationships between the waves, offers the trader a level of anticipation and/or prediction when searching for and identifying trading opportunities with solid reward/risk ratios.

Impulsive Patterns (Basic Waves)

In this pattern there will be 3 or 5 waves in a given direction (going upward or downward). These waves shall move in the direction of the basic movement. This movement can indicate bull phase or bear phase.

Corrective Patterns (Reaction Waves)

These 3 waves are against the basic direction of the basic movement. Correction involves correcting the earlier rise in case of bull market and fall in case of bear market.

 

In Elliott’s model, market prices alternate between an impulsive, or motive phase, and a corrective phase on all time scales of trend. Impulses are always subdivided into a set of 5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3.

In the above Figure, wave (1), (3) and (5) are motive waves and they are subdivided into 5 smaller degree impulses labelled as 1, 2, 3, 4 and 5. Wave (2) and (4) are corrective waves and they are subdivided into 3 smaller degree waves labelled as A, B and C. The 5 waves move in wave 1, 2, 3, 4, and 5 make up a larger degree motive wave (1)

Corrective waves subdivide into 3 smaller-degree waves, denoted as ABC. Corrective waves start with a five-wave counter-trend impulse (wave A), a retrace (wave B), and another impulse (wave C). The 3 waves A, B, and C make up a larger degree corrective wave (2)

Random Walk Theory

The random walk theory suggests that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement. In short, this is the idea that stocks take a random and unpredictable path.

A follower of the random walk theory believes it’s impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time – in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.

Efficient Markets are Random

This theory raised a lot of eyebrows in 1973 when author Burton Malkiel wrote “A RANDOM WALK DOWN WALL STREET.” The book popularized the efficient market hypothesis, an earlier theory posed by University of Chicago professor William Sharp. The efficient market hypothesis says that stock prices fully reflect all available information and expectations, so current prices are the best approximation of a company’s intrinsic value. This would preclude anyone from exploiting mispriced stocks on a consistent basis because price movements are largely random and driven by unforeseen events. Sharp and Malkiel concluded that, due to the short-term randomness of returns, investors would be better off investing in a passively managed, well-diversified fund. In his book, Malkiel stated that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

While discussing the Dow Jones theory, we have seen that the theory is based on the assumption that the behavior of stock market itself contains trends which give clues to the future behavior of stock market prices. Thus supporters of the theory argue that market prices can be predicted if their patterns can be properly understood. Such analysis of stock market patterns is called technical analysis. Apart from this theory there are many approaches to technical analysis. Most of them, however, involve a good deal of subjective judgment.

Many investment managers and stock market analysts believe that stock market prices can never be predicted because they are not a result of any underlying factors but are mere statistical ups and downs. This hypothesis is known as Random Walk hypothesis which states that the behavior of stock market prices is unpredictable and that there is no relationship between the present prices of the shares and their future prices. Proponents of this hypothesis argue that stock market prices are independent.

A British statistician, M. G. Kendell, found that changes in security prices behave nearly as if they are generated by a suitably designed roulette wheel for which each outcome is statistically independent of the past history. In other words, the fact that there are peaks and troughs in stock exchange prices is a mere statistical happening – successive peaks and troughs are unconnected. In the layman’s language it may be said that prices on  the stock exchange behave exactly the way a drunk would behave while walking in a blind lane, i.e., up and down, with an unsteady way going in any direction he likes, bending on  the side once and on  the other side the second time.

The supporters of this theory put out a simple argument. It follows that:

• Prices of shares in stock market can never be predicted.
• The reason is that the price trends are not the result of any underlying factors, but that they represent a statistical expression of past data.
• There may be periodical ups or downs in share prices, but no connection can be established between two successive peaks (high price of stocks) and troughs (low price of stocks).

Charting Techniques

• Point & Figure Chart
• Line Chart
• Bar Chart
• Candlestick Chart

Point & Figure Chart

A point & figure chart is a chart that plots day-to-day price movements without taking into consideration the passage of time. Point and figure charts are composed of a number of columns that either consist of a series of stacked X’s or O’s. A column of X’s is used to illustrate a rising price, while O’s represent a falling price. As you can see from the chart below, this type of chart is used to filter out non-significant price movements, and enables the trader to easily determine critical support and resistance levels. Traders will place orders when the price moves beyond identified support/resistance levels.

Additional points are added to the chart once the price changes by more than a predefined amount (known as the box size). For example, if the box size is set to equal one and the price of the asset is $15, then another X will be added to the stack of Xs once the price surpasses $16. Each column consists of only one letter (either X or O) – never both. New columns are placed to the right of the previous column and are only added once the price changes direction by more than a predefined reversal amount.

Point & Figure Chart

 

Line Chart

A line chart connects a series of data points with a line and is used by traders to monitor closing prices. This is the most basic type of chart used in finance and is created by joining a series of closing prices together. Line charts can be used on any timeframe.

Line charts are the most basic type of chart because it represents only the closing prices over a set period. The line is formed by connecting the closing prices for each period over the timeframe. While this type of chart doesn’t provide much insight into intraday price movements, many investors consider the closing price to be more important than the open, high, or low price within a given period. These charts also make it easier to spot trends since there’s less ‘noise’ happening compared to other chart types.

Line Chart

 

Bar Chart

In a bar chart, a vertical line (bar) represents the lowest to the highest price, with a short horizontal line protruding from the bar representing the closing price for the period. Since volume and price data are often interpreted together, it is a common practice to plot the volume traded, immediately below the line and the bar charts.

A bar chart is a style of chart used by some technical analysts on which the top of the vertical line indicates the highest price a security is traded at during the day, and the bottom represents the lowest price. The closing price is displayed on the right side of the bar, and the opening price is shown on the left side of the bar.

A single bar represents one day of trading. These are the most popular type of charts used in technical analysis. The visual representation of price activity over a given period of time is used to spot trends and patterns. Bar charts are very similar to Japanese candlestick charts with the exception of the bodies not being filled on bar charts.

Candlestick Chart

Candlestick charts originated in Japan over 100 years before the West developed the bar and point-and-figure charts. In the 1700s, a Japanese man named Homma discovered that, while there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of traders. Candlesticks show that emotion by visually representing the size of price moves with different colors. Traders use the candlesticks to make trading decisions based on regularly occurring patterns that help forecast the short-term direction of the price.

Just like a bar chart, a daily candlestick shows the market’s open, high, low and close price for the day. The candlestick has a wide part, which is called the “real body.” This real body represents the price range between the open and close of that day’s trading. When the real body is filled in or black, it means the close was lower than the open. If the real body is empty, it means the close was higher than the open.

Candlestick Chart

 

Market indicators

All of the technical analysis tools discussed up to this point were calculated using a security’s price (e.g., high, low, close, volume, etc). There is another group of technical analysis tools designed to help you gauge changes in all securities within a specific market. These indicators are usually referred to as “market indicators,” because they gauge an entire market, not just an individual security. Market indicators typically analyze the stock market, although they can be used for other markets (e.g., futures).

While the data fields available for an individual security are limited to its open, high, low, close, volume (see page ), and sparse financial reports, there are numerous data items available for the overall stock market. For example, the number of stocks that made new highs for the day, the number of stocks that increased in price, the volume associated with the stocks that increased in price, etc. Market indicators cannot be calculated for an individual security because the required data is not available.

Market indicators add significant depth to technical analysis, because they contain much more information than price and volume. A typical approach is to use market indicators to determine where the overall market is headed and then use price/volume indicators to determine when to buy or sell an individual security. The analogy being “all boats rise in a rising tide,” it is therefore much less risky to own stocks when the stock market is rising.

Categories of market indicators

• Monetary indicators
• Sentiment indicators
• Momentum indicators

Monetary Indicators

Monetary indicators concentrate on economic data such as interest rates. They help you determine the economic environment in which businesses operate. These external forces directly affect a business’ profitability and share price. Examples of monetary indicators are interest rates, the money supply, consumer and corporate debt, and inflation. Due to the vast quantity of monetary indicators, I only discuss a few of the basic monetary indicators in this book.

Sentiment Indicators

Sentiment indicators focus on investor expectations–often before those expectations are discernible in prices. With an individual security, the price is often the only measure of investor sentiment available. However, for a large market such as the New York Stock Exchange, many more sentiment indicators are available. These include the number of odd lot sales (i.e., what are the smallest investors doing?), the put/call ratio (i.e., how many people are buying puts versus calls?), the premium on stock index futures, the ratio of bullish versus bearish investment advisors, etc.

Momentum Indicators

The third category of market indicators, momentum, show what prices are actually doing, but do so by looking deeper than price. Examples of momentum indicators include all of the price/volume indicators applied to the various market indices (e.g., the MACD of the Dow Industrials), the number of stocks that made new highs versus the number of stocks making new lows, the relationship between the number of stocks that advanced in price versus the number that declined, the comparison of the volume associated with increased price with the volume associated with decreased price, etc.

1. Breadth Index

It is an index that covers all securities traded. It is computed by dividing the net advances or declines in the market by the number of issues traded. The breadth index either supports or contradicts the movement of the Dow Jones Averages. If it supports the movement of the Dow Jones Averages, this is considered sign of technical strength and if it does not support the averages, it is a sign of technical weakness i.e. a sign that the market will move in a direction opposite to the Dow Jones Averages. The breadth index is an addition to the Dow Theory and the movement of the Dow Jones Averages.

2. Volume of Transactions

The volume of shares traded in the market provides useful clues on how the market would behave in the near future. A rising index/price with increasing volume would signal buy behavior because the situation reflects an unsatisfied demand in the market. Similarly, a falling market with increasing volume signals a bear market and the prices would be expected to fall further. A rising market with decreasing volume indicates a bull market while a falling market with dwindling volume indicates a bear market. Thus, the volume concept is best used with another market indicator, such as the Dow Theory.

3. Confidence Index

It is supposed to reveal how willing the investors are to take a chance in  the market. It is the ratio of high-grade bond yields to low-grade bond yields. It is used by market analysts as a method of trading or timing the purchase and sale of stock, and also, as a forecasting device to determine the turning points of the market. A rising confidence index is expected to precede a rising stock market, and a fall in the index is expected to precede a drop in stock prices. A fall in the confidence index represents the fact that low-grade bond yields are rising faster or falling more slowly than high grade yields. The confidence index is usually, but not always a leading indicator of the market. Therefore, it should be used in conjunction with other market indicators.

4. Relative Strength Analysis

The relative strength concept suggests that the prices of some securities rise relatively faster in a bull market or decline more slowly in a bear market than other securities i.e. some securities exhibit relative strength. Investors will earn higher returns by investing in securities which have demonstrated relative strength in the past because the relative strength of a security tends to remain undiminished over time.

5. Odd – Lot Theory

This theory is a contrary – opinion theory. It assumes that the average person is usually wrong and that a wise course of action is to pursue strategies contrary to popular opinion. The odd-lot theory is used primarily to predict tops in bull markets, but also to predict reversals in individual securities.

Support and Resistance Levels

Support and resistance are the next major concept after understanding the concept of a trend. You’ll often hear technical analysts talk about the ongoing battle between bulls and bears, or the struggle between buyers (demand) and sellers (supply). The proverbial ‘battle lines’ can be defined as the support and resistance levels where the most trading occurs. Support levels are where demand is perceived to be strong enough to prevent the price from falling further, while resistance levels are prices, where selling is thought to be strong enough to prevent prices from rising higher.

 

When the index/price goes down from a peak, the peak becomes the resistance level. When the index/price rebounds after reaching a trough subsequently, the lowest value reached becomes the support level. The price is then expected to move between these two levels. Whenever the price approaches the resistance level, there is a selling pressure because all investors who failed to sell at the high would be keen to liquidate, while whenever the price approaches the support level, there is a buying pressure as all those investors who failed to buy at the lowest price would like to purchase the share. A breach of these levels indicates a distinct departure from status quo, and an attempt to set newer levels.

Evaluation of Technical Analysis

Technical Analysis has several supporters as well several critics. The advocates of technical analysis offer the following interrelated argument in their favour:

• Under influence of crowd psychology trend persist for some time. Tools of technical analysis help in identifying these trends early and help in investment decision making.
• Shift in demand and supply are gradual rather than instantaneous. Technical analysis helps in detecting this shift rather early and hence provides clues to future price movements.
• Fundamental information about a company is observed and assimilated by the market over a period of time. Hence price movement tends to continue more or less in same direction till the information is fully assimilated in the stock price.

Detractors of technical analysis believe that it is a useless exercise; their arguments are as follows:

• Most technical analysts are not able to offer a convincing explanation for the tools employed by them.
• Empirical evidence in support of random walk hypothesis cast its shadow over the useful ness of technical analysis.
• By the time an uptrend and down trend may have been signaled by technical analysis it may already have taken place.
• Ultimately technical analysis must be self-defeating proposition. With more and more people employing it, the value of such analysis tends to decline.

Efficient Market Theory (Efficient Market Hypothesis)

Efficient Market Theory was developed by University of Chicago professor Eugen Fama in the 1960s. As per this theory, at any given time, all available price sensitive information is fully reflected in securities’ prices. Thus this theory implies that no investor can consistently outperform the market as every stock is appropriately priced based on available information.

Stating otherwise theory states that no none can “beat the market” hence making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices as stocks are always traded at their fair value on stock exchanges. Hence it is impossible to outperform the overall market through expert stock selection or market timing and that the only way an  investor can possibly obtain higher returns is by purchasing riskier investments.

When empirical evidence in favour of Random walk hypothesis seemed overwhelming, researchers wanted to know about the Economic processes that produced a Random walk. They concluded that randomness of stock price was a result of efficient market that led to the following view points:

• Information is freely and instantaneously available to all market participants.
• Keen competition among the market participants more or less ensures that market will reflect intrinsic values. This means that they will fully impound all available information.
• Price change only response to new information that is unrelated to previous information and therefore unpredictable.

Misconception About Efficient Market Theory

Efficient Market Theory implies that market prices factor in all available information and as such it is not possible for any investor to earn consistent long term returns from market operations.

Although price tends to fluctuate they cannot reflect fair value. This is because the future is uncertain. The market springs surprises continually and as prices reflect the surprises they fluctuate.

Inability of institutional portfolio managers to achieve superior investment performance implies that they lack competence in an efficient market. It is not possible to achieve superior investment performance since market efficiency exists due to portfolio managers doing this job well in a competitive setting.

The random movement of stock prices suggests that stock market is irrational. Randomness and irrationality are two different things, if investors are rational and competitive, price changes are bound to be random.

Procedure for Computing Exponential Moving Average (EMA)

1. Consider the index value of current day
2. Subtract EMA of previous day from current index value
3. Multiply the exponent value to the difference computed above (Exponent Value will be given in question)
4. “Add” or “Less” the product obtained above to EMA of previous day, for obtaining EMA for current day.

Level of Market Efficiency

That price reflects all available information, the highest order of market efficiency. According to FAMA, there exist three levels of market efficiency:-

1. Weak form efficiency – Price reflect all information found in the record of past prices and volumes.
2. Semi – Strong efficiency – Price reflect not only all information found in the record of past prices and volumes but also all other publicly available information.
3. Strong form efficiency – Price reflect all available information public as well as private.

Procedure for testing the Weak form of “Efficient Market Hypothesis”

1. Compare the closing index value of current day with previous day and identify whether the index has moved up or down.
2. Identify upward or downward movements (with “+” or “-” signs) (r = Total number of runs)
3. Count the total number of “+” signs as n₁ and total number of “-” signs as n₂.
4. Determine the average (µ)

5. Determine the deviation (σ)

6. Test the Hypothesis (“Z” distribution for large samples and “t” distribution for small samples). In case of “t” distribution, the degree of freedom to be considered should be = n1 + n₂ – 1.
7. Determine the upper and lower limit of deviation and observe whether “r” lies between such limits.

Lower Limit = µ – t X σ

Upper Limit = µ + t X σ

 

Question 1

The closing value of Sensex for the month of October, 2007 is given below:

You are required to test the week from of efficient market hypothesis by applying the run test at 5% and 10% level of significance.

Following value can be used:

Value of t at 5% is 2.101 at 18 degrees of freedom

Value of t at 10% is 1.734 at 18 degrees of freedom

Value of t at 5% is 2.086 at 20 degrees of freedom

Value of t at 10% is 1.725 at 20 degrees of freedom

(Nov. 2008, 8 marks)

 

Question 2

Closing values of BSE Sensex from 6^th to 17^th day of the month of January 2017 were as follows:

Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days simple moving average of Sensex can be assumed as 15,000. The value of exponent for 30 days EMA is 0.062.

Give detailed analysis on the basis of your calculations.

(Nov. 2009, 12 Marks)