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FNCE 3020 Financial Markets and Institutions. Lecture 6; Part 2 Forecasting with Fundamental Analysis and Technical Analysis. Beginning Quotes. “The only function of economic forecasting is to make astrology look respectable.” John Kenneth Galbraith
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FNCE 3020Financial Markets and Institutions Lecture 6; Part 2 Forecasting with Fundamental Analysis and Technical Analysis
Beginning Quotes “The only function of economic forecasting is to make astrology look respectable.” John Kenneth Galbraith “An economic [forecaster] is an expert who will know tomorrow why the things she/he predicted yesterday didn't happen today.” Laurence J. Peter “Isn't it interesting that the same people who laugh at science fiction listen to weather forecasts and economists?” Kelvin Throop III
Objective for This Lecture Series To introduce you to two different approaches to forecasting financial asset prices. (1) Fundamental analysis Uses economic and financial data upon which identify undervalued assets and then to estimate the future price move of a particular financial asset. (2) Technical analysis Forecasting future financial asset price movements based on past price (and volume) movements. Finally, if financial markets are efficient, is it possible to use this efficiency to determine what the market is expecting? Future interest rates Future rates of inflation
Fundamental Analysis • Attempts to identify “undervalued” financial assets. • That is, a financial asset whose market price is below its intrinsic (true) value. • Assumes that prices may be undervalued in the short term, but eventually the market will “catch up” and re-price the asset. • However, if financial markets are efficient, financial assets are priced correctly, and thus there will be no undervalued assets. • Warren Buffett on market efficiency (Fortune Magazine, April 3, 1995): “I'd be a bum in the street with a tin cup if the markets were efficient.” • For an interesting account of Warren Buffett see: http://beginnersinvest.about.com/cs/warrenbuffett/a/aawarrenbio.htm
Forecasting Assuming Efficient Financial Markets • According to the Efficient Market Hypothesis, when new information hits the market, the news spreads very quickly and is incorporated into asset prices with little delay. • If this this the case, then any technique (forecast) suggesting greater returns than the over-all market (or the individual security) is questionable at best. • So as we work through the following forecasting approaches, consider how efficient markets would impact upon each technique. • See Appendix 1 for a discussion of the three forms of market efficiency and their implications for forecasting.
Background on Fundamental Analysis • Traced to the writings of Columbia University professors Benjamin Graham and David Dodd (1934, Security Analysis). • Graham and Dodd argued that investors should buy undervalued stocks. Some indicators to look for are: • Current assets exceeding current liabilities, and/or • Low price/earnings (p/e) ratio. • Graham and Dodd advocated searching out stocks which are undervalued by the market. • Once an undervalued security is found, it's simply a matter of buying the stock and waiting for the market to realize the "more accurate" value of that security. • Warren Buffett studied under Benjamin Graham at Columbia University in the early 1950s.
Calculating the Value of Common Stock Through Fundamental Analysis • Two general “fundamental” approaches to valuing common stock (i.e., for determining their intrinsic value) are: • (1) Discounted Cash Flow: Assumes a stock’s value is based on the present value of its future cash flows, such as dividends, or earnings. • Estimate future cash flows and discount to the present, and compare to market price. • (2) Relative Valuation Approach: Assumes a stock’s value is determined by certain variables, such as the company's earnings, revenues or book value. • Compare value to market price.
Top Down Fundamental Approach • The top-down approach is probably the most comprehensive of all fundamental techniques. It usually involves specific steps (and investment teams) such as: • 1. Economic Forecast (global, national, regional) • 2. Industry Selection • Which industries are likely to do well in the forecasted environment. • 3. Analysis of Companies within the Industry • Leaders, innovators, start-ups, etc. • 4. Company Selection • Company’s plans and outlook • New product development, red flags (litigation, etc.) • Management • Analysis of company’s financial statements. • 5. Determination of the intrinsic value of the stock.
Fundamental Analysis: Importance of Appropriate Model • The selection of an appropriate “pricing” model (i.e., independent variables) is critical to the forecasting procedure. • Market price of long-term bonds • Interest rate models with focus on future inflation. • Foreign exchange rate (short term horizon) • Short term interest rate differential models with focus on central bank policies • Foreign exchange rate (longer term horizon) • Trade (imports and exports) and capital flows (stock market, foreign direct investment). • Inflation. • Common stock • Economic, industry and company models.
Forecasting with Technical Analysis • This technique examines past (including the most recent) financial asset prices in an attempt to predict future moves in asset prices. • However, if markets are efficient, then the quick flow of new information will be immediately reflected in asset prices. • Thus tomorrow's price change will reflect only tomorrow’s news and since tomorrow’s news is unpredictable, tomorrow’s price will be unpredictable and random (aka, Fama’s “random walk”). • Warren Buffet on Technical Analysis: “If past history was all there was to the game, the richest people would be librarians.”
Definitions of Technical Analysis Robert Edwards and John Magee’s classic book (Technical Analysis of Stock Trends, 1948): Technical Analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in “the Averages” and then deducing from that pictured history the probable future trend.” Martin J. Pring (Technical Analysis Explained, 1979). "The technical approach to investing is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political, and psychological forces. The art of technical analysis -- for it is an art -- is to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed."
History of Technical Analysis • The origins of technical analysis can be traced to a series of articles published by Charles H. Dow in the Wall Street Journal between 1900 and 1902. • Charles Dow suggested the use of “past price behavior to guide investing decisions.” • Dow Theory: “The market is in an upward trend if one of its averages (industrial or transportation) advances above a previous high and is followed by the other.” • “When both averages dip below previous lows, it's regarded as an indicator of a downward trend.” • See Appendix 3 for a short bio on Charles Dow.
History and Use of Technical Analysis • Origins can be traced to articles published by Charles H. Dow in the Wall Street Journal between 1900 and 1902. • Charles Dow suggested the use of “past price behavior to guide investing decisions.” • Dow Theory: “The market is in an upward trend if one of its averages (industrial or transportation) advances above a previous high and is followed by the other.” • Technical analysis essentially believes that the price of an financial asset is determined by the supply of and demand for that asset. • Furthermore, early shifts in demand and/or supply are indicated through the charting of these financial assets.
Summary of Technical Analysis Technical Analysis NOT interested in financial or economic data that may affect the asset’s price. Sometimes referred to as “noise” trading (i.e., not interested in news). Utilizes charts of past price movements to estimate where prices may move in the future. Sometimes referred to as a chartist (or charting) approach. Assumes prices are not random That patterns of prices develop and can be used to forecast the future.
Summary of Technical Analysis Technical Analysis Generally uses a short forecasting time frame: Intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), Daily, weekly or monthly. Can be applied to any financial asset who’s price is determined by supply and demand. Stock, bonds, foreign exchange, key commodities.
Examples of Technical Approaches Moving Average Analysis of Stocks Where is the individual stock (or market) in relation to some moving average of past prices? If breaking above moving average, this is a signal of strength. If breaking below moving average, this is a signal of weakness. Overbought and Oversold Analysis of Stocks (or Bollinger Bands) Is the individual stock (or market) trading above or below its historical range (measured by +/- 2 standard deviations of historical data)? Above its range suggests overbought condition. A signal that the stock (or market) should move down. Below its range suggests oversold condition. A signal that the stock (or market) should move up. Head and Shoulders Reversal Pattern (see Appendix 4 for description and examples)
Use of Technical Analysis in Foreign Exchange Markets • Since the early 1990s, a number of studies have surveyed foreign exchange market participants concerning their use of technical analysis. • These studies conclude that technical analysis is in widespread use among professional foreign exchange traders. • See: • Allen, Helen, and Mark P. Taylor. 1990. "Charts, Noise and Fundamentals in the London Foreign Exchange Market." Economic Journal 100 (supplement): 49-59. • Taylor, Mark P., and Helen Allen. 1992. "The Use of Technical Analysis in the Foreign Exchange Market." Journal of International Money and Finance 11: 304-14. • Following slides show examples of the use of technical analysis in forecasting foreign exchange rates.
Sources of Technical Charts and Discussions For a discussion of types of technical signals: http://www.tradetrek.com/education/tech_tra/tech_trading_strategy03.asp Technical charts of individual U.S. stocks and the market: http://finance.yahoo.com/q/bc?s=goog&t=1d Technical charts for U.S. stock market and overseas stock markets: http://finance.yahoo.com/intlindices?u Discussion of foreign exchange technical signals: http://www.fxstreet.com/rates-charts/forex-charts/ Technical charts for foreign exchange rates: http://fx.sauder.ubc.ca/
What can we Forecast if Markets are Efficient? • Perhaps we can use efficient market models to evaluate “real time” market assessments about the future, assuming market participants are forming expectations about the future. These might include: • Yield Curves: • Allow us to measure the markets’ “forecast” for future interest rates (i.e., forward rates) and or economic activity (via an inverted yield curve) • TIPS Versus Nominal Treasury Bonds: • The difference between the two might provide us with the markets’ “forecast” for future inflation.
TIPS: Inflation Linked Bonds • Treasury Inflation-Protected Securities, or TIPS, are U.S. Government securities that provide protection against inflation (they are now called inflation indexed securities). • They were first issued in the U.S. on January 29, 1997 • U.K. started issuing them in 1981. • The principal value i.e., maturity value) of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI-U = all urban consumers). • A daily inflation adjustment index is generated through a linear interpolation of Consumer Price Index values, and this interpolated index is applied each day to the TIPS principal.
TIPS: Inflation Linked Bonds • Coupon payments (TIPS pay interest twice a year) are calculated by applying the fixed coupon rate to the adjusted principal. • Thus, interest payments (i.e., the dollar amount) rise with inflation and fall with deflation. • Therefore, TIPS promise investors a stable “real return” over the lifetime of the financial asset.
A TIPS Example • Assume, a 3% coupon TIPs is purchased at issuance date at a face (par) value of $1,000. • By the end of the first year, the CPI-U has risen by 4%. • At the end of the first year, the inflation adjusted face value would increase to $1,040 ($1,000 x 1.04). • The interest paid would be $31.20 (.03 x $1,040) – assume interest paid once a year. • Assume the rate of inflation for the second year is 3%. • The inflation adjusted face value = $1,071.20 ($1,040 x 1.03) • The interest paid = $32.14 (.03 x $1,071.20) • Each year the face value will increase (or decrease) with inflation (or deflation). At maturity, the TIPS will be redeemed at the final inflation adjusted face value or the face value at issuance ($1,000) which ever is greater.
Using TIPS to Measure Inflationary Expectations • In principle, the yield difference between conventional (nominal) Treasuries and TIPS may offer us a “market-based” measure of “inflation expectations.” • Why? • If we assume that TIPS reflect real returns and conventional (nominal)Treasuries incorporate an inflationary expectations premium (i.e., the Irving Fisher model), then the difference between the two should reflect inflationary expectations.
TIPS Data; Bloomberg.Com March 16, 2009 Calculated Inflation Expectations Annual rates over the next: 5 years 1.91 – 1.25 = 0.66% 10 years 2.95 – 1.84 = 1.11% 30 years 3.77 – 2.23 = 1.54%
Historical Relationship of TIPS to Observed Inflation Data • When TIPS were first issued in 1997, it was hoped that they could be used to measure inflationary expectations. • Unfortunately, the results after ten years have proved less than hoped for. • Long term evidence suggests that the expected inflation derived from the TIPS market has tended to underestimate actual inflation.
What’s Wrong with TIPS as an Inflation Estimate? • There are two possible factors that can cause errors in the TIPS inflation estimates. • (1) The existence of an “inflation risk premium” on non-TIPS government securities. • (2) A liquidity premium on TIPS. • Unfortunately, these two biases likely go in different directions in terms of their impact on the forecast error.
Inflation Risk Premium • In recent years the Fisher interest rate theory (which was developed in the 1930s) has been further refined to include an inflation risk premium. • This premium is a market compensation for the possibility that actual inflation will be higher (or lower) than expected inflation. • The greater the ‘range of possibilities” the higher this risk premium. • Furthermore, this risk is not associated with TIPS which guarantee a return equal to the actual rate of inflation.
Illustrating Inflation Risk • The existence of inflation risk on non-TIPS bonds suggests that the TIPS measure of inflation (referred to as the Break Even Inflation Rate) will overestimate actual expected inflation. • A 2004 study suggested that the inflation risk premium ranged from 50 to 100 basis points on 10 year securities.
Liquidity Premium on TIPS • The TIPS secondary market, while deepening since its inception, does not approach the depth of the secondary Treasury note and bond market • The Treasury non-TIPS note and bond markets markets are large and active in comparison to the TIPS market. • This suggests that investors in TIPS must be compensated for the relative illiquidity of these securities (compensation would take the form of lower prices or higher interest rates). • For this reason TIPS would underestimate expected inflation.
Liquidity Premium on TIPS During a Credit Crisis • During periods of severe liquidity concerns (e.g., during a credit crisis) when the market moves into highly liquid save haven financial assets (e.g., Treasury bills) the liquidity premium on TIPS is likely to increase. • Essentially as overall liquidity risk rises in financial markets, the liquidity risk in the TIPS market will also rise. • Prices on TIPS will fall (through reduction in demand) resulting in an increase in interest rates. • As a result the TIPS-derived expected inflation will understates expected inflation even more during this crisis. • See next slide for 2008 example. • Conclusion: the liquidity premium is not likely to be constant over time and we need to adjust for the financial situation.
The TIPS Liquidity Premium Affect During the 2008 Credit Crisis Yields Inflation Expectation
Adjusting for Liquidity Premiums and Inflation Risk Basis Point Adjustment Adjusted Inflation Expectations Using March 16, 2009 data Annual rates over the next: 5 years 1.91 – 1.25 + .95 = 1.61% 10 years 2.95 – 1.84 + .95 = 2.06% 30 years 3.77 – 2.23 + .95 = 2.49% • A 2004 Federal Reserve Bank of Cleveland study reported that correcting for inflation risk and liquidity premiums would result could result in an additional 95 basis points to the Break Even Inflation Rate.
The Future of TIPS • In my view, the future application of TIPS as an inflation estimator is encouraging for the following two reasons: • 1. Issue of Liquidity Premium. As the size of the TIPS market grows, the liquidity premium will shrink. • TIPS now represent approximately 10% of the Treasury “marketable” debt market and it is likely to grow over time. • 2. Issue of Inflation Risk Premium. The recent adoption of an inflation target by the Federal Reserve should over time reduce the inflation risk premium. • This will be especially true if the Fed’s target is achieved over time and Fed inflation target credibility grows.
Appendix 1: Three Forms of Market Efficiency and Forecasting The following two slides discuss (1) the three forms of market efficiency and (2) the use of forecasting with these three forms.
Three Forms of The Efficient Market Hypothesis There are actually three stages of the EMH model: Weak Form: Current prices reflect all past price and past volume information. The fundamental information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. Semi-strong Form: Current prices reflect all past price and past volume information AND all publicly available information. Information such as interest rates, earnings, inflation, etc. Strong Form: Current prices reflect all past price and past volume information, all publicly available information publicly available information AND all private (e.g., insider) information.
Forecasting asset prices within the 3 Types of Efficient Markets: Weak form: In this type of a market, all past data and prices are reflected in the current prices. Thus, Technical Analysis is not of any use. Semi strong form: In this type of a market, all public information is reflected in the current stock prices. Thus, here, even Fundamental Analysis is of no use (as well as technical analysis) Strong form: In this type of market, all information is reflected in the current stock prices. Thus, not only is any kind of analysis useless, even insider information is useless for predicting future stock market prices.
Appendix 2 Interview with Benjamin Graham
Interview with Graham in the 1970s Question: In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues? Graham: In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.
Appendix 3 Charles Dow
Charles Dow • Born: 5-Nov-1851Birthplace: Sterling, CTDied: 4-Dec1902 • After working for some years as financial reporters Charles Dow and Edward Jones formed Dow, Jones & Company in 1882 to put out their own ideal business journal. The company was initially located in the basement of a candy shop. Within a year it was putting out the Customer's Afternoon Letter a two page summary of the daily financial news. This small affair would eventually become The Wall Street Journal. • On July 3, 1884 Charles Dow released the first Dow Jones average in his report. He used eleven companies to compile the average: • Chicago & North Western • Delaware, Lackawanna & Western • Lake Shore • Louisville & Nashville • Missouri Pacific • New York Central • Pacific Mail • St. Paul • Northern Pacific • Union Pacific • Western Union • Dow dropped all the non-railroad companies from this average and formed a separate stock average for industrial companies. He called it the Dow Jones Industrial Average.
