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Fundamental Stock Analysis

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					                                CHAPTER 8
                   TECHNICAL AND FUNDAMENTAL ANALYSIS:
                  HOW THE PROS MAKE INVESTMENT DECISIONS


STUDENT LEARNING OBJECTIVES

After reading Chapter 8, students should be able to answer the following questions.

1.   How do technical and fundamental analysis differ?
2.   What are some technical indicators?
3.   How well does technical analysis work?
4.   What is the process of fundamental analysis?
5.   How well does fundamental analysis work?


SUGGESTIONS FOR USE AND TEACHING TIPS

Chapter 8 reviews the two major techniques used by professional investors to make
investment decisions: technical and fundamental analysis. We believe this is important
material and recommend you require students to read the whole chapter. The material
in Chapter 8 is not conceptually difficult and we think you’re students will find the
chapter to be interesting and fairly easy reading. The chapter affords numerous
opportunities for students to examine actual investment decision making, successes
and well as failures.

We suggest that you lecture over most, if not all, the material in Chapter 8. This chapter
is the only place where technical analysis is examined in any depth (though some of the
issues associated with technical analysis were also discussed in Chapter 7). Most
students have heard of technical analysis, and will want to learn more. On the other
hand, we devote four chapters to the process of fundamental analysis. If you plan on
covering Chapters 11 through 14 in detail, you may wish to merely summarize
fundamental analysis at this point.

Throughout Chapter 8 we have attempted to present a balanced picture of how
professionals make investment decisions. We have considered both the successes and
failures of both technical and fundamental analysis. Too often, we believe, academics
tend to dismiss technical analysis as being virtually worthless. Fundamental analysis is
usually presented in a somewhat more positive light, but often academics tend to dwell
on the mistakes and blown calls. We would agree that much of what many technicians
have to say may be of little or no value, but some technicians have what appear to be
excellent track records. Further, while analysts blow calls occasionally, investors are
often wise to listen to what they have to say.

If you’re too negative about technical and fundamental analysis, students can get
confused. After all, they can watch Wall Street Week on PBS or various programs on



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CNBC and see technicians or analysts being praised for this or that correct call. Ask
yourself how many times you heard this comment from a student: “[Some pro] has
made millions of dollars for those who follow his or her advice. How can you say that
this pro’s technique has no value?” We believe students should be able to objectively
evaluate professional investment advice. Why professionals are right is as important as
why they are wrong.

If you want to give your students some more practice interpreting the success or failure
of a technical indicator, albeit a somewhat whimsical one, we’ve included some data on
the “Super Bowl Theory” at the end of this section.

Some other suggestions and teaching tips for Chapter 8 include:

     Make sure students understand the basic premise behind all technical
      indicators—that past patterns in security prices repeat themselves. The key is to
      recognize the pattern.

     Our discussion of technical indicators is not comprehensive. We’ve tried to put
      together a representative sample but there are many more.

     An important point to stress is that interpreting technical indicators is more of an
      art than a science. One technician may see a bullish pattern while another might
      see a bearish pattern from the same set of technical information. In addition,
      technical indicators are often ambiguous. Testing technical analysis, however,
      requires the establishment of mechanical buy and sell rules.

     Students often get confused over the role supply and demand play in setting
      prices. Technicians believe that a whole host of factors—some economic some
      psychological—determine supply and demand. Fundamentalists, on the other
      hand, believe that, in the long run, economic factors determine supply and
      demand.

     Make sure students understand the pressure exerted on analysts to say positive
      things about the companies they follow.




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LECTURE OUTLINE

I.     Technical versus fundamental analysis

       A.    The premise behind technical analysis

       B.    The premise behind fundamental analysis

       C.    The role of supply and demand

II.    Understanding technical analysis

       A.    Charting

             1.     Dow theory

             2.     Support and resistance levels

             3.     More complex price patterns

             4.     Trendlines

             5.     Moving averages

       B.    Investor sentiment indicators

             1.     Contrary opinion indicators

             2.     Smart money indicators

       C.    Market momentum indicators

             1.     What is market momentum

             2.     Advance/decline ratio

             3.     Relative strength indicators

III.   Assessment of technical analysis

       A.    Two minutes of fame on Wall Street

       B.    Why technical analysis might work

             1.     Inadequate fundamental information

             2.     Self-fulfilling prophecy

       C.    How well do technical indicators work?



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IV.   What is fundamental analysis

      A.     Some historical background

      B.     The process of fundamental (security) analysis

      C.     An example of fundamental analysis in action

V.    Assessing fundamental analysis

      A.     Stock price reaction to analyst comments

      B.     Track records of fundamental analysts

             1.     Forecasting earnings

             2.     Blown calls

             3.     Success stores

      C.     Why fundamental analysis might fail

             1.     Delta Airlines’ 1991 earnings

             2.     Behavior of the analysts

VI.   Implications for investors

      A.     Mixed track record

             1.     Hold a well diversified portfolio

             2.     Limits of human judgment

      B.     Value of professional advice

             1.     Think for yourself

             2.     Be skeptical of anyone who claims to have a “system”

             3.     The past is never a guarantee of the future




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INVESTMENT HISTORY BOX – The Future of Investment Research

The Investment Insight box raises interesting questions about the conflict of interest for
investment banking firms that provide investment research on the firms that they
service. If reforms add prohibitive costs to the investment banking firms to create semi -
autonomous research units, they may abandon their research department altogether.
Some questions and issues to discuss with your students concerning this box include:

   What are the implications for small investors?

   How will the internet information age help small investors?

   Will it change how small investors obtain information to invest? Why or why not?


INVESTMENT INSIGHT BOX – The Limits of Human Judgment

The Investment Insight box raises an interesting, and controversial, point that human
behavior is the biggest obstacle to outstanding investment performance. Successful
investing often runs contrary to human nature. Some questions and issues to discuss
with your students concerning this box include:

      Why does successful investing sometimes run contrary to human nature?

      Give another example of people ignoring the information contained in base rates.

      Why do investors prefer personal experience to base rates? Give another
       investment example of people substituting experience for the information
       contained in a base rate.

      What is the relationship between the “herd instinct” and speculative bubbles?




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ANSWERS TO END OF CHAPTER EXERCISES

Review Exercises

1.   The major assumption behind technical analysis is that past patterns in securities
     prices repeat themselves. By looking at such indicators as price charts, trading
     volume, or relative strength indicators, all of which are based on past patterns,
     the technician can reliably predict the direction of future securities prices.
     Technicians believe that past price patterns, and the indicators based on them,
     show the beginnings of shifts in supply and demand. Supply and demand,
     technicians argue, are determined by a whole host of ra tional and irrational
     factors.

2.   A support level is a secondary low and a resistance level is a secondary high
     within a primary movement (either up or down) in securities prices. If prices
     break through a support or resistance level, this suggests that the secondary
     move has become a primary move. For example, if prices break through a
     support level during a bull market, this may suggest that the secondary down
     move has become a primary move; the bull market has become a bear market.

3.   A trend line is a straight line that connects all the secondary highs or lows. If the
     upper and lower trend lines are moving closer together during a bull market, a
     technician probably would take this as a sign that the bull market is going to
     continue.

4.   The weekly prices and four week moving average are shown below. The moving
     average is considered to be a better indicator of the overall trend because it
     ignores the weekly price volatility and the moving average smooths out the
     movement over the four weeks.

       Week          Price      Moving           Week         Price        Moving
                                Average                                    Average
          1         35.875                        11         41.625        40.969
          2         36.625                        12         41.500        41.531
          3         38.000                        13         40.750        41.594
          4         39.000       37.375           14         40.375        41.063
          5         40.125       38.438           15         40.875        40.875
          6         39.250       39.094           16         40.750        40.689
          7         38.000       39.094           17         40.375        40.594
          8         39.250       39156            18         40.000        40.500
          9         40.500       39.250           19         40.375        40.375
         10         42.500       40.063           20         40.500        40.438


5.   Investor sentiment is how investors “feel” about the market. Are investors
     optimistic or pessimistic. Examples of investor sentiment include the various



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      contrary opinion indicators. If, for example, investors as a group are optimistic,
      then the market is about to peak.

6.    If prices are rising, on rising volume, that is taken as a sign that the bull market
      has a good deal of momentum behind it; prices should go even higher since it will
      take longer for the bull market (the “train”) to stop. Measures of relative strength
      are often considered to be indicators of momentum.

7.    Reasons why technical analysis might work include the inadequacies of
      fundamental information, the role of investor emotion security valuation, and
      through the effects of a self-fulfilling prophecy. Technical analysis might fail to
      work if technical indicators give clear signals only after its too late and if investors
      try to anticipate buy and sell signals. Another reason technical analysis might fail
      to work comes from the fact that the financial markets function pretty well and
      prices adjust very quickly to new information.

8.    The main reason it is difficult to assess the record of technical a nalysis comes
      from the fact that interpreting technical indicators is very subjective--more an art
      than a science. The appropriate standard is to compare the returns (adjusted for
      differences in risk and transactions cost) from an investment strategy using
      technical analysis to a simple buy-and-hold strategy.

9.    Fundamental analysis is based on the belief that all securities have an intrinsic
      value and, in the long run, all securities’ prices will equal their respective intrinsic
      value. A fundamentalist, for example, would recommend buying securities with
      prices below their respective intrinsic values. On the other hand, technical
      analysis is based on the believe that stock prices caan be predicted through the
      study of the trends from past data. Moreover, the two analyses are different in a
      way that technical analysis base their decisions mostly on supply and demand of
      the stocks while fundamentalist base their decision on true intrinsic value.

      Intrinsic value is the true economic value of the stock. It is important to the
      fundamentalists because they believe all stocks will converge to its intrinsic
      values. Thus a stock trading below its intrinsic value is a “good” investment
      (undervalued) while a stock trading above its intrinsic value is a “bad” investment
      (overvalued).

10.   The three step process moves from the general to the specific: economic
      analysis to industry analysis to company analysis. While economic and industry
      factors are important, company analysis is probably the single most important
      step. The four variables that, in general, determined stock prices are current
      earnings and dividends, future growth rates in earnings and dividends,
      uncertainty surrounding growth rates, and interest rates.

11.   Several reasons fundamental analysis might fail to work include bad data, the
      influence of random events, and the behavior of the analysts themselves. Many
      argue that technical analysis simply cannot work, no matter how well the


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      technician does his or her job. It is based on faulty assumptions. On the other
      hand, most critics of fundamental analysis do not question the validity of the
      assumptions fundamental analysis is based on. The problem is the execution
      critics contend.

12.   Analysts are under pressure from both the firms they work for and the companies
      they follow to say positive things. Analysts who say negative things about a
      company risk being cut off from sources inside the company making it difficult to
      do their jobs. The herd instinct states that a normal human reaction in the face of
      uncertainty is the tendency to stick together and follow the crowd. Moreover, if
      the consensus recommendation is off, it “probably could not have been
      predicted, but if one person who stands out is off, he was dead wrong.


Critical Thinking Exercises

1.    The computer work required by this exercise is not difficult. What is difficult,
      however, is establishing support and resistance levels and then interpreting the
      buy and sell signals. This exercise should give your students a pretty good idea
      of the subjective nature of technical analysis.

      a.     The graph will reveal that the Nasdaq rose sharply during the two year
             period, albeit somewhat erratically. The graph is shown in the Instructor
             workbook

      b.     The graph will show that the moving averages are far more stable than the
             raw series and better illustrate the general upward trend in the Nasdaq
             index. The graph is shown in the Instructor workbook.

      c.     The first resistance level is established at around 2,000; the first support
             level is established around 1,500. The index breaks through the
             resistance level and continues rising up 2,500 where another resistance
             level is established. The index then moves sideway for a while and
             establishes another resistance level at around 2,750. It breaks through
             that resistance level on its way up to 4,000.

      d.     The 10 day moving average breaks above the 200 day moving average in
             late October of 1998 (a buy signal). It remains above the 200 day moving
             average for the rest of the period. The index breaks above the 2,500
             resistance level in November 1998.

      e.     Your students should understand why interpreting technical indicators is
             difficult and often ambiguous. Whether following either chart would have
             produced higher profits than simply a buy and hold strategy is debatable.

2.    This exercise is slightly more difficult than the first exercise and your students
      may need a little more guidance to answer the questions.


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      a.     The relative strength measures are in the Relative Strength worksheet in
             the Instructor Workbook.

      b.     Very clearly Boeing’s relative strength declines throughout the time period.
             Disney’s relative strength initially increases and then falls sharply. Only
             the Gap’s relative strength increases.

      c.     Many students will have a difficult time coming up with some sort of a
             trading rule based on relative strength. Suggest they think about how a
             moving average might help to develop buy and sell signals (i.e., when the
             relative strength falls below the moving average, a sell signal is given, and
             vice-versa.)

3.    This exercise is fairly straightforward and will require only a minimal amount of
      guidance. Suggest students utilize the Internet—it will save them a great deal of
      time. The investment oriented Web sites are a good place to find data on
      earnings surprises.

      a.     Many investment oriented Web sites have sections on “earnings
             surprises.”

      b.     Students will likely find several earnings surprises that are fairly
             substantial, especially on the upside. For example, in April 2000
             Advanced Micro Devices announced quarterly earnings that were 150%
             higher than the consensus forecast.

      c.     There should be little relationship between the size of the surprise and the
             number of analysts following the stock. ADM, for example, is followed by
             16 analysts.

      d.     In the case of ADM, the analysts underestimated the demand for the
             company’s latest chips and the success of its recent restructuring plan.


THE “SUPER BOWL THEORY”

Some students have probably heard of something called the Super Bowl Theory of
stock prices. It says that if a NFC, or old NFL, team wins the Super Bowl, stock prices
will rise. If an old AFL teams wins, stock prices will decline. Now, we’re convinced the
Super Bowl Theory started as a joke, but it seems to have acquired too serious
reputation in recent years. (Alas, some people have no sense of humor.) Some
classify the theory as a technical indicator; others classify it as a market anomaly. If
you’re in the later group, you could use what follows while covering Chapter 7.

In the table below we present enough data for your students to “test” the theory. You
might suggest students construct two portfolios, one active and one passive. In the
passive portfolio, stocks are purchased at the end of January 1967 and held through the
end of January 1997. The other holds either T-bills or stocks depending on the

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outcome of the Super Bowl. If you use this approach, your students should discover
that the active portfolio outperforms the passive portfolio by a wide margin. Ask
students, does this mean the Super Bowl Theory is a good market timing device?

The table includes the winner each year and the prediction for stock prices. The returns
are from the end of January of the year indicated to the end of January of following
year. Have fun!




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                                                          Returns
Year         Winner     Conference       Indicator   Stocks       T-bills
1967   Green Bay       NFC            Hold stocks       9.47%       4.12%
1968   Green Bay       NFC            Hold stocks      14.15%       5.20%
1969   NY Jets         AFC            Hold bills      -15.93%       6.42%
1970   Kansas City     AFC            Hold bills       15.76%       6.11%
1971   Baltimore       Old NFL        Hold stocks      11.19%       4.21%
1972   Dallas          NFC            Hold stocks      13.85%       3.89%
1973   Miami           AFC            Hold bills      -15.10%       6.92%
1974   Miami           AFC            Hold bills      -18.10%       7.64%
1975   Pittsburgh      Old NFL        Hold stocks      31.16%       5.54%
1976   Pittsburgh      Old NFL        Hold stocks       5.04%       4.83%
1977   Raiders         AFC            Hold bills       -8.59%       5.12%
1978   Dallas          NFC            Hold stocks      16.63%       7.23%
1979   Pittsburgh      Old NFL        Hold stocks      18.72%       9.89%
1980   Pittsburgh      Old NFL        Hold stocks      17.68% 10.87%
1981   Raiders         AFC            Hold bills       -2.20%     13.49%
1982   San Francisco   NFC            Hold stocks      24.36%       9.91%
1983   Washington      NFC            Hold stocks      16.34%       8.51%
1984   Raiders         AFC            Hold bills       14.13%       9.28%
1985   San Francisco   NFC            Hold stocks      20.92%       7.35%
1986   Chicago         NFC            Hold stocks      29.11%       5.84%
1987   NY Giants       NFC            Hold stocks      -3.32%       5.21%
1988   Washington      NFC            Hold stocks      18.34%       6.41%
1989   San Francisco   NFC            Hold stocks      13.45%       8.06%
1990   San Francisco   NFC            Hold stocks       8.05%       7.47%
1991   NY Giants       NFC            Hold stocks      20.46%       5.26%
1992   Washington      NFC            Hold stocks      10.00%       3.35%
1993   Dallas          NFC            Hold stocks       8.79%       2.62%
1994   Dallas          NFC            Hold stocks        .57%       3.90%
1995   San Francisco   NFC            Hold stocks      38.58%       5.60%
1996   Dallas          NFC            Hold stocks      18.98%       5.21%
1997   Green Bay       NFC            Hold stocks      26.37%       5.23%
1998   Denver          AFC            Hold bills       23.18%       4.75%
1999   Denver          AFC            Hold bills       21.00%       4.90%
2000   St. Louis       NFC            Hold stocks




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