The mechanics of trading

(Part four of our series on capital markets)

ANALYSIS OF SECURITIES MARKETS

Global markets have become more closely correlated. What happens in one economy is quickly transferred to other economies because of integration and globalization; whatever happens to one market—also affects other markets. For example, if one country’s currency depreciates, its exports become more competitive and, thus, the exports of its competitor countries would decline ceteris paribus.

TECHNICAL ANALYSIS

Technical analysts develop trading rules from observations of past price movements of the stock market and individual stocks. Technical analysis involves the examination of past market data such as prices and the volume of trading, which lead to an estimate of future price trends and, therefore, an investment decision. The technical analyst uses market data because they believe that the market is its own best predictor. If you are a technical analyst, you would not want to concern yourself too much with economic, industry and company variables to arrive at a value for the company. All that you have to do is observe the past price movements which will signal future price movements.

ASSUMPTIONS UNDERLYING
TECHNICAL ANALYSIS

Technical analysts base trading decisions on examinations of prior price and volume data to determine past market trends from which they predict future behaviour for the market as a whole and for individual securities. There are several assumptions that lead to this view of price movements:

I)  Supply and demand solely determines the market value of any good or service

II)  Supply and demand are governed by numerous   factors, which are continually and automatically weighed by the market;

III)  There are trends that persist for appreciable lengths of time that affect the prices of individual securities and the overall value of the market;

The shifts in trends can be detected sooner or later in the action of the market itself.

The technical analyst expects a gradual price adjustment to reflect the gradual flow of information. In addition, technical analysts do not try to predict a new equilibrium value but rather just try to keep ahead of others in knowing whether the new equilibrium value would be higher or lower than the current equilibrium value. If the trend is down, they will sell. If the trend is up, they will buy.

ADVANTAGES OF
TECHNICAL ANALYSIS

Technical analysts do not believe that a vast majority of investors can consistently get new information before other investors and consistently process it correctly and quickly. They believe that only by being able to process new information correctly and quickly can a fundamental analyst make money. Moreover, technical analysts make a claim that their method is superior because it is not heavily dependent on financial accounting statements. The reason why technical analysts do not rely too much on financial statements is because:-

1.     The information contained therein might be insufficient;

2.      There are different choices of reporting that is allowed by the various accounting boards; and

3.      There are many factors that do not appear on the financial statements.

As such, most of the data used by technical analysts are derived from the market itself. Examples of these are security prices, volume of trading, and other trading information. Furthermore, in contrast to a fundamental analyst, a technical analyst does not need to know why the market or stock is moving in a certain direction. The only thing that is important to a technical analyst is that he or she must catch the movement towards that new equilibrium.

CHALLENGES TO
TECHNICAL ANALYSIS

With respect to the technical trading rules, an obvious challenge is that past prices or relationships between specific market variables and stock prices may not be repeated. Sometimes the trading rules that are followed become self-fulfilling prophecies. Another problem is that the success of a trading rule will encourage many investors to adopt it. When the trading rule is adopted by a sufficient number of investors, its effectiveness diminishes. Also, trading rules all require a great deal of subjective judgment. Two technical analysts looking at the same thing may end up with different interpretations.

TECHNICAL TRADING RULES
AND INDICATORS

Technicians base buy or sell decisions on a consensus of signals, because complete agreement of all the rules is rare. They try to determine when the majority of investors is either strongly bullish or bearish and then trade in the opposite direction. Second is where some technical analysts have created a set of indicators that they expect to show the behaviour of investors and create rules that follow them. In other cases, they can measure the number of issues that have increased each day and the number of issues that declined and make predictions using those data. If you listen to stock market news, they usually have a number of winners and number of losers for the day. This is an application of this rule.

THE STOCK MARKET INDEX:
WHAT IT IS AND HOW IT WORKS

From time to time, the business news will report that the stock market index ended the day at some points up or down. What does this mean and what does it tell us about the general state of the stock market?

The stock market index is a statistical price index which compares the average price of stocks on the market on the day on which the index is quoted with the average price of the stocks on the market in the base year in which the index was established. The index is one of the tools employed by technical analysts in order to measure the movement of an entire stock market or of a particular sector consisting of many stocks within the market. The index is a measure of the movement of the price of stocks on the market today compared with yesterday or to some previous period, starting with the base year. Actually, the stock market index measures growth or contraction of activities on the stock exchange. It tells if there is an increase or decrease in the value of the market or in the value of companies listed on the exchange. The more prices on the stock exchange increase, the higher the stock market index and the lower the prices the lower the index will be.

Fundamental analysis

How does an investor determine if a stock is undervalued, overvalued, or trading at fair market value? This can be done with fundamental analysis, which is a method of evaluating a security by attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.

Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors such as the overall economy and industry conditions and specific factors such as the financial condition and management of companies. If all the information regarding a corporation’s future anticipated growth, sales figures, cost of operations and industry structure are available and examined, then the resulting analysis should provide the intrinsic value of the stock.

To a fundamentalist, the market price of a stock tends to move towards its intrinsic or true value. If that value is above the current market price, the investor would purchase the stock. However, if the investor found through analysis, that the intrinsic value of a stock was below the market price for that stock, the investor would try to sell the stock. The end goal of performing fundamental analysis is to produce a value that an investor can compare with the security’s current price in trying to figure out what sort of position to take  with that security. Again, if it is underpriced you buy, and if overpriced, you sell.

Steps associated with fundamental analysis

a)  The investor must make an examination of the current and future overall condition of the economy as a whole.

b)  Attempt to determine the short-, medium- and long-term direction and level of interest rates. This may be done through forecasting interest rates.

c)  An understanding of the industry sector involved, including the maturity of the sector and any cyclical effects that the overall economy has on it, is also necessary.

Once these steps have been undertaken, the individual firm must be analyzed. This analysis must include the factors which give the firm a competitive advantage in its sector (low cost producer, technological superiority, distribution channels, etc.) in addition factors such as management experience and competence, history of performance, accuracy of forecasting revenues and costs, growth potential, etc., must be examined.

There are two quantitative models that can be helpful for the investor willing to better understand the firm being investigated for investment. The two most commonly used methods for determining the intrinsic value of a firm are the dividend discount model, and the price/earnings model. Both methods, if employed properly, should produce similar intrinsic values.

When using the dividend discount model, the type of industry involved and the dividend policy of the industry is important in choosing which of the dividend discount models to employ.

This method of securities analysis, fundamental analysis, is considered to be the opposite of technical analysis. Fundamental analysis is about using real data to evaluate a security’s value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security.

For example, an investor can perform fundamental analysis on a bond’s value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings. For assessing stocks, this method uses revenues, earnings, future growth, return on equity, profit margins and other data to determine a company’s underlying value and potential for future growth. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated.

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