A Random Walk Down Wall Street

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A Random Walk Down Wall Street
PART II HOW THE PROS PLAY THE BIGGEST GAME IN
TOWN

• Business 3059
• Investment Management

Chapter 6 Technical and Fundamental Analysis
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NOTICE

• This text is mandatory reading for this course.
  This slide set has been constructed to help you
  understand that there are important concepts in
  this resource for you to understand.
• This slide set IS NOT a substitute for your own
  independent reading of the text.

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Part II How the Pros Play the Biggest Game in
Town

• Part II of A Random Walk Down Wall Street
  concentrates on how professional work the
  investments gameand then how academics have
  concluded that the professionals arent worth the
  money you pay for them.

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Chapter 6 Technical and Fundamental Analysis

• the profession of high finance is certainly one
  of the most generously compensated.
• The stock market in the late 1990s and early
  2000s has become one of the biggest games in
  town.
• Players in the game are among the most highly
  paid people in society
• Academics study the work and results of
  professionals and draw conclusions about their
  effectivenessacademics study markets and prices
  and draw conclusions about their
  behaviourefficiencyand espouse new theories to
  explain what is going on.
• This chapter introduces you to the two schools
  of thought in the investments gamechartists or
  technicians who try to predict the future
  studying past trends in graphs of stock
  pricesand fundamental analysts who try to
  estimate a current intrinsic value (or inherent
  worth) of a stock based upon forecasts of the
  future in terms of cash flows, discount rates,
  growth rates, etc.

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Technical Versus Fundamental Analysis

• Technical analysis is the method of predicting
  the appropriate time to buy or sell a stock used
  by those believing in the castle-in-the-air view
  of stock pricing.
• Fundamental analysis is the technique of
  applying the tenets of the firm-foundation theory
  to the selection of individual stocks.

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Technical Analysis

• Chartists study both the past movements of common
  stock prices and trading volume for a clue to the
  direction of future change.
• UNDERLYING ASSUMPTION
• That the market is only 10 percent logical and 90
  percent psychological
• The key to the game is to anticipate how other
  people play the game.
• Chartists hope that careful study of past
  behaviour will shed light on what the crowd is
  likely to do in the future.

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Fundamental Analysis

• Fundamental analysts seek to determine an issues
  proper value.
• Value is determined through forecasts for growth,
  dividend payout, interest rates and risk.
• The goal is to identify undervalued securities
  that can be purchases prior to their rise to the
  proper valueor short sale of overvalued
  securities prior to their fall to their proper
  value.
• UNDERLYING ASSUMPTION
• That the market is only 90 percent logical and 10
  percent psychological
• The key to the game is to be a superior analyst
  capable of identifying unrealized valuethat
  eventually be discovered by the street.

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What Can Charts Tell You?

• Principles of Technical Analysis
• A chart showing past prices and volume of trading
  contains all of the information that a security
  analyst needs to know.
• Prices tend to move in trends (moving market
  prices have momentum and stocks at rest tend to
  remain at rest.) Trends tend to continue until
  something happens to change the supply-demand
  balance.

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Chartist Vocabulary

• Double bottoms
• Breakthrough
• Violating the lows
• Firmed-up
• Big play
• Ascending peaks
• Buying climax
• Head and shoulders

• Areas of support
• Areas of resistance

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The Rationale for Charting

• we can never hope to know why the market
  behaves as it does, we can only aspire to
  understand how.
• Magee, Technical Analysis of Stock Trends
• Possible explanations for why trends might tend
  to perpetuate themselves
• Crowd psychology causes people to lose their
  individual sense of what is right and wrong.
  Crowd behaviour can be predicted.
• Information asymmetry ( there may be unequal
  access to fundamental information about a
  company)hence the people in the know move
  first causing prices to changeand then slowly
  the rest of the market begins to join in allowing
  the price to show momentum.

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Further Rationale for charting

• Chartists claim the public remembers what price
  they paid for a stockand make decisions with
  respect to that point of reference.
• This gives rise to resistance areas and
  support levels

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Why Might Charting Fail to Work?

• Chartists react only to price trendsso the trend
  must be established first, before they will
  actwith sharp reversalsthey will miss most of
  the opportunities.
• Chartist techniques are self-defeatingin that if
  a chartist makes money with a system then
  others will attempt to copy thisno buy or sell
  signal can be worthwhile if everyone tries to act
  on it simultaneously.
• Traders try to anticipate technical signalsand
  tend to buy before, not after, it breaks through.
• The market is driven by highly motivated,
  self-interested individuals making it a highly
  efficient mechanismif some people know that the
  stock price will go to 40 tomorrowit will go to
  40 today. (Prices may adjust so quickly to new
  information as to make the whole process of
  technical analysis a futile exercise.)

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From Chartist to Technician

• Chartists was the term applied to people who used
  stock charts in the pastwith the advent of
  computer databases, computer statistical analysis
  programs and graphical user interfaceschartists
  have now morphed into technicians
• Technicians are able to convert stock price and
  trading volume data into a wide variety of forms
  and analyze this informationfor example
• 200 day moving averages
• Relative strength indicators
• Primary, secondary and tertiary waves, etc.

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The Technique of Fundamental Analysis

• The fundamentalist strives to be relatively
  immune to the optimism and pessimism of the
  crowd.
• The fundamental analyst believes there is an
  intrinsic value (or inherent worth) and that the
  price may occasionally not be equal to thatthe
  fundamental analysts believes, however, that
  eventually the market will become efficient to
  the mistake and that the price will move to the
  intrinsic value (achieve equilibrium).
• The fundamental analyst believes that there are
  key factors that influence the value of a
  stockdividends, growth, risk and the level of
  interest rates.
• The higher the riskthe lower the p/e (price
  earnings) multiple.

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Why Might Fundamental Analysis Fail to Work?

• The information (data) and analysis might be
  incorrect.
• The security analysts estimate of value might
  be faulty
• The market may not correct its mistake.

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Using Fundamental and Technical Analysis Together

• Rule 1 Buy only companies that are expected to
  have above average earnings growth for five or
  more years.
• Rule 2 Never pay more for a stock that its firm
  foundation value
• Rule 3 Look for stocks whose stories of
  anticipated growth are of the kind on which
  investors can build castles in the air.

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Key Lessons Learned

• Understand that there are two radically different
  schools of thought followed by professionals in
  the investment industryand be able to recognize
  those in each camp through their words and
  actions
• the market hasnt discounted the recent growth
  in earnings in the stock price as yet
• the stock price will encounter a zone of
  resistance at the 20 level

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Key Lessons Learned

• Understand the there are two radically different
  schools of thought followed by professionals in
  the investment industryand be able to recognize
  those in each camp through their words and
  actions
• the market hasnt discounted the recent growth
  in earnings in the stock price as yet
  (fundamental analyst)
• the stock price will encounter a zone of
  resistance at the 20 level (technical analyst)