FINS1612 Chapter Notes - Chapter 7: Fundamental Analysis, Prospect Theory, Robert J. Shiller
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Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 7
Forecasting share price movements
Learning objective 7.1: Identify and interpret economic variables that impact on share price
movements within the context of the top-down approach to fundamental analysis
• The price of a share is essentially determined by the demand for and supply of the share. At any
moment, the balance between buyers and sellers of a company’s shares is determined by their
assessments of the future profitability of a company and forecast movement in the share’s price.
• Investors and share analysts may conduct their evaluations and issue their buy/sell
recommendations using fundamental analysis.
• Fundamental analysis, incorporating the top-down approach and the bottom-up approach,
examines variables that finance and economic theories identify as being relevant to a company’s
future performance.
• The top-down approach looks at prospective developments in the broader economic environment
within which the various industry sectors and specific companies are situated.
• Important variables that are identified as being of relevance to the future performance of various
industry sectors, and therefore companies operating within those sectors, include:
o developments in major international economies
o the rate of growth within a domestic economy
o the variability and volatility of exchange rates, particularly those of major trading partners
o changes in monetary policy settings and movements in interest rates
o the balance of payments current account, and whether the current account is in surplus or
deficit
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o upward pressures on wages growth relative to increases in productivity.
Learning objective 7.2: Evaluate and apply the principles of the bottom-up approach to
fundamental analysis, in particular the analysis of the financial and operational performance of a
corporation
• Once an investor has determined which economies and which industry sectors offer the most
attractive investment opportunities (using the top-down approach), the investor must conduct an
analysis of firms in those sectors to decide which shares to buy or sell.
• The fundamental analysis bottom-up approach uses accounting ratios and other performance
measures to analyse the financial, operational and management performance of a particular
company.
• Ratios that are analysed include capital structure, liquidity, debt servicing, profitability, share
price and equity and risk.
• Ratios will be measured over time and compared with those of similar corporations in the same
industry. (Note: Ratios use historic data which may not accurately reflect future performance.)
• Other indicators include key management, corporate governance and strategic direction.
Learning objective 7.3: Describe and apply technical analysis to forecasting movements in share
prices
• Technical analysis adopts an alternative approach to share price forecasting. The approach is
based on the assumption that, over time, apparent trends and patterns in share price movements
are formed.
• It is further assumed that as a new pattern emerges the past behaviour pattern observed in an
historic pattern will also re-emerge.
• Two principal models used by technical analysts are (1) moving-averages models and (2)
charting.
• A moving-averages model is a graph of a series of average prices constructed over time. The
moving average is designed to smooth out the effects of intra-period volatility. An example
might be the construction of a 10-day moving -averages model or a 30-day model.
• Alternatively, a weighted model may be structured in order to give greater value to the most
recent data observations. Therefore the most recent information will have a higher weight than
earlier or past data.
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• Technical analysts use strict decision rules; that is, if a model develops in a certain pattern,
decisions to buy or sell are automatically triggered.
• Another form of technical analysis is the use of charting. A chartist will use price movements to
plot uptrend and downtrend lines. A return line is drawn to create a trend channel. A chartist is
looking for support and resistance lines incorporating continuation patterns such as triangles,
pennants and flags.
• Each of these patterns denotes price behaviour patterns and enables the chartist to make forecasts
on future price movements. After a major shift in a trend line, a chartist will expect reversal
patterns to emerge. One such pattern is known as the head and shoulders pattern.
• Elliot wave theory contends that there are distinctive wave patterns that characterise share-
market cycles.
Learning objective 7.4: Examine the role of electronic trading in influencing share price
movements
• Program trading refers to buy/sell orders that are automatically triggered by computer-based
share trading systems.
• Such automated programs may result in rapid share price changes which in turn may trigger
further buy/sell orders.
• A number of stock exchanges, including the NYSE and the ASX, have rules in place whereby
trading is suspended if the markets move by more than a specified percentage during a trading
day.
• High-frequency trading (HFT) is the application of high-speed supercomputers that are
controlled by algorithms that analyse data, identify investment opportunities, and influence stock
order flows and therefore share prices in the market.
• Flash trading is a situation where certain privileged institutional investors, typically HFT firms,
receive (are flashed) information from a stock exchange of incoming stock orders a fraction of a
second before this information is sent to the exchanges trading system.
• Dark pools is a dedicated trading system that operates within an exchange that allows certain
institutional investors to place large buy or sell orders without having to disclose the trade to the
entire market.
• News analytics involves the analysis of large volumes of textual or qualitative information from
newspapers, blogs, websites and social media in order to derive insights relating to factors such
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Document Summary
At any moment, the balance between buyers and sellers of a company"s shares is determined by their assessments of the future profitability of a company and forecast movement in the share"s price. 1: upward pressures on wages growth relative to increases in productivity. Learning objective 7. 3: describe and apply technical analysis to forecasting movements in share prices: technical analysis adopts an alternative approach to share price forecasting. The approach is based on the assumption that, over time, apparent trends and patterns in share price movements are formed. The moving average is designed to smooth out the effects of intra-period volatility. An example might be the construction of a 10-day moving -averages model or a 30-day model: alternatively, a weighted model may be structured in order to give greater value to the most recent data observations. Therefore the most recent information will have a higher weight than earlier or past data.
