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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-2

Chapter Organisation
7.1
Fundamental Analysis: Top-down Approach
7.2
Fundamental Analysis: Bottom-up Approach
7.3
Technical Analysis
7.4
Program Trading
7.5
Random Walk and Efficient Market Hypotheses
7.6
Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
– Fundamental analysis: top-down
– Fundamental analysis: bottom-up
– Technical analysis
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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 firmspecific and relate to management’s impact on company performance
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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, which 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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 less
• Exchange rates also affect firms indirectly
– e.g. devaluation of currency increases cost of imports, thereby increasing inflation
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-10

Top-down approach —domestic economy
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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-11

Top-down approach —domestic economy
(cont.)
Current account of balance of payments
• If current account is in deficit (i.e. total international payments exceed total international receipts) then
– 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-12

Top-down approach —domestic economy
(cont.)
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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-13

Top-down approach —domestic economy
(cont.)
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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-14

Chapter Organisation
7.1
Fundamental Analysis: Top-down Approach
7.2
Fundamental Analysis: Bottom-up Approach
7.3
Technical Analysis
7.4
Program Trading
7.5
Random Walk and Efficient Market Hypotheses
7.6
Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-16

7.2 Fundamental Analysis: Bottom-up
Approach (cont.)
• Considers factors like the following
– 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-17

7.2 Fundamental Analysis: Bottom-up
Approach (cont.)
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-18

Chapter Organisation
7.1
Fundamental Analysis: Top-down Approach
7.2
Fundamental Analysis: Bottom-up Approach
7.3
Technical Analysis
7.4
Program Trading
7.5
Random Walk and Efficient Market
Hypotheses
7.6
Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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 a mass psychology, from which regular patterns emerge
• Two main forecasting models
– Moving averages (MA)
– Charting
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-20

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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-22

Moving Averages (MA) Models (cont.)
• Typically for daily price series both 10-day (shortterm) and 30-day (medium-term) moving averages are calculated
• Weighted MA
– The most recent information is given the greatest weight
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-23

Charting
• Investigating patterns in price charts
• Several techniques
– Trend lines
– Support and resistance lines
– Continuation patterns
– Reversal patterns
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-24

Charting (cont.)
Trend lines
• Trends are regular movements in share prices
• Two types of trends
– Uptrend line—connecting the lower points of rising price series
– 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-26

Charting (cont.)
Continuation patterns
• Sideways share trading that does not normally signal a change in a trend
• Two types
– 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)
– Pennants and flags—formed during a sharp rise in prices
(‘the pole’); trading volume then reduces and then increases suddenly to take prices sharply higher
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
 Left shoulder —formed by volume-strong rally on uptrend, followed by reduced-volume reaction
 Head —second rally increases price before reaction moves price back to previous low
 Right shoulder —final rally marked by reduced volume indicating price weakness
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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 down-legs, resulting in a reversion of share prices to about 60% of the peak
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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 share price behaviour at times
– More likely to forecast successfully when share prices move out of a range explained by economic and financial fundamentals
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-30

Chapter Organisation
7.1
Fundamental Analysis: Top-down Approach
7.2
Fundamental Analysis: Bottom-up Approach
7.3
Technical Analysis
7.4
Program Trading
7.5
Random Walk and Efficient Market Hypotheses
7.6
Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
– 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-32

Chapter Organisation
7.1
Fundamental Analysis: Top-down Approach
7.2
Fundamental Analysis: Bottom-up Approach
7.3
Technical Analysis
7.4
Program Trading
7.5
Random Walk and Efficient Market Hypotheses
7.6
Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
• 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-35

7.5
Random Walk and Efficient Market
Hypotheses (cont.)
• 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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e 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
 Weak form —historic price data reflected in share price
 Semi-strong form —all publicly available information is reflected in share price
 Strong form —public and private information is fully reflected in share price
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-37

Chapter Organisation
7.1
Fundamental Analysis: Top-down Approach
7.2
Fundamental Analysis: Bottom-up Approach
7.3
Technical Analysis
7.4
Program Trading
7.5
Random Walk and Efficient Market Hypotheses
7.6
Summary
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-38

7.7
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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-39

7.7
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
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2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
7-40