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Topic #4 Financial Instruments in the Market: II Stocks

Topic #4 Financial Instruments in the Market: II Stocks. J.D. Han King’s College, UWO. Three Methods of Valuation/Prediction. 1. Technical Analysis 2. Fundamental Analysis 3.Rational Expectations Analysis. I. Technical Analysis. :”Charting” technique

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Topic #4 Financial Instruments in the Market: II Stocks

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  1. Topic #4 Financial Instruments in the Market: II Stocks J.D. Han King’s College, UWO

  2. Three Methods of Valuation/Prediction • 1. Technical Analysis • 2. Fundamental Analysis • 3.Rational Expectations Analysis

  3. I. Technical Analysis :”Charting” technique • Trying to identify “deterministic” pattern in historical stock prices • Stock prices are believed to go through this ‘deterministic’ life cycles

  4. Technical Analysis in the real world • What are they? How do they work? http://stockcharts.com/education/TradingStrategies/index.html • Do they make an economic sense? • A higher profit with TA than without it. • At what cost? -Practicality Issue http://www.recognia.com/about/news/2003_01_27.htm

  5. II. Fundamental Analysis “Accounting” Method 1. Basic Premise: Price-Earnings Ratio gravitates towards a certain Benchmark Value. The Benchmark Value is just like a Long-Run equilibrium value in economics. # Does it exist?

  6. 2. Investment Strategy of Fundamental Analysis “Pick up Undervalued Stocks” (1) Simplest Method • If P/E ratio < Benchmark P/E, the stock is undervalued: “Buy” • If P/E ratio < Benchmark P/E, the stock is overvalued: “Sell” (2) Most Complex(Obscure) Methods • John Templeton’s strategy • Warren Buffett’s strategy http://www.investopedia.com/articles/01/071801.asp

  7. 3. Stock Price P = D/ (r – g) P: ‘fair’ Stock Price D: Annual Dividends r: Discount Rate (=Interest Rate from alternative investment) g: (Expected) Annual Growth rate of Dividends

  8. 4. Price-Earnings Ratio P/E Ratio = Price / Earnings = (Dividends/Earnings) / (r - g)

  9. * Numerical Example (Question) Would you buy or sell the following stock? Actual Price of a Stock = $55 Dividends = $1 Interest Rate = 5% Annual Growth Rate of Dividends = 3% (Solution) What is the ‘fair price’ of this stock? Is the actual market price higher or lower?

  10. III. Rational Expectations Analysis • “There is no mis-priced stock in the market” • “No known information or deterministic information is useful in predicting a future price change”

  11. 1. Why?: Efficient Market Theorem • Financial Market is Efficient in Utilizing Information • All known/expected information has been already reflected in the current price through immediate market actions possibly by those close to information sources: The current price of an asset is the result of market actions based on the known/expected information. No chance for an average investor with public information to make profits

  12. 2. Three Versions of Efficient Market Theorem Weak Version: past price has no ‘informational’ value, and does not help you predict a future price change • History does not help predict the future • Technical analysis is useless Semi-strong Version: Public information is useless. Strong Version: No information is helpful

  13. 3. What does the Rational Expectations Theory say about the Stock Prices over time? • Current Stock Prices have already incorporated all expected information. • Any even that has been anticipated does not affect the stock price again. • Only the event that has not been anticipated affects the stock price. • Stock Prices respond only to “News” or “Surprise” • News are random, and thus Changes in Stock Price are Random Walk (not denying the trend of stock price itself).

  14. 4. Implications for Investment Strategy • Long-Term Buy and Hold: • Short-Term Unpredictability: You cannot beat the market “Timing the market” is a bad idea

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