Tài chính kế toán - Chapter 7: Forecasting share price movements

Chapter 7Forecasting shareprice movementsLearning objectivesEvaluate and apply bottom-up and top-down approaches to fundamental analysisDescribe and apply technical analysis techniquesExamine the role of program tradingExplain the theoretical concepts and implications of the random walk and efficient market hypotheses when forecasting share price movementsChapter organisation7.1 Fundamental analysis: top-down approach7.2 Fundamental analysis: bottom-up approach7.3 Technical analysis7.4 Program trading7.5 Random walk and efficient market hypotheses7.6 Summary7.1 Fundamental analysis: top-down approachShare price is determined by supply and demand of a company’s sharesExpectation of bad company performance causes investors to sell their shares, increasing supply and reducing the priceExpectation of good company performance increases demand and leads to an increase in share price(cont.)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 question1. Fundamental analysis: top-down2. Fundamental analysis: bottom-up3. Technical analysis(cont.)7.1 Fundamental analysis: top-down approach (cont.)Fundamental analysisConsiders macro and micro factors that impact upon cash flows and future share prices of various industry sectors and firmsMacro factors include interest rates, economic growth, business investmentMicro factors are firm-specific and relate to management’s impact on company performance(cont.)7.1 Fundamental analysis: top-down approach (cont.)Top-down approach considers macro factorsEconomic growth of international economiesExchange ratesInterest ratesDomestic economyGrowth rateBalance of paymentsInflationWage and productivity growthGovernment responses to changes in the above factorsTop-down approach—International economiesThe higher the growth rate in the rest of the world, the greater the demand for Australian exportsSectors benefitting from international growth determined by source of the growthGrowth can be driven by:increased consumer demandincreased business investment in equipmentTop-down approach—rate of growth of an economyGenerally, greater domestic growth leads to increased profitability of firmsBut high growth can lead to any of the following factors that can reduce firm profitability:Deterioration in balance of paymentsIncrease in inflationary pressuresPressure on wagesDepreciation of the exchange rateRise in interest ratesTop-down approach—exchange ratesAffect the domestic currency profit of exporters that quote their products in foreign currency pricesA strengthening Australian dollar (AUD) makes these firms worse off because the AUD value of their exports is lowerThe strength of the AUD over the past few years has led to calls for assistance from the manufacturing industry, for exampleExchange rates also affect firms indirectlyE.g. devaluation of currency increases cost of imports, thereby increasing inflationTop-down approach—interest ratesHave both a direct and indirect impact on a firm’s valueDirect effect on profitabilityRepresents the cost of debt finance for borrowers and the return for finance providersIndirect effect on profitabilityRise in interest rates may indicate a slowing of economic activityFuture reduction in profitabilityA strong relationship exists between interest rates and exchange ratesTop-down approach—balance of payments current accountIf current account is in deficit (i.e. total international payments exceed total international receipts):some export income is diverted to service debtneed to borrow foreign currency to service debtIndirect effect on firms’ profitabilityGovernment may increase interest rates to slow economic growth and control the debtTop-down approach—inflationary pressuresEffect of inflation on firm’s real profitTax treatment of inflationMakes historical-based depreciation allowances inappropriateCombined with higher replacement costs, leads to an overstatement of after-tax profitInventory‘Inflated’ selling price of inventory creates an illusion of inventory profitsTop-down approach—wages growthIncrease in wages growth raises the amount of business profit used for salariesThis will impact most heavily on those firms that are highly labour intensiveChapter organisation7.1 Fundamental analysis: top-down approach7.2 Fundamental analysis: bottom-up approach7.3 Technical analysis7.4 Program trading7.5 Random walk and efficient market hypotheses7.6 Summary7.2 Fundamental analysis: bottom-up approachFollowing 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 theseBottom-up approach considers micro factors using ratios and other measures of a firm’s financial characteristics and performance(cont.)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 industryAdditional information on key management changes, corporate governance and strategic direction(cont.)7.2 Fundamental analysis: bottom-up approach (cont.)Chapter organisation7.1 Fundamental analysis: top-down approach7.2 Fundamental analysis: bottom-up approach7.3 Technical analysis7.4 Program trading7.5 Random walk and efficient market hypotheses7.6 Summary7.3 Technical analysisExplains and forecasts share price movements based on past price behaviourAssumes markets are dominated at certain times by mass psychology, from which regular patterns emergeTwo main forecasting modelsMoving averages (MA)Charting1. Moving averages (MA) modelsSmooth out a series facilitating the identification of trends in the seriesCalculation of MAAssuming a five-day moving average, the MA is calculated by taking the average of the price series for the preceding five days(cont.)Moving averages (MA) models (cont.)Trading rulesBuy when the price series cuts the MA from belowBuy when the MA series is rising strongly and the price series cuts or touches the MA from above for only a few observationsSell when the MA flattens or declines and the price series cuts the MA from aboveSell when the MA is in decline and the price series cuts or touches the MA from below for only a few observations(cont.)Moving averages (MA) models (cont.)Typically, for daily price series both 10-day (short-term) and 30-day (medium-term) moving averages are calculatedWeighted MAThe most recent information is given the greatest weight2. ChartingInvestigating patterns in price chartsSeveral techniquesTrend linesSupport and resistance linesContinuation patternsReversal patterns(cont.)Charting (cont.)Trend linesTrends are regular movements in share pricesTwo types of trends1. Uptrend line—connecting the lower points of rising price series2. Downtrend line—connecting the higher points of falling price seriesReturn line—line drawn parallel to a trend line to create a trend channelCritical issue is to determine when the trend line is going to change(cont.)Charting (cont.)Support and resistance linesSupport levels—where there is sufficient demand to halt further price fallsResistance 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(cont.)Charting (cont.)Continuation patternsSideways share trading that does not normally signal a change in trendTwo types1. Triangles—composed of a series of price fluctuations, each smaller than its predecessorSymmetrical 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(cont.)Charting (cont.)Reversal patternsOccur after a major market moveResult in a ‘head and shoulders’ patternThree successive rallies and reactions, the second rally being stronger than the first and third ralliesLeft shoulder—formed by volume-strong rally on uptrend, followed by reduced-volume reactionHead—second rally increases price before reaction moves price back to previous lowRight shoulder—final rally marked by reduced volume indicating price weakness(cont.)Charting (cont.)Elliott wave theoryThe existence of distinctive wave patterns that characterise share-market cyclesKey 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 peak7.3 Technical analysis (cont.)Validity of technical analysisEven where techniques have no apparent underlying validity, if they are followed by enough participants they may impact on share price behaviour at timesMore likely to forecast successfully when share prices move out of a range explained by economic and financial fundamentalsChapter organisation7.1 Fundamental analysis: top-down approach7.2 Fundamental analysis: bottom-up approach7.3 Technical analysis7.4 Program trading7.5 Random walk and efficient market hypotheses7.6 Summary7.4 Program tradingRefers to buy and sell strategies generated by computer programsPrograms range between:simple buy/sell orders based on moving averages; andcomplex monitoring of both derivatives and share markets for the purpose of hedging a share portfolioProgram trading increases the speed at which prices changeChapter organisation7.1 Fundamental analysis: top-down approach7.2 Fundamental analysis: bottom-up approach7.3 Technical analysis7.4 Program trading7.5 Random walk and efficient market hypotheses7.6 Summary7.5 Random walk and efficient market hypothesesTwo theories on security values and changes in price:1. Random walkShare price is assumed to be formed by investor’s expectations of future cash flows, i.e. intrinsic valuePrice will change in response to new information; since information arrives in a random fashion, stock prices adjust in an unpredictable fashion(cont.)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 priceThere is an equal probability that the next price will move up, down or remain unchanged(cont.)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 informationIt is not possible for an investor to make abnormal profits through superior information(cont.)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 price2. Semi-strong form—all publicly available information is reflected in share price3. Strong form—public and private information is fully reflected in share price(cont.)7.5 Random walk and efficient market hypotheses (cont.)Alternative models of investor behaviour have attracted renewed attention following the GFCBehavioural Finance:Attempts to understand investor behaviourBased on psychological principles of behaviourExplaining market volatility and stock market crashes:Over-confidence and over-pessimismHerdingNoise tradingHeuristicsFramingChapter organisation7.1 Fundamental analysis: top-down approach7.2 Fundamental analysis: bottom-up approach7.3 Technical analysis7.4 Program trading7.5 Random walk and efficient market hypotheses7.6 Summary7.6 SummaryDemand and supply determines the price of sharesDemand and supply of shares is determined by expectations about futureCompany performanceFundamental analysisTop-down approachBottom-up approachShare price movementTechnical analysisMoving averages modelsCharting(cont.)7.6 Summary (cont.)Program trading involves buy and sell orders generated by computer programsRandom walk hypothesis—the price of a share is independent of its previous priceEfficient market hypothesis—prices adjust immediately to new information