Lecture Financial institutions, instruments and markets (6/e): Chapter 7 - Christopher Viney

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Chapter 7 Forecasting Share Price Movements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-1 Learning Objectives • Evaluate and apply bottom-up and top-down approaches to fundamental analysis • Describe and apply technical analysis techniques • Examine the role of program trading • Explain the theoretical concepts and implications of the random walk and efficient market hypotheses when forecasting share price movements Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-2 Chapter Organisation 7.1 7.2 7.3 7.4 7.5 7.6 Fundamental Analysis: Top-down Approach Fundamental Analysis: Bottom-up Approach Technical Analysis Program Trading Random Walk and Efficient Market Hypotheses Summary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-3 7.1 Fundamental Analysis: Top-down Approach • Share price is determined by supply and demand of a company’s shares • Expectation of bad company performance causes investors to sell their shares, increasing supply and reducing the price • Expectation of good company performance increases demand and leads to an increase in share price Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-4 7.1 Fundamental Analysis: Top-down Approach (cont.) • What causes the shifts in demand and supply of a company’s securities on the secondary market? • Three approaches to answering this question 1. Fundamental analysis: top-down 2. Fundamental analysis: bottom-up 3. Technical analysis Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-5 7.1 Fundamental Analysis: Top-down Approach (cont.) • Fundamental analysis – Considers macro and micro factors that impact upon cash flows and future share prices of various industry sectors and firms  Macro factors include interest rates, economic growth, business investment  Micro factors are firm-specific and relate to management’s impact on company performance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-6 7.1 Fundamental Analysis: Top-down Approach (cont.) • Top-down approach considers macro factors – Economic growth of international economies – Exchange rates – Interest rates – Domestic economy      Growth rate Balance of payments Inflation Wage and productivity growth Government responses to changes in the above factors Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-7 Top-down approach—international economies • The higher the growth rate in the rest of the world, the greater the demand for Australian exports • Sectors benefitting from international growth determined by source of the growth • Growth can be driven by: – increased consumer demand – increased business investment in equipment Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-8 Top-down approach—rate of growth of an economy • Generally, greater domestic growth leads to increased profitability of firms • But high growth can lead to any of the following factors that can reduce firm profitability: – – – – – Deterioration in balance of payments Increase in inflationary pressures Pressure on wages Depreciation of the exchange rate Rise in interest rates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-9 Top-down approach—exchange rates • Affect the domestic currency profit of exporters that quote their products in foreign currency prices – A strengthening Australian dollar (AUD) makes these firms worse off because the AUD value of their exports is lower • Exchange rates also affect firms indirectly – E.g. devaluation of currency increases cost of imports, thereby increasing inflation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-10 Top-down approach—interest rates • Have both a direct and indirect impact on a firm’s value – Direct effect on profitability  Represents the cost of debt finance for borrowers and the return for finance providers – Indirect effect on profitability  Rise in interest rates may indicate a slowing of economic activity  Future reduction in profitability • A strong relationship exists between interest rates and exchange rates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-11 Top-down approach—balance of payments current account • If current account is in deficit (i.e. total international payments exceed total international receipts): – some export income is diverted to service debt – need to borrow foreign currency to service debt • Indirect effect on firms’ profitability – Government may increase interest rates to slow economic growth and control the debt Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-12 Top-down approach—inflationary pressures • Effect of inflation on firm’s real profit • Tax treatment of inflation – Makes historical-based depreciation allowances inappropriate – Combined with higher replacement costs, leads to an overstatement of after-tax profit • Inventory – ‘Inflated’ selling price of inventory creates an illusion of inventory profits Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-13 Top-down approach—wages growth • Increase in wages growth raises the amount of business profit used for salaries • This will impact most heavily on those firms that are highly labour intensive Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-14 Chapter Organisation 7.1 7.2 7.3 7.4 7.5 7.6 Fundamental Analysis: Top-down Approach Fundamental Analysis: Bottom-up Approach Technical Analysis Program Trading Random Walk and Efficient Market Hypotheses Summary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-15 7.2 Fundamental Analysis: Bottom-up Approach • Following identification of the best economies and industry sectors for investment using the top-down approach, the bottom-up approach can be used to identify the best companies within these • Bottom-up approach considers micro factors using ratios and other measures of a firm’s financial characteristics and performance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-16 7.2 Fundamental Analysis: Bottom-up Approach (cont.) • Considers factors such as: – Accounting ratios that assess a company’s capital structure, liquidity, debt servicing, profitability, share price and risk (see Chapter 6), observing the trend and making comparisons with firms in the same industry – Additional information on key management changes, corporate governance and strategic direction Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-17 7.2 Fundamental Analysis: Bottom-up Approach (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-18 Chapter Organisation 7.1 7.2 7.3 7.4 7.5 7.6 Fundamental Analysis: Top-down Approach Fundamental Analysis: Bottom-up Approach Technical Analysis Program Trading Random Walk and Efficient Market Hypotheses Summary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-19 7.3 Technical Analysis • Explains and forecasts share price movements based on past price behaviour • Assumes markets are dominated at certain times by mass psychology, from which regular patterns emerge • Two main forecasting models 1. Moving averages (MA) 2. Charting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-20 1. Moving averages (MA) models • Smooth out a series facilitating the identification of trends in the series • Calculation of MA – Assuming a five-day moving average, the MA is calculated by taking the average of the price series for the preceding five days Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-21 Moving averages (MA) models (cont.) • Trading rules – Buy when the price series cuts the MA from below – Buy when the MA series is rising strongly and the price series cuts or touches the MA from above for only a few observations – Sell when the MA flattens or declines and the price series cuts the MA from above – Sell when the MA is in decline and the price series cuts or touches the MA from below for only a few observations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-22 Moving averages (MA) models (cont.) • Typically, for daily price series both 10-day (short-term) and 30-day (medium-term) moving averages are calculated • Weighted MA – The most recent information is given the greatest weight Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-23 2. Charting • Investigating patterns in price charts • Several techniques – – – – Trend lines Support and resistance lines Continuation patterns Reversal patterns Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-24 Charting (cont.) Trend lines • Trends are regular movements in share prices • Two types of trends 1. Uptrend line—connecting the lower points of rising price series 2. Downtrend line—connecting the higher points of falling price series  Return line—line drawn parallel to a trend line to create a trend channel • Critical issue is to determine when the trend line is going to change Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-25 Charting (cont.) Support and resistance lines • Support levels—where there is sufficient demand to halt further price falls • Resistance levels—where there is sufficient supply to halt further price increases • ‘Strong’ levels—historical support and resistance • ‘Weak’ levels—support and resistance based on more recent activity Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-26 Charting (cont.) Continuation patterns • Sideways share trading that does not normally signal a change in trend • Two types 1. Triangles—composed of a series of price fluctuations, each smaller than its predecessor  Symmetrical triangle (no change in trend); ascending triangle (uptrend); descending triangle (downtrend) 2. Pennants and flags—formed during a sharp rise in prices (‘the pole’); then trading volume reduces and increases suddenly to take prices sharply higher Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-27 Charting (cont.) Reversal patterns • Occur after a major market move • Result in a ‘head and shoulders’ pattern – Three successive rallies and reactions, the second rally being stronger than the first and third rallies i. Left shoulder—formed by volume-strong rally on uptrend, followed by reduced-volume reaction ii. Head—second rally increases price before reaction moves price back to previous low iii. Right shoulder—final rally marked by reduced volume indicating price weakness Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-28 Charting (cont.) Elliott wave theory • The existence of distinctive wave patterns that characterise share-market cycles • Key proposition is that a bull market consists of three major waves upwards, followed by two major downlegs, resulting in a reversion of share prices to about 60% of the peak Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-29 7.3 Technical Analysis (cont.) • Validity of technical analysis – Even where techniques have no apparent underlying validity, if they are followed by enough participants they may impact on share price behaviour at times – More likely to forecast successfully when share prices move out of a range explained by economic and financial fundamentals Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-30 Chapter Organisation 7.1 7.2 7.3 7.4 7.5 7.6 Fundamental Analysis: Top-down Approach Fundamental Analysis: Bottom-up Approach Technical Analysis Program Trading Random Walk and Efficient Market Hypotheses Summary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-31 7.4 Program Trading • Refers to buy and sell strategies generated by computer programs • Programs range between: – simple buy/sell orders based on moving averages; and – complex monitoring of both derivatives and share markets for the purpose of hedging a share portfolio • Program trading increases the speed at which prices change Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-32 Chapter Organisation 7.1 7.2 7.3 7.4 7.5 7.6 Fundamental Analysis: Top-down Approach Fundamental Analysis: Bottom-up Approach Technical Analysis Program Trading Random Walk and Efficient Market Hypotheses Summary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-33 7.5 Random Walk and Efficient Market Hypotheses • Two theories on security values and changes in price 1. Random walk – Share price is assumed to be formed by investor’s expectations of future cash flows, i.e. intrinsic value – Price will change in response to new information; since information arrives in a random fashion, stock prices adjust in an unpredictable fashion Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-34 7.5 Random Walk and Efficient Market Hypotheses (cont.) • Random walk (cont.) – Each observation in the (price) series is assumed to be independent of the previous price – There is an equal probability that the next price will move up, down or remain unchanged Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-35 7.5 Random Walk and Efficient Market Hypotheses (cont.) 2. Efficient market hypothesis (EMH) – EMH proposes that markets are information-efficient if prices adjust immediately to new information – It is not possible for an investor to make abnormal profits through superior information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-36 7.5 Random Walk and Efficient Market Hypotheses (cont.) • Efficient market hypothesis (EMH) (cont.) – Three forms 1. Weak form—historical price data reflected in share price 2. Semi-strong form—all publicly available information is reflected in share price 3. Strong form—public and private information is fully reflected in share price Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-37 Chapter Organisation 7.1 7.2 7.3 7.4 7.5 7.6 Fundamental Analysis: Top-down Approach Fundamental Analysis: Bottom-up Approach Technical Analysis Program Trading Random Walk and Efficient Market Hypotheses Summary Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-38 7.6 Summary • Demand and supply determines the price of shares • Demand and supply of shares is determined by expectations about future – Company performance  Fundamental analysis • Top-down approach • Bottom-up approach – Share price movement  Technical analysis • Moving averages models • Charting Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-39 7.6 Summary (cont.) • Program trading involves buy and sell orders generated by computer programs • Random walk hypothesis—the price of a share is independent of its previous price • Efficient market hypothesis—prices adjust immediately to new information Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions, Instruments and Markets 6e by Viney Slides prepared by Anthony Stanger 7-40
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