CSC volume 2

Market Theories

Efficient Market

Random walk

rational expectations

Which theory reflects a stock's price fully reflects all available information and represents the best estimate of the stock's true value

efficient market hypothesis

which theory reflects stock's price fully reflects all available information and represents the best estimate of the stock's true value

random walk

which market belief is where people are rational and have access to all necessary information,use this information intelligently and in their own self interest and will make intelligent decision after weighing all available information

rational expectations

4 parts to fundamental macroeconomic analysis

fiscal policy

monetary policy

flow of funds

inflation

factors that limit the effectiveness of fiscal policy

lag time, approval of legislation and when fiscal action is taken and the time the acton affects the economy

effects of tax cuts

boost profits

common share prices

effects of tax hike

lower consumer spending

business profitability

during a period of economic expansion

demand for credit grows and prices move upwards too quickly

leads to higher short term interest rates

economy slowing down

increase money supply and availability of credit

lower short term interest rates

what happens to bond yields when economic growth occurs

bond yields rise

growth recession

temporary slowdown in economic growth that does not lead to a full recession

long-term rates fall while short-term rates rise

bond market temporarily signals its approval of the degree of economic slowing

inverting or a tilting of the yield curve

long-term bond yields fall while short-term rates rise

process of tilting yield curve

-rising bond yields cause a decline in bond prices

-short term interest rates rise, rate at which bond yields increase slows down. Bond yields are still rising but at a slower pace.

higher real bond yields over time increase the degree of competition between

bonds and equities

there is a shift of capital flows from one asset class to another

relative valuation of instruments change

shifts in flow of funds is caused by

changes in interest rate levels

equity mutual fund purchases should ____ as interest rates fall

rise

Non resident net purchases

lags behind other purchases

inflation impact

increases passed on to consumers in higher prices to ensure manufactures maintain profitability

eventually consumer will no longer want to pay

rate of inflation and p/e multiples have an

inverse relationship

average annual increase in 2 decades before mid 1960s was

less than 2.5% plus or minus business cycle fluctuations

what period of time was inflation very high

1978 and 1982

10.3% annualized

S&P/TSX Composite Index classifies stocks into 10 major sectors based on the

GICS

Global Industry Classification Standard

industry classification benchmark used by dow jones indexes and FTSE group

ICB

two factors to understand the competitive forces within the industry

prospects for growth

degree of risk

3 basic questions to ask regarding sales growth

industry's sales compare with the rate of growth in nominal GDP

rate of change in real GDP compare with the industry's rate of change in units

industry's price index compare with the overall rate of inflation

Revenue growth may result from

higher prices

increased sales volume

Law of survivorship

As the size of a market increases, a decline in unit costs occurs due to economies of

scale

for a company to survive it must become either

low cost producer

producer of a product that has real or perceived differences

classifying industries by stage of growth

emerging growth

growth

mature

declining

emerging growth industry characteristics

negative cash flows

may be unprofitable at first, although future prospects may appear promising

growth industry characteristics

sales and earnings are consistently expanding at a faster rate than most other industries

above-average rate of earnings on invested capital over a period of several years

-increasing sales in terms of both dollars and units, coupled with a firm control of costs

-companies lower prices as production costs decrease and competition intensifies

- often finance much of their expansion using retained earnings

-relatively high price-earnings ratios and low dividend yields

at what stage do companies lower prices as production costs decrease and competition intensifies

growth stage

at what stage do companies typically have negative cash flows

emerging growth

Mature Industries characteristics

slowing of growth to a rate that more closely matches the overall rate of economic growth

-price competition increases, margins fall, may expand into new business with better growth prospects

-slower, more stable growth rates in sales and earnings

declining industries characteristics

- produce products for which demand has declined because of changes in technology, an inability to compete on price, or changes in consumer tastes.

-Cash flow may be large, because there is no need to invest in new plant and equipment

Porter's 5 forces

ease of entry

degree of competition between existing firms

threat of substitutes

bargaining power of buyers

bargaining power of suppliers

2 types of Industries by Stock Characteristics

defensive

cyclical

cyclical industries

sensitive to global economic conditions

-large international exporters of commodities

3 main groups of cyclical industries

commodity basic

industrial

consumer

energy and gold are what type of industry?

cyclical

single greatest influence in determining the profitability of cyclical Canadian companies

rate of expansion or contraction in the U.S. business cycle

cyclical industries benefit from what position in the dollar

declining Canadian dollar

defensive industries characteristics

-relatively stable ROE

-tend to do relatively well during recessions

-dominant market position, strong internal financing, effective management

industries considered blue chip

utilities as well as Canadian banks, but they are sensitive to interest rates

why are utilities sensitive to interest rate risk

carry large amounts of debt

speculative industries

risk and uncertainty are unusually high due to a lack of definitive information

why is roe important to shareholders

measures the profitability of the common shareholders' capital in the business

which industry tends to outperform during recessions

defensive

ddm formula

dividend current year / (required rate of return of stock - constant growth rate for dividend)

div1 / (r- g)

Dividend Discount Model

assumes that there will be an indefinite stream of dividend payments, whose present values can be calculated

assumes that these dividends will grow at a constant rate

P/E ratio

inversely related to the prevailing level of inflation and interest rates

Technical analysis

study, and plot on charts, the past and present movements of prices, the volume of trading, statistical indicators

Market action includes three primary sources of information

price

volume

time

3 assumptions of technical analysis

All influences on market action are automatically accounted for or discounted in price activity

Prices move in trends and those trends tend to persist for relatively long periods of time

The future repeats the past

main difference between technical and fundamental analysis

echnician studies the effects of supply and demand (price and volume), while the fundamental analyst studies the causes of price movements.

four main methods used by a technical analyst to identify trends and possible trend turning points

chart analysis

quantitative analysis

analysis of sentiment indicators

cycle analysis

support level

low of the trading range

price at which the majority of investors start sensing value, and therefore are willing to buy (demand is strong)

demand begins to exceed supply

resistance level

high of the trading range

supply exceeds demand

prices tend to fall

Chart formations reflect market participant behavioural patterns and can indicate either

a trend reversal (reversal pattern)

a pause in an existing trend (continuation pattern)

market bottom head and shoulders is known as

inverse head-and-shoulder or a head-and-shoulders bottom

market top head and shoulders known as

head and shoulders top formation

Continuation patterns are

pauses on price charts

referred to as a consolidation of an existing trend

most popular continuation pattern

symmetrical triangle

Quantitative analysis

form of technical analysis that has been greatly enhanced by the growing sophistication of computers

two general categories of statistical tools

-moving averages

-oscillators

moving average

device for smoothing out fluctuating values (week-to-week or day-to-day) in an individual stock or in the aggregate market as a whole

calculating moving averages

adding the closing prices for a stock (or market index) over a predetermined period of time and dividing the total by the time period selected

If the overall trend has been down, the moving average line will generally be

above the current individual prices

sell signal in moving average

price breaks through the moving average line from above on heavy volume

moving average line starts to fall

buy signal in moving average

price breaks through the moving average line from below on heavy volume and moving average starts to move higher

Oscillators

indicators that are used when a stock's chart is not showing a definite trend in either direction

when is an oscillator most beneficial

when a stock is moving in either a horizontal or sideways trading pattern

oscillator used in 3 ways

1. When the oscillator reading reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move has gone too far

2. A divergence between the oscillator and prices when the oscillator is in an extreme position is usually an important warning that a trend may be weakening

3. On a scale of -1 to +1, the crossing of the zero line can give important trading signals

market is said to be overbought when

prices are near the upper extreme

moving average convergence-divergence(MACD) dates

standard periods used are a 12-day and 26-day moving average of a specific stock

MACD signal line

A 9-day moving average of the MACD is then created and this line is called the signal line

signal in macd

when the MACD crosses the signal line

macd identify divergence

-If a stock is moving higher but the MACD is trending lower, this could be interpreted as a warning signal that the stock price is losing its upward momentum

-a series of higher MACD lows when the stock price is moving down may 1indicate a bottom may be near for the stock's price

Contrarian investors

move in the opposite direction from the majority

use as evidence to support other indicators

Sentiment Indicators

investor expectations

-four general categories of cycle lengths

• Long-term (greater than two years)

• Seasonal (one year)

• Primary/intermediate (nine to 26 weeks)

Trading (four weeks)

Elliott Wave Theory

tock market moves in huge waves and cycles. Superimposed on these waves are smaller waves, and superimposed on the smaller waves, even smaller waves

- market moves up in a series of five waves and down in a series of three waves

volume changes

to confirm other indicators

In a bull market, volume should increase when prices rise

-tells investors weight of money is on the buy side of market

prices rise and volume does not increase, the market may be in the beginning stages of a potential

bearish reversal

breadth of the market

monitors the extent of the number of stocks participating in a market trend

greater number of stocks following a trend

greater the breadth

Ways to measure breadth

advance-decline line

why are returns called "expected returns"

Returns are rarely guaranteed

expected return formula

cash flow + capital gain

Return %

((Cash Flow + (Ending Value - Beginning Value) )/ Beginning Value) x 100

holding period return

transaction period were for longer or shorter than a year

ex-ante returns

projection of expected returns

ex-post returns

historical returns

Choosing a realistic expected rate of return

expect the T-bill rate plus a certain performance percentage given the level of risk

highest rates of return were achieved by securities

that had the greatest variability or risk as measured by standard deviation

risk free rate

t bill

types of risk

-business

-inflation

-political

-liquidity

-interest rate

-foreign exchange risk

-default risk