1. Copyright  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 Chapter 7 Forecasting Share Price Movements

2. Copyright  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 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

3. Copyright  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 Chapter Organisation 7.1Fundamental Analysis: Top-down Approach 7.2Fundamental Analysis: Bottom-up Approach 7.3Technical Analysis 7.4Program Trading 7.5Random Walk and Efficient Market Hypotheses 7.6Summary

4. Copyright  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 7.1Fundamental 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

5. Copyright  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 7.1Fundamental 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

6. Copyright  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 7.1Fundamental 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

7. Copyright  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 7.1Fundamental 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

8. Copyright  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—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

9. Copyright  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—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

10. Copyright  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—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

11. Copyright  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 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

12. Copyright  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.) 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

13. Copyright  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.) 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

14. Copyright  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 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

15. Copyright  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 Chapter Organisation 7.1Fundamental Analysis: Top-down Approach 7.2Fundamental Analysis: Bottom-up Approach 7.3Technical Analysis 7.4Program Trading 7.5Random Walk and Efficient Market Hypotheses 7.6Summary

16. Copyright  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 7.2Fundamental 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

17. Copyright  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.) 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

18. Copyright  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 7.2 Fundamental Analysis: Bottom-up Approach (cont.)

19. Copyright  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 Chapter Organisation 7.1Fundamental Analysis: Top-down Approach 7.2Fundamental Analysis: Bottom-up Approach 7.3Technical Analysis 7.4Program Trading 7.5Random Walk and Efficient Market Hypotheses 7.6Summary

20. Copyright  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 7.3Technical 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

21. Copyright  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 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

22. Copyright  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.) 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

23. Copyright  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 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

24. Copyright  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 Investigating patterns in price charts Several techniques –Trend lines –Support and resistance lines –Continuation patterns –Reversal patterns

25. Copyright  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.) 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

26. Copyright  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.) 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

27. Copyright  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.) 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

28. Copyright  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.) 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

29. Copyright  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 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

30. Copyright  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 7.3Technical 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

31. Copyright  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 Chapter Organisation 7.1Fundamental Analysis: Top-down Approach 7.2Fundamental Analysis: Bottom-up Approach 7.3Technical Analysis 7.4Program Trading 7.5Random Walk and Efficient Market Hypotheses 7.6Summary

32. Copyright  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 7.4Program 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

33. Copyright  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 Chapter Organisation 7.1Fundamental Analysis: Top-down Approach 7.2Fundamental Analysis: Bottom-up Approach 7.3Technical Analysis 7.4Program Trading 7.5Random Walk and Efficient Market Hypotheses 7.6Summary

34. Copyright  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 7.5Random 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

35. Copyright  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 7.5Random 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

36. Copyright  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 7.5Random 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

37. Copyright  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 7.5Random 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

38. Copyright  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 Chapter Organisation 7.1Fundamental Analysis: Top-down Approach 7.2Fundamental Analysis: Bottom-up Approach 7.3Technical Analysis 7.4Program Trading 7.5Random Walk and Efficient Market Hypotheses 7.6Summary

39. Copyright  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 7.7Summary 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

40. Copyright  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 7.7Summary (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