IMTS FINANCE MANAGEMENT (Investment Analysis) by IMTS INSTITUTE

I ns t i t ut eo fMa na g e me nt & Te c hni c a lSt udi e s I NVESTMENTANALYSI S

500

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INVESTMENT ANALYSIS

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INVESTMENT ANALYSIS CONTENTS:

Chapter 01 Introduction -

01-09 Meaning and concept of environment – investment objectives and

constraints – investment classification – investment process – financial markets – real investment avenues

Chapter 02

10-14

Sources of economic data – sources of market data – sources of company data – sources of international economic data

Chapter 03

15-32

Stock markets and their features –development of securities markets in India – regulations of securities market – primary market and secondary market – trading and settlement – clearing and settlement procedure.

Chapter 04

33-38

Security market indicators constructions of security market indices – types of security market indices in India –equity share indices – limitations of various indices

Chapter 05

39-49

Fundamental analysis -objectives and beliefs of fundamental analysis – frame work of fundamental analysis –concept of intrinsic value – concept of market value – economic analysis

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Chapter 06

50-65

Industry analysis -classification of industries –key characteristic of industry analysis – industry life cycle – business cycle analysis – company analysis

Chapter 07

66-91

technical analysis -Meaning and concept of technical analysis .tools for technical analysis – the Dow theory –efficient market theory –random walk theory – advantages of technical analysis – limitations of technical analysis Chapter 08

92-113

Charting techniques -meaning of charts – method of preparing charts – trend lines – moving averages – contrary opinion theories - Elliot wave theory

Chapter 09

114-118

Investment strategies-growth shares – meaning of growth shares – speculation in shares – active strategies and passive strategies - reasons for fluactions in price

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INVESTMENT ANALYSIS

CHAPTER-01 INVESTMENT SCENARIO STRUCTURE 1.0. OBJECTIVES 1.1. INTRODUCTION 1.2. MEANING AND CONCEPT OF ENVIRONMENT 1.3. INVESTMENT OBJECTIVES AND CONSTRAINTS 1.4. INVESTMENT CLASSIFICATION 1.5. INVESTMENT PROCESS 1.6. FINANCIAL MARKETS 1.7. REAL INVESTMENT AVENUES 1.8. QUESTIONS 1.9. FURTHER READINGS

1.0. OBJECTIVES After studying this unit, you should be able to understand: 

Meaning and concept of environment



Investment objectives and constraints



Investment classification



Investment process



Financial markets



Real investment avenues

1.1. INTRODUCTION Investment is the employment of funds with the aim of achieving additional income or growth in value. The essential quality of an investment is that it involves ‘waiting’ for a reward. It involves the commitment of resources which have been saved or put away from current consumption in the hope that some benefits will accrue in future.

1.2. MEANING AND CONCEPT OF ENVIRONMENT Investment is the allocation of monetary resources to assets that are expected to yield some gain or positive return over a given period of time. These assets range from safe investments to risky investments. Investments in this form are also called ‘Financial Investments.

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1.3. INVESTMENT OBJECTIVES AND CONSTRAINTS Investment Objectives: Rationally stating, all personal investing is designed in order to achieve a goal, which may be tangible (e.g., a car, a house, etc.) or intangible (e.g., social status, security, etc.). Goals can be classified into various types based on the way investors approach them viz: a. Near-term High Priority Goals: These are goals which have high emotional priority to the investor and he wishes to achieve these goals within a few years at the most. b. Long-Term High Priority Goals: For the most people, this goal is an indication of their need for financial independence at a point some years ahead in the future. c.

Low Priority Goals: These goals are much lower down in the scale of priority and are not particularly painful if not achieved. For people with moderate to substantial wealth, these could range from a world tour to donating funds for charity.

d. Entrepreneurial or Money Making Goals: These goals pertain to individuals who want to maximize wealth and who are not satisfied by the conventional saving and investing approach. These investors usually put all the spare money they have into stocks preferably of the company in which they are working/owning and leave it there until it reaches some level which either the individual believes is enough or is scared of losing what has been built-up over the years. Investment Constraints: An investor seeking fulfillment of one of the above goals operates under certain constraints: 

Liquidity



Age



Need for Regular Income



Time Horizon



Risk Tolerance



Tax Liability The challenge in investment management, therefore, lies in choosing the appropriate

investments and designing a unit that will meet the investment objectives of the investor subject to his constraints. To take on this challenge the first step will be to get acquainted with the different types of investments that are available in our financial market

1.4. INVESTMENT CLASSIFICATION Broadly speaking investment can be categorized as follows: This study will concentrate more on the financial investment part and so only financial instruments are elaborated with a brief introduction to real investments.

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Fixed Income Investment Financial Investment Investment

Variable Income Avenues Real Investment

Security Forms of Financial Investment: We know that the recipient of money in a financial investment issues a document or a piece of paper to the investor (supplier of money), evidence the liability of the former to the latter to provide returns. This document also outlines the rights of the investor to certain prospects and/or property and sets the conditions under which the investor can exercise his/her rights. This document is variously called ‘Security Certificate’, ‘Note’ and so on. Gilt-Edged Securities: The debt securities issued by the government and semi-government bodies are called gilt-edged securities. They comprise the treasury bills and the dated securities (also called bonds or dated loans) of the central government, state government and semi-government bodies like Port Trusts and State Electricity Boards. Treasury bills: These short-term securities are issued by the RBI on behalf of the Central Government. Currently, the T-Bills having a maturity of 91 and 364 days only are being traded. No interest is paid on these bills. Instead they are sold at a discount. Central government dated securities: These securities of the central government have a maturity period longer than one year and carry a fixed rate of interest. The interest is payable semi-annually and the payment is usually made by issuing coupons which can be encased at any bank. Though these securities are redeemed at par, their issue price can be higher or lower than the face value depending upon the prevailing market conditions. Semi-government dated securities: These are the promissory notes issued by the institutions and corporations set-up by the central/state governments. They also include the securities of municipal corporations, the semigovernments bodies such as electricity boards, housing boards, port trusts, and central and state financial institutions issue securities to meet the financial needs of their development activities. SemiGovernment securities are guaranteed by their respective government and carry a higher coupon rate or lower issue price than for their counterpart state government dated securities. Corporate debentures: Corporate debentures are the promissory notes issues by the joint stock companies in the private sector. They are thus the debt obligations of the issuing corporation. Like government securities, they

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INVESTMENT ANALYSIS

have an issue price at which they are originally issued, a coupon interest rate, and a specified maturity date. Preference Shares: These are a hybrid variety of securities which have some features of equity shares and some features of debentures. Preference shares carry a fixed rate of dividend. Preference dividend is payable only out of distributable profits. Generally, dividend on preference shares is cumulative. Equity Shares: Investor’s Classification of Equity Stocks: Unlike in the West where we find different classes of common stock with differing voting rights to income and assets of the company, the equity stocks of all Indian joint stock companies belong to just one class. The right and privileges conferred on the shareholders are all the same and they are enjoyable in proportion to one’s shareholdings. Non-Security Forms of Financial Investment: There are a number of non-security forms investment opportunities available to an investor in India. Unlike stocks and debentures discussed above, the certificates or notes evidencing these investments are neither transferable nor are they traded in any organized financial market. Hence, the nomenclature ‘Non-Security Form’, although in the strict sense, is a misnomer. National Saving Schemes: Over the years, the Government of India has floated several national savings schemes with a view to mobilize private savings for public use. These schemes are operated mainly through the post Offices because the familiarity of these places to the masses. Some series of National Savings Schemes are operated through the State Bank of India and other nationalized banks.

Public Provident Fund Scheme: This was introduced on July 1, 1968 and is primarily meant for self-employed individuals. The salaried individuals are also allowed to make contributions to this scheme over and above their contributions to the recognized provident funds in their organizations. It is a 15-year scheme with a facility th

to accept the last contribution in the 16 year. Post Office Savings Scheme: These include savings bank account, time and recurring deposit accounts. These accounts can be operated in the post offices throughout the country. Interest so earned is totally tax-free under Section 10 of the Income Tax Act. Deposit with Commercial/Co-operative Banks: The major deposit schemes of the Commercial/Co-operative banks include the savings bank account, fixed deposits, recurring deposits and annuity deposit schemes. Corporate Fixed Deposits: Investors can also consider depositing their money for a fixed term with companies.

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Units of UTI: The Unit Trust of India (UTI) in the public sector is the only units investment trust in the country. It was set up in 1964 with a view to mobilize small savings by selling ‘Units’ and invest the proceeds in the corporate stocks and debentures and gilt-edged securities. Unit Scheme for Charitable and Religious Trusts and Societies: The units sold under the scheme have a face value of Rs.100 and a participating trust or society is required to buy at least a 100 units. A participant can opt for reinvestment of dividends. The investment, however, cannot be withdrawn for the first three years. Children’s Gift Growth Fund 1986: Under this scheme, an irrevocable gift can be given by any adult to any child under 15 years of age. This investment remains with UIT till the child attains the age of 21 years. As it is indicated by the name, its primary aim is to build-up a fund for children. Till the scheme matures, there is an assured dividend of 12.5% p.a. which is automatically reinvest in further units, so the investment grows at a compound rate. Units can be gifted in multiples of 10 subject to a minimum of 50. Units are sold at par at Rs.10 throughout the year. Mutual Fund Unit Scheme 1986 (Master shares): This scheme provides an opportunity to the investors to participate in the growing equity market. The funds mobilized through Master shares are invested in a basket of equities spread over a wide range of industries, thus giving the benefit of diversification and spread of risk to the common investor. Master shares are quoted on the stock market and so can be bought or sold at any time. Growing Monthly Income Scheme (GMIS’91): This scheme is launched to satisfy the growing needs of middle class investors for regular income schemes and to cope with the rising cost of living. The scheme offers two options. Option ‘A’ provides regular monthly income of 14.5% p.a. for the first 3 years and 15% p.a. for the last two years with a minimum 2% capital appreciation on maturity. Under Option ‘B’ invested amount more than doubles itself in 5 years. The Investment Process-Stages in Investment The investment process is generally described in four stages. These stages are investment policy, investment analysis, valuation of securities and portfolio construction. Investment Policy: The first stage determines and involves personal financial affairs and objectives before making investments. It may also be called preparation of the investment policy stage. The investor has to see that he should be able to create an emergency fund, an element of liquidity and quick convertibility of securities into cash. Investment Analysis: When an individual has arranged a logical order of the types of investments that he requires on his portfolio, the next step is to analyze the securities available for investment. He must make a comparative analysis of the type of industry, kind of security and fixed Vs/variable securities.

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Valuation of Securities: The third step is perhaps the most important consideration of the valuation of investments. Investment value, in general, is taken to be the present worth to the owners of future benefits from investments. The investor has to bear in mind the value of these investments. An appropriate set of weights have to be applied with use of forecasted benefits to estimate the value of the investment assets. Portfolio Construction: As discussed earlier under features of an investment programme, portfolio construction requires knowledge of the different aspects of securities. These are briefly recapitulated here, consisting of safety and growth of principal, liquidity of assets after taking into account the stage involving investment timing, selection of investment and allocation of savings to different investments.

1.5. INVESTMENT PROCESS Investment Policy: 

Determination of investible wealth



Determination of portfolio objectives



Identification of potential investment assets



Consideration of attributes of investment assets



Allocation of wealth to asset categories

Investment Valuation: Valuation of stocks

Valuation of debentures and bonds

Valuation of other assets

Investment Analysis: Analysis of the Economy Equity Analysis

Debentures and Bond Analysis

Screening of Industries

Analysis of yield structure

Analysis of Industries

Quantitative analysis

Quantitative analysis of stocks

Quantitative

analysis

Other Asset Analysis

Qualitative analysis

debentures

Portfolio Construction: 

Determination of diversification level



Consideration of investment timing



Selection of investment assets



Allocation of investible wealth to investment assets



Evaluation of portfolio for feedback

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1.6. FINANCIAL MARKETS Financial markets in popular culture: Only negative stories about financial markets tend to make the news. The general perception, for those not involved in the world of financial markets is of a place full of crooks and con artists. Big stories like the Enron scandal serve to enhance this view. Stories that make the headlines involve the incompetent, the lucky and the downright skillful. The Barings scandal is a classic story of incompetent, the mixed with greed leading to dire consequences. Another story of note is that of black Wednesday, when sterling came under attack from hedge fund speculators. This led to major problems for the United Kingdom and had a serious impact on its course in Europe. A commonly recurring event is the stock market bubble, whereby market prices rice to dizzying heights in a so called exaggerated bull market. Financial markets are merely tools. Like all tools they have both beneficial and harmful uses. Overall, financial markets are used by honest people. In economics, a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflects the efficientmarket hypothesis. Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity. Both general markets (where many commodities are traded) and specialized markets work by placing many interested buyers and sellers in one “place”, thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non – market economy such as a gift economy. The term “market” is sometimes used for what are more strictly exchanges, organizations those facilities the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange, still, corporate actions ( merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without an exchange. Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges. Financial markets can be domestic or divided can be international. Types of financial markets: The financial markets can be divided into different subtypes: Capital markets which consist of stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. Bond markets which provide financing through the issuance of bonds, and enable.

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The subsequent trading thereof commodity markets, which facilities the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contract for trading products at some future date, see also forward market. Insurance markets, which facilities the redistribution of various risks. Foreign exchange markets, which facilities the trading of foreign exchange.

1.7. REAL INVESTMENT AVENUES There are a large number of investment instruments available today. To make our lives easier we would classify or group them under 4 main types of investment avenues. We shall name and briefly describe them. 1. Financial securities: These investment instruments are freely tradable and negotiable. These would include equity shares, preference shares, convertible debentures, non-convertible debentures, public sector bonds, savings certificates, gilt-edged securities and money market securities. 2. Non-securitized financial securities: These investment instruments are not tradable, transferable nor negotiable. And would include bank deposits, post office deposits, company fixed deposits, provident fund schemes, national savings schemes and life insurance. 3. Mutual fund schemes: If an investor does not directly want to invest in the markets, he/she could buy units/shares in a mutual fund scheme. These schemes are mainly growth (or equity) oriented, income (or debt) oriented or balanced (i.e. both growth and debt) schemes. 4.

Real assets: Real assets are physical investments, which would include real estate, gold & silver,

precious stones, rare coins & stamps and art objects. Before choosing the avenue for investment the investor would probably want to evaluate and compare them. This would also help him in creating a well diversified portfolio, which is both maintainable and manageable. Investment avenues available in India: Before you start your investment process, here are a few answers to some fundamental points that you might have in your mind. Investment under Automatic Route with repatriation benefits: Non Resident Indians (NRIs), Person of Indian Origin (PIOs) and Overseas Corporate Bodies (OCBs) can invest in shares / convertible debentures of Indian companies under the Automatic Route without obtaining Government or RBI permission except for a few sectors where Foreign Investment

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Promotion Board (FIPB) / SIA permission is necessary, or where the investment can be made only up to a certain percentage of paid up capital. Investment with Government approval: Investments not eligible under the Automatic Route are considered by the FIPB, a high Powered inter-ministerial body under the chairmanship of Secretary, Department of Industrial Policy & Promotion, SIA, subject to sectoral limits / norms. These investments also enjoy full repatriation benefits. Other investments with repatriation benefits: Investment in Domestic Mutual Funds Investment in Bonds Issued By Public Sector Undertakings Purchase of Shares Of Public Sector Enterprises Deposits with Companies (For A Minimum Period Of 3 years) Investment in Government Securities / Shares 1.8. QUESTIONS Section - A 1. What do you understand by the term Treasury bills? 2. Explain the concept of Gilt-Edged Securities? 3. Explain the Meaning and concept of environment? 4. What are Investment constraints? 5. What are Investment Objectives? Section - B 1. Explain the types of Investment objectives? 2. Give a detailed note on financial markets 3.

What are factors to be considered to select real investment avenues

Section - C 1. Explain briefly about various Investment objectives and constraints 2. What are investment classifications? 3. Explain about investment process 1.9. FURTHER READINGS 1. Dr.v.balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and

portfolio

management, shri venkateswara publications. 2. Introduction to security analysis, the Icfai University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house pvt ltd

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CHAPTER - 02 SOURCES OF FINANCIAL INFORMATION STRUCTURE 2.0. OBJECTIVES 2.1. INTRODUCTION 2.2. SOURCES OF ECONOMIC DATA 2.3. SOURCES OF MARKET DATA 2.4. SOURCES OF COMPANY DATA 2.5. SOURCES OF INTERNATIONAL ECONOMIC DATA 2.6. QUESTIONS 2.7. FURTHER READINGS

2.0. OBJECTIVES After studying this unit, you should be able to understand 

Sources of economic data



Sources of market data



Sources of company data



Sources of international economic data

2.1. INTRODUCTION The objective and intelligent investment decisions are always based on sound information as the prospects for better rewards on an investment depends upon what the future holds, a primary task of an investors , an investment manager , investment broker is to look ahead . This looking ahead involves making projections about prospective rewards and risks of investment in the near as well as distinct feature. The date has to be gathered on economic and market events, national and international events, public and corporate policies. Since the gathering of primary both time consuming and costly, the investing public has to resort to the sources of secondary information. There are a number of trade journal, periodical, official documents, advisory reports published by investment brokers that can be valuable sources of information for investment decision making.

2.2. SOURCES OF ECONOMIC DATA Economic and industry Data: 

The economic Survey, the explanatory Memorandum on the Budget of the central Government, and the Finance Budget of the Government of India provide data analysis of current economic scene, the effects of fiscal and monetary policies in the past, government revenues,

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expenditures and deficit financing, proposed fiscal and monetary measures to be adopted in the forthcoming year, policy revisions concerning imports, exports, investments, industry, agriculture, etc. 

The weekly statistical supplement, monthly Bulletin, Repot on currency and finance and the annual Report of the Reserve Bank of India (RBI) are an invaluable source of macro data. In these publications, the RBI provides considerable data in a concise form, among others, money supply, prices, exchange rates, money market rates, balance of payment situation, bank credit, liquidity position of the banking system, and the strategy and review of many monetary tools employed by the RBI. Thus, these sources shed considerable light on the financing and investment climate prevailing in the country.



The center for Monitoring Indian Economy (CMIE) and the commerce Research Bureau (CRB) are two non-government agencies that collect, classify. And present main economic data in a capsule form. These agencies, besides compilation, review the data, analyze trends, and discuss current policy developments in their publications. The Economic intelligence service of the Center for Monitoring Indian Economy publishes a Monthly Review of Indian Economy, index Numbers of whole sale prices. Economic indicators and economic outlook (yearly) provide data on money and prices, outlook in various economic fields, and a review of economic events, trends in corporate finance, investments, etc. The Economic Monitoring Service of the commerce Research Bureau brings out a Weekly Report on Prices, Banking Money and World Currency Developments, a Monthly Review of the Indian Economy, and a monthly document on investment climate in India. Its annual publications include Basic Statistics on Indian Economy, Basic Statistics on state Economics of India. Companies inviting Deposits and the rates they offer, selected statistics of Eighty Countries of the world, foreign trade statistics of India , and position papers on major Indian industries besides many special documents and reports such as a pre-Budget review, Industrial policy and investment incentives, CII reports etc.

2.3. SOURCES OF MARKET DATA A number of sources provide stock market data ranging from price quotations to review of stock market trends in India. Important sources of market information include: 

Stock exchanges daily official list: it provides daily price quotation and various characteristics of the quoted securities.



Official year book / directory of stock exchange these publications review stock markets trends, new issues made during the year, official policy on capital issues, brokerage, stamp duty etc.



RBI’S Weekly statistical supplement , monthly bulletin and report on currency and finance



The economic times, financial express, business standard, fortune India, investments today, economic scene, commerce and business India are some of the news papers and periodicals

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that carry, on a regular basis, a wealth of stock market information, market quotations, reviews of stock market trends, and very incisive and thought provoking articles on current developments affecting stock markets future movements and other matters of interest to the investor. 

The reports and newsletters of investment brokerage and counselling firms are other important sources of market data.

2.4. SOURCES OF COMPANY DATA The fundamental analysis and valuation of stocks calls for gathering and examination of the company’s specific data. Further, a considerable insight in respect of prospective return and risk of a security can be gained from going through of prospective return and risk of a security can be gained from going through the announcement and future plans often published by the companies. So, the company data, historic and futuristic, is of interest to the investors. 1. Company’s annual reports and prospectuses are the main sources of company data, the former being an annual feature of a public company and the latter being published while making public issue. The annual report contains the chairman’s speech, balance sheet and profit and loss account with explanatory notes, and a review of the working of the company over the last previous year having a bearing on the company’s performance and how the company responded to those events. It also outlines what the company proposes to do in the next year. Some companies include in their annual reports also a statement of changes in financial position and a forecast of earnings for the next couple of years besides, presenting the trends in earnings per share, dividend per share, and their share prices. 2.

Stock exchange official directory is another important source. It covers all the companies whose shares are listed on the stock exchange and gives for each company, its brief history, progress and balance sheet and profit and loss account for the period of 10 years. Moreover, important financial ratios, their trend over the last 10 years and yearly high and low prices quoted for the company’s shares are present as well in the directory.

3. Kothari’s economic and investment guide of India, a yearly publication of Kothari and sons, is yet another important source of company data. It guide contain a lot of data on individual companies, their progress and management besides a good write- up on industry scene. 4. In their regular feature columns such as investors guide, company profiles reports, company news and comments and business notes etc. The economic times, financial express, business standard, commerce and business India, and India Today present reports, comments, reviews of the working of individual companies . 5. Some government sources provide company or company related information, company news and notes , a monthly publication of the department of the company affairs , government of India, carries circulars and notifications in respect of changes and / or interpretation of the provisions of the companies act. The office of the registrar of Companies supplies on request, for a minimal

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charge, a company’s annual report, list of members, prospectuses, product-by-product information in respect of licensed capacity, installed capacity, actual production, exports , imports, exchange earnings, etc. The Director General, Technical Development and the licensing Committee of the Minister of commerce supply excellent supplementary data relating to capacity, expansion plans and export performance of the companies.

2.5. SOURCES OF INTERNATIONAL ECONOMIC DATA In today’s interdependent world, the international economic, political, market, business and technological development have a considerable bearing on the conditions and prospects prevailing in a country’s economy, the market and for the business firms. The oil crisis of 1970’s, international financial crisis and the growing protectionist attitude of the western countries whose effects are felt world over are the good examples of this impact. To evaluate the investment worth of securities of companies engaged in joint ventures with foreign collaborators, export oriented companies, and of those that have diversified their direct investment beyond the national boarders, it is important to collect and examine the international economic market ,and business data further more, information relating to the international money, capital and currency exchange, market data is important for international portfolio investment if and when such investment is allowed by the RBI. For example an Indian stock broker or investment counselor intending to attract non – resident of Indian origin clientele, who are allowed to make portfolio investments in India need to compile this type of data so that he can offer a good advice on the portfolio investment choices. Some important sources of international data include the following: 1. International Financial Statistics, a monthly publication of the international Monetary Fund (IMF) provides each country’s yearly, quarterly and monthly data on major economic indicators such as GNP, money supply, consumer price index, stock market indices, currency exchange rate expressed in the U.S dollars and balance of payment conditions. The IMF also brings out occasionally supplementary document on prices, production, balance of payment, exchange rates etc. covering along historical period . 2. Moody’s and standard and poor’s industrial, banking and finance, transportation, utility and international manual cover

extensively the individual company profiles of both the U.S and

international companies. For each company, the historical background the management team and lot financial information are provided in these manuals. 3. Capital international perspective, a Geneva publication, reports on the various national stock market indices, world capital market, international interest rates and capital flows. 4. The financial times of London, the economist, a UK Weekly, the wall street journal, a US Daily, Baron’s national business and financial weekly of the USA, international business week are some of the international newspapers and periodical that contain a lot of information on current international developments of interest to business executives and the investors.

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2.6. QUESTIONS Section - A Very Short Answer Questions: 1. State the meaning of economic data 2. Write short on stock exchange daily official list 3. What is official year book? 4. Expand the term IFM Section – B Short Answer Questions: 1. What are the sources of company data? 2. Give a detailed note on the sources of international economic data Section –C Essay type questions: 1. What are the sources of economic data? 2. What are the sources of market data?

2.7. FURTHER READINGS 1. Dr.v.balu & Dr.M. Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and portfolio management, shri venkateswara publications. 2. Introduction to security analysis, the ICFAI University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house pvt ltd

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CHAPTER – 03 STOCK MARKET IN INDIA STRUCTURE 3.0. OBJECTIVES 3.1. INTRODUCTION 3.2. STOCK MARKETS AND THEIR FEATURES 3.3. DEVELOPMENTS OF SECURITIES MARKETS IN INDIA 3.4. REGULATIONS OF SECURITIES MARKETS 3.5. PRIMARY MARKET AND SECONDARY MARKET 3.6. TRADING AND SETTLEMENT 3.7. CLEARING AND SETTLEMENT PROCEDURE 3.8. QUESTIONS 3.9. FURTHER READINGS

3.0 OBJECTIVES After studying this unit, you should be able to understand 

Stock markets and their features



Developments of securities markets in India



Regulations of securities markets



Primary market and secondary market



Trading and settlement



Clearing and settlement procedure

3.1. INTRODUCTION Stock exchanges are intricately inter-woven in the fabric of a nation’s economic life. Without a stock exchange, the saving of the community-the sinews of economic progress and productive efficiency-would remain underutilized. The task of mobilization and allocation of savings could be attempted in the old days by a much less specialized institution than the stock exchange. But as business and industry expanded and the economy assumed more complex nature, the need for “permanent finance” arose. Entrepreneurs needed money for long term whereas investors demanded liquidity-the facility to convert their investments into cash at any given time. Nature and Function of Stock Exchange: There is an extraordinary amount of ignorance and prejudice born out of ignorance with regard to the nature and functions of stock exchange. As economic development proceeds, the scope for acquisition and ownership of capital by private individuals also grows. Along with it, the opportunity for stock exchange

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to render the service of stimulating private savings and channeling such savings into productive investment exists on a vastly great scale. These are services which the stock exchange alone can render efficiently. It is no exaggeration to say that in a modern industrialist society, which recognizes the rights of private ownership of capital, stock exchanges are not simply a convenience, they are essential. In fact, they are the markets which exist to facilitate purchase and sale of securities of companies and the securities or bonds issued by the government in the course of its borrowing operation. As our country moves towards liberalization, this tendency is certain to be strengthened.

3.2. STOCK MARKETS AND THEIR FEATURES Stock market: A stock market is a public market for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. The stocks are listed and traded on stock exchanges which are entities of a corporation or mutual organization specialized in the business of bringing buyers and sellers of the organizations to a listing of stocks and securities together. The stock market in the United States includes the trading of all securities listed on the NYSE Euro next, the NASDAQ, the Amex, as well as on the many regional exchanges, e.g. OTCBB and pink sheets. European examples of stock exchanges include the London stock exchange, the deutsche brose. Trading: The London stock exchange: Participants in the stock market range from individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order. Some exchanges are physical locations where transactions are carries out on a trading floors, by a method known as open outer. This type of auction is used in stock exchanges and commodity exchanges where traders may enter “verbal” bids and offers simultaneously. The other type of stock exchange is a virtual kind, composed of a network of computers where traders are made electronically via traders. The purpose of a stock exchange is to facilities the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). The exchange provides real-time trading information on the listed securities, facilitating price discovery. New York stock exchange: The New York stock exchange is a physical exchange, also referred to as a listed exchange only stocks listed with the exchange may be traded. Orders enter by way of exchange members and flow down to a floor broker, who goes to the floor trading post specialist for that stock to trade the order. The specialist’s job is to match buy and sell orders using open outery. If a spread exists, no trade immediately takes place – in the case the specialist should use his/her own resources (money or stock) to close the

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difference after his/her judged time. Once a trade has been made details are reported on the “tape” and sent back to the brokerage firm, which then notifies the investor who placed the order. Although there is a significant amount of human contact in this process, computers play an important role, especially for socaaled “program trading”. The NASDAQ is a virtual listed exchange, where all of the trading is done over a computer network. The process is similar to the New York Stock Exchange. However, buyers and sellers are electronically matched. One or more NASDAQ market makers will always provide a bid and ask price at which they will always purchase or sell 'their' stock. Importance of stock market: The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange provides affords investors the ability to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate. History has shown that the price of shares and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an up and coming economy. In fact, the stock market is often considered the primary indicator of a country's economic strength and development. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the raison d'être of central banks. Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction. The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity. Relation of the stock market to the modern financial system: The financial system in most western countries has undergone a remarkable transformation. One feature of this development is disintermediation. A portion of the funds involved in saving and financing flows directly to the financial markets instead of being routed via the traditional bank lending and deposit operations. The general public's heightened interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process. Statistics show that in recent decades shares have made up an increasingly large proportion of households' financial assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made up almost 60 percent of households' financial wealth, compared to less than 20 percent in the 2000s. The

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major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized countries. In all developed economic systems, such as the European Union, the United States, Japan and other developed nations, the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another. The stock market, individual investors, and financial risk: Riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such as 'investment' property, i.e., real estate and collectables).

3.3. DEVELOPMENTS OF CAPTAL MARKET IN INDIA The Significance & History of Capital Market the capital market is a place where the suppliers and users of capital meet to share one anotherâ&#x20AC;&#x2122;s views, and where a balance is sought to be achieved among diverse market participants. The securities decouple individual acts of saving and investment over time, space and entities and thus allow savings to occur without concomitant investment. Moreover, yieldbearing securities makes present consumption more expensive relative to future consumption, inducing people to save. The composition of savings changes with less of it being held in the form of idle money or unproductive assets, primarily because more divisible and liquid assets are available. The capital market acts as a brake on channeling savings to low- yielding enterprises and impels enterprises to focus on performance. It continuously monitors performance through movements of share prices in the market and the threats of takeover. This improves efficiency of resource utilization and thereby significantly increases returns on investment. As a result, savers and investors are not constrained by their individual abilities, but facilitated by the economyâ&#x20AC;&#x2122;s capability to invest and save, which inevitably enhances savings and investment in the economy. Thus, the capital market converts a given stock of investible resources into a larger flow of goods and services and augments economic growth. In fact, the literature is full of theoretical and empirical studies that have established causal robust (statistically significant) two-way relation between the developments in the securities market and economic growth. The Indian capital markets dates back to the 18th century when the securities of the East India Company were traded in Mumbai and Kolkata. However, the orderly growth of the capital market began with the setting up of The Stock Exchange, Bombay in July 1875 and Ahmadabad Stock Exchange in 1894.

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Eventually, 22 other Exchanges in various cities sprang up. Given the significance of capital market and the need for the economy to grow at the projected over 8 per cent per annum, the managers of the Indian economy have been assiduously promoting the capital market as an engine of growth to provide an alternative yet efficient means of resource mobilization and allocation. Further, the global financial environment is undergoing unremitting transformation. Geographical boundaries have disappeared. The days of insulated and isolated financial markets are history. The success of any capital market largely depends on its ability to align itself with the global order. To realize national aspirations and keep pace with the changing times, the capital markets in India have gone through various stages of liberalization, bringing about fundamental and structural changes in the market design and operation, resulting in broader investment choices, drastic reduction in transaction costs, and efficiency, transparency and safety as also increased integration with the global markets. The opening up of the economy for investment and trade, the dismantling of administered interest and exchange rates regimes and setting up of sound regulatory institutions have enabled this. 3.4. REGULATIONS OF SECURITIES MARKET The capital markets in India were underdeveloped, opaque, dominated by a handful of players, and concentrated in a few cities. Manipulation and unfair practices were perceived to be widespread and rampant, prompting an overseas researcher to describe it as a â&#x20AC;&#x153;snake pitâ&#x20AC;?. The transformation of the Indian securities markets was initiated with the establishment of the Securities and Exchange Board of India (SEBI) in 1989, initially as a informal body and in 1992 as a statutory autonomous regulator with the twin. Objectives of protecting the interests of the investors and developing and regulating the securities markets over a period of time. SEBI has been empowered to investigate, examine, visit company premises, summon records and persons and enquire and impose penalties commensurate with misconduct. The first and foremost challenge for the fledgling regulator was to create a regulatory and supervisory framework for the market, a job that proved formidable, because vested interests resisted every new step. However, with the designing and notification of 32 regulations/guidelines (amended many times over), during a decade and half of its existence, the apparatus steadily evolved and has come to grips with the situation. On request, SEBI provides informal guidance on payments of nominal fees and issues no action letter so that the participants can seek clarity on any aspect and adopt appropriate business strategy in consonance with the applicable regulations. SEBI has put time lines for performance of its various functions like registration and renewal on the website. These measures work as a self- disciplining mechanism within SEBI and provide full transparency to its functioning.

3.5. PRIMARY MARKET AND SECONDARY MARKET Capital Market: Capital market is the market for medium and long term funds. It covers all the facilities and the institutional arrangements for the lending and borrowing of term funds. It does not deal in capital goods but is concerned with the raising of financial capital.

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Capital market refers to a market for long term capital. It involves all the facilities and institutional arrangements for borrowings and lending long term capital. Capital market consists of (a) Primary market or new issue market & (b) Secondary market or old issue market. Factor affecting capital market:  General economic conditions prevailing in a country with particular reference to industrial production and profitability.  Government, fiscal and industrial policies.  Trends in the money market particular reference to price and saving, situation from time to time.  Demand for capital from public and private sectors for development expenditure by way of new issue of industrial securities.  Investor’s preference for liquidity and forward looking expectations. Structure or concept of Indian capital market: In India, the capital market is divided into (a) Gilt-edged market and (b) Industrial security market. Capital market

Gilt edged market

industrial security market

Primary market

secondary market

Gilt edged market: The gilt edged market refers to Government securities. They are called gilt edged because the documents will have yellow border on the sides. So that they can be distinguished as Government securities. These are preferred as they are guaranteed by the Government, both for the principal and interest. It is called Sovereign guarantee.  Industrial security market: This refers to the securities of the companies consisting of shares and debentures of old and new companies. The industrial security market is divided in to new issue market and old capital market. Industrial security can be subdivided as follows:  Primary market: A primary market is one which new securities are offered to the investing public for the first time. Hence it is also called new issues market.

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Advantages of the primary market or the new issue market: 

It provides opportunity for new investors to start new enterprises: Persons with technical know-how may resort to promote new ventures which are profit-oriented. The new issue market gives them an opportunity to materialize their ideas.



Existing companies will be in a position to expand their activities: When the existing companies find their product obsolete, they would like to venture into new areas of production for which they require additional capital. The issue market helps them raise the required funds.

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Promotion of partnership firm into public Ltd., companies or merger of companies or facilitates buy back shares: When new venture are started, a management may wish to have a control on the ownership and for this purpose, they would like to enter into a buy-back arrangement.

Securities dealt in the new issue market or primary markets are classified as: Primary market

Equity shares

Preference shares

Debentures 

Equity shares: These are shares issued by companies for raising capital. The owners of these shares are shareholder. Normally, the face value of the shares may be Rs.10 or Rs.100. A group of fully paid shares are called stock and these can be transferred. The shareholders are entitled for profit, which are distributed to them in the form of dividend. The share capital will be refunded to them only during the winding up of the companies provided the company has sufficient assets.

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Preference shares: Preference shares are similar to equity shares but are given on a preference basis to certain shareholder like promoters; auditors etc., there are cumulative, non-cumulative, participating, redeemable, irredeemable, convertible and non-convertible preference share. The preference shareholder will get the first preference in the distribution of dividend over equity shareholder. The same condition applies in the repayment of capital at the time of winding up.

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Debentures: It is a loan obtained by the company from the public for a fixed interest rate for a fixed period. Those investors who do not to take any risks will prefer debenture as they have less risk on the repayment compared to shares. There are debentures which have mortgage charges on the assets of the company and these debenture holders are assured of the repayment.

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Functions of new issue market: Functions of new issue market

Organization

Underwriting

Distribution

Organization: 

Investigation: It involves a study of technical, economic, financial and legal aspects of the issuing company based on this; issue house will back the company for issue of shares.

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Analysis: Here quality of capital is analyzed. This includes determination of the class of security, price of the issue on the basis of market condition.

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Processing of new proposals: It involves the study of timing and magnitude of issue, method of flotation and technique of selling. Here, the new issue market plays a major role.

Underwriting: The need for underwriting was felt due to the provisions of the companies’ act, whereby when a company fails to raise the main capital through the issue, then it has to refund the money to the subscribers and this had led to the failure of the whole issue. Hence, the need for underwriters was felt. Underwriters enter into an agreement with the company for the sale of certain minimum quantity of shares and debenture to the public. For this purpose, they are entitled for a commission called underwriting commission. If the issue is fully subscribed, the underwriters have no liability and in the case of short fall, the underwriter will have to fulfill his commitment. Advantages of underwriting: 

Large issued could be undertakes successfully.

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Companies with a long gestation period cannot raise capital without the support of professional underwriters.

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Technocrats could promote companies with their poor financial knowledge.

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New projects in the market could be taken boldly.

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Companies could be promoted is back ward areas.

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Certain projects which are not financially viable in the initial stages, especially in priority sector could be promoted with the support institutional underwrites.

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Distribution: Distribution function of new issue market

Private Placement Rights Issue

Bonus Shares

Prospectus Offer for Sale

Book Building

Prospectus: This is a method by which a company directly sells its share to the public. Through the media, the company advertises and interested persons are given the prospectus which carry full details about the company. Based on this the public apply to the company and shares of the new company are allotted at the face value. 

Offer for sale: Here the company resorts to the sale of shares through intermediaries who are stock brokers or issue houses. By this method, the company is able to promote the sale of shares and the sale is also guaranteed with the help of underwriters.



Private placement: The shares of the companies are given to the investing public with the help of issue houses.

This method is adopted by certain companies as it prevents the presence of

underwriters. 

Rights issue: When a company wishes to expand its capital base, it prefers to issue shares to the existing shareholders which are called rights shares. But before the issuing the right shares, the company should get permission of the government (SEBI) and a resolution has to be passed by the board of directors. The rights issue will be based on a proportion of existing shares held by the shareholders.

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Bonus shares: When a company decides to capitalize its profits, it will issue bonus shares which will be available only to the existing shareholders. Bonus shares can be issued only by companies which earned profit, which is a commercial profit arising out of their business operations.

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Book building: When a company, instead of offering shares directly to the public, invites bids from the merchant bankers for the sale of shares. It is called book building. The merchant bankers will take the full responsibility for the issue of the shares.

 Secondary market: A secondary market refers to the availability of shares from the stock market through the brokers. Share are purchased or sold according to the returns or expectations in the future market. Importance of capital market:  It is only with the help of capital market, long-term funds are raised by the business community.

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 It provides opportunity for the public to invest their savings in attractive securities which provide a higher return.  A well developed capital market is capable of attracting funds even from foreign country. Thus, foreign capital flows into the country through foreign investments.  Capital market provides an opportunity for the investing public to know the trend of different securities and the condition prevailing in the economy.  It enables the country to achieved economic growth as capital formation is promoted through the capital market.  Existing companies, because of their performance will be able to expand their industries and also go in for diversification of their activities due to the capital market.  Capital market is the bolometer of the economy by which you are able to study the economic conditions of the country and it enables the government to take suitable action.  Through the press and different media, the public are informed about the prices of different securities that enable them to take necessary investment decisions.  Capital market provides opportunities for different institutions such as commercial banks, mutual funds, investment trust etc., to earn a good return on investing funds. Functions of capital market:  It facilitates growth in savings and mobilizes the same for investment on one hand. On the other hand it provides funds to the borrowers with deficits by connecting the lenders with surpluses with the former.  It helps the corporate sector to expand, grow and diversify and thereby it facilitates growth of income in the economy of nation.  In capital market banks including development banks act as intermediaries between the borrowers and lenders.  Capital market raise funds for government sector undertakings and governments. Players in the primary & secondary market:  Merchant Bankers: They act as lead managers and co managers to the issue and their job is very responsive.

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 Registrars to issues: They are responsible for allotment and dispatch of share certificates for the allotees. They have to attend the complaints of investors.  Collecting bankers: They are in charge of collecting cash or DD or cheque and also receiving the application.  Underwriters, sub underwriters, brokers and sub brokers: They engage in marketing the issue and so they should work for giving assurance as to the success of that issue.  Printers, advertisers, mailing agents, solicitors and auditors: Each one has their own part to perform certain functions and make the issue of securities a success. Players in the secondary market:  Brokers: They are commission agents and they act on behalf of non members. They are paid a commission on the purchase and sales made through them.  Jobbers: A jobber is one who acts for himself and he is not an agent for any member. He buys and sells securities in his own name.  Arbitrators: They involve in inter market deals for a profit through differences in prices between two markets say Bombay and Chennai.  Security dealers: They specialize in the buying and selling of Gilt edged securities which are issued by central and state Governments. They operate in close liason with RBI.  Badla financiaries: They are members of the stock exchange but finance carry forward deals in specified group i.e., a group for a return (i.e., Interest) such a return is called budle rat Primary market: The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers. The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus. Features of primary markets are: 

This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

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In a primary issue, the securities are issued by the company directly to investors.

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The company receives the money and issues new security certificates to the investors.

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Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

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The primary market performs the crucial function of facilitating capital formation in the economy.

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The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as "going public."

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The financial assets sold can only be redeemed by the original holder.

The primary market, which at one time was flooded with a number of issues floated by dubious promoters, depriving gullible investors of their life-time savings has since been transformed. The changes in this area have been epoch-making and include detailing of complete profile of promoters, comprehensive disclosures, the existence of tangible assets and a track record of profit as also reporting end uses of funds to the Company Board as a part of corporate governance, etc. Sometime back when the story of Google’s IPO Was being flaunted around the world in various sections of media as one of the greatest innovations of recent times in raising risk capital, the Financial Times, London, carried the following observation: “The World’s Biggest Democracy can show Google how to conduct an online IPO. In India you cannot apply on the web but investors can access one of the world’s largest financial networks with 7000 terminals scattered around 350 cities. And every step of the book building process is public. The Indian system is a refreshing example of a transparent IPO market but it is also a rare one, especially in the insider-friendly Asian markets.” All the IPOs since the reforms started have been a success and barring a few exceptions are trading at a premium over the issue price. The regulatory framework has been modified to provide options to Indian firms for raising resources either domestically, or globally, or through both. This helps in price discovery and reducing the cost of funds. A number of Indian firms have raised money through American Depository Receipts (ADR), Global Depository Receipts (GDR) and External Commercial Borrowings (ECB). And the amount raised was next only Hong Kong and way ahead of Japan, Korea & Singapore through primary market. In fact, the corporate sector and governments (Centre and States) together raised a total of Rs. 3.75 trillion from the securities market during 2005. Thankfully, so far, no major mishap has been noticed in the recent times. Secondary Market: If a Rip Van Winkle woke up from a prolonged deep slumber of a couple of years, he would be amazed to see the quality of the secondary market of India. The deafening noise of an out-cry trading system has been replaced with a silence of a summer through the Electronic Consolidated Anonymous Limit Order Book, with price time priority matching being accessed through more than 10,000 terminals spread in over 400 cities and towns across the Indian sub-continent, something perhaps without a parallel in the world. The cost of transacting is the lowest, as compared to the most developed markets.

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The Indian Settlement system conforms to the CPSS-IOSCO (Committee on Payment and Settlement- International Organization of Securities Commissions) principles and G30 committee (January 2003, under the chairmanship of Sir Andrew Large) recommendations, which even the most developed markets of the world have been proposing to implement by end of 2006. The institution of central counter party (CCP), which provides full novation and guarantees settlement, has eliminated counter party risk entirely. Over 99percent of the dematerialization of market capitalization and Straight-Through Processing (STP), mandatory for all institutional trades, have enabled Indian settlement system to function seamlessly, not withstanding the size and spread. On a T+2 cycles, all scrips are electronically cleared fully through a central counter party (CCP) on a rolling settlement. The CCP of the exchanges, which operates a tight risk management system and maintains short (T+2) and consistent settlement cycle, is now financially potent to meet the obligations for 4-5 consecutive settlements even if all the trading members default in their obligations. The dynamic risk management system comprises capital adequacy norms, trading and exposure limits, index-based market-wide circuit breakers, margin (mark to market) requirements. The encashability of the underlying of the margins, comprising cash, bank guarantees and securities is evaluated periodically. The real time monitoring of broker positions and margins and automatic disablement of terminals with Value-added Risk (VAR) margining, built on much higher sigma deviation than the best of the markets in the world, has reduced the operational risk to the lowest. In an unfortunate very sharp (over 25 percent in two days) fall of the market in May 2004 the strength of the risk management of the system got tested to the hilt. There was not a single broker failure or default and on the third day (after the two consecutive days of fall) the market functioned as if nothing unusual had happened. Even the CCP was not required to fund any broker- dealer’s obligations. The three- legged corporate compliance stool----disclosure, accounting standards and board room practices -- has lifted India to the global pedestal in corporate governance. “India scores 100% as far as disclosure standards are concerned”. The Indian accounting standards are aligned with international accounting standards and are ‘principle based’. “In terms of consolidation, segmental reporting, deferred tax accounting and related party transactions, the gap between Indian and US GAAP is minimal.” On corporate governance it might be worthwhile to recall what the Economic Intelligence Unit 2003 study said: The Asian Experience incorporates - “Top of the Country class, as might be expected is Singapore followed by Hong Kong and somewhat surprisingly, India where overall disclosure standards have “The securities markets have made enormous progress in recent years. India’s equity market is now being increasingly recognized as a success story on the world scale.” These reforms have boosted the confidence of investors (domestic and international) in Indian securities market. There are four parameters to ascertain the level of investor confidence: –

(a) investments by FIIs, (b) growth of mutual funds industry,

(c) subscriptions to the IPOs and (d) the increase in the number of accounts with the depositories. Let me quote the last financial year (2005-06) figures. The mutual funds mobilized net resources of about Rs. 520 Billion, equivalent to about one fourth of incremental bank deposits. Mutual funds’ assets increased from Rs. 1.1 Billion at the end of March 2003 to Rs.300 Billion at the end of August 2006. Indian companies

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raised about Rs. 38 Billion through euro issues. The year gone by witnessed a net FII (portfolio moneys) inflow of US $ 14 billion. The benchmark indices, namely the SENSEX and S&P CNX NIFTY, generated astounding returns of 83 per cent and 81per cent respectively, during 2002-03 and 2003-04. The market capitalization grew from Rs. 7 trillion at the end of March 2003 to Rs. 14 trillion at the end of March 2004 to Rs 28 trillion as on June 2006, indicating that the equity market is bigger than the banking system. The primary issues in the last year added at least Rs. 2 trillion market capitalizations. The trading in cash segment of exchanges increased from Rs. 9,32,062 crore in 2002-03 to Rs. 23,85,632 crore in 2005-06. The trading in derivatives increased from Rs. 4, 42,332 crore to Rs. 48, 40,362 crore during the same period. The turnover in government securities increased from Rs. 1,941,621 crore to Rs. 2,639,897 crore. The number of demat accounts with the Depository Participants (DPs) has increased considerably during the last three years from 3.5 million to 8.5 million & is increasing at the rate of over 100,000 per month. The efficacy of the market where entry and exit are possible at will and the liquidity has spread from being skewed to just about 100 to more than 500 securities, is a matter of substantial comfort. Over 2,500 securities (equity) are traded for more than 100 days in a year. The overseas investors are no more glued to researches and assessments on index stocks and have been observing keenly and investing in the mid-cap segment. The changes in the market have been really fast-paced and it has been possible with the co-operation of all the market participants, other regulators and the Government of India.

3.6. TRADING AND SETTLEMENT Stock market is a trading platform which provides an opportunity to buyers and sellers of securities to do transactions. As of now there are 23 recognized stock exchanges in India and 24th is likely to get functional soon. However the majority of transactions in securities happen only on the National Stock Exchange. The Bombay stock Exchange is the second largest contributor in the overall pie of total transactions. However its contribution is restricted to 5 to 7 percent only. There are three types of instruments that are traded on National Stock Exchange namely equities, derivatives and debt instruments. This article attempts to explain the procedure involved in trading and settlement of equities. Before understanding the procedure of trading and settlement, it is important to have an overview of changes that have taken place in Indian securities market in last ten years. Three most noticeable changes which have taken place are 1) Dematerialization, 2) Introduction of screen based trading and 3) Shortening of trading and settlement cycles. The Depositories Act was passed by the parliament in 1995 and this paved the way for conversion of physical securities into electronic. With establishment of National Stock Exchange, there was a significant change in the level of technology used for the operation of stock market. It led to introduction of Screen Based Trading thereby removing the earlier system of open outcry where prices of securities were quoted by symbols. Now all the transactions happen on computer which is spread across country and connected to National Stock Exchange through VSAT. These two factors

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combined together helped in reducing the trading and settlement cycle in Indian securities market which got reduced from as long as 22 days to 2 days currently. Presently in India, stock exchanges follow T+2 days settlement cycle. Under this system, trading happens on every business day, excluding Saturday, Sunday and exchange notified holidays. The trading schedule is between 10:00 a.m. in the morning to 3:30 p.m. in the evening. During this period, shares of the companies listed on a particular stock exchange can be bought and sold. The SEBI has made it mandatory that only brokers and sub-brokers registered with it can buy and sell shares in the stock exchange. A person desirous of buying or selling shares on the stock market needs to get himself registered with one of these brokers / sub-brokers. There is a provision for signing of broker/sub-broker - client agreement form. Brokers/sub brokers ask their clients to deposit money with them known as margin based on which brokers provide exposure to the clients in the stock market. However signing of client-broker agreement is not sufficient. It is also essential for a person to open a demat account through which securities are delivered and received. This demat account can be opened with a depository participant which again is a SEBI registered intermediary. Some of the leading depository in the country is Stock Holding Corporation of India Ltd., ICICI Bank, HDFC Bank etc. If an individual buys shares, it is in the demat account that credit of shares are received. Similarly when a person sells shares, he has to transfer shares to the brokers account through his demat account. All the brokers/sub-brokers also essentially have a demat account. Shares can be bought and sold through a broker on telephone. Brokers identify their clients by a unique code assigned to a client. After the transaction is done by a client broker issues him contract note which provides details of transaction. Apart from the purchase price of security, a client is also supposed to pay brokerage, stamp duty and securities transaction tax. In case of sale transaction, these costs are reduced from the sale proceeds and then remaining amount is paid to the client. After the securities happen on the first day, while settlement of the same happens two days. This means that a security bought on Monday will be received by the client earliest on Wednesday which is called pay out day by the exchange. However there is provision which allows a broker to transfer securities till 24 hours after pay out receipt. Hence the broker may transfer shares latest by Thursday for a security bought on Monday. Any transfer after Thursday would invite penalty for the broker. If a person has bought security then he is supposed to pay money to the broker before pay in deadline which is two days after trading day but the second day is considered till 10:30 a.m. only. Hence the client must pay money to the broker before 10:30 a.m. On T+2 day. Settlement of securities is done by the clearing corporation of the exchange. Settlement of funds is done by a panel of banks registered with the exchange. Clearing corporation identifies payable/ receivable position of brokers based on which obligation report for brokers is created. On T+2 days all the brokers who

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have transacted two days before receive shares or give shares to the clearing corporation of exchange. This all is done through automated set up Depository which involves NSDL and CDSL. One of the most noticeable achievements of Indian securities market have been reduction in the settlement cycle which has brought it at par with global securities market.If India is able to attract huge investments in securities now, it is not only because of inherent strength of the economy but also because stock markets have reached very advanced stage which make outsiders to understand the process in Indian market easily. 3.7. CLEARING AND SETTLEMENT PROCEDURE Clearing and settlement: Clearing Center acts as the Central Counterparty to the trades executed on Standard and OTC repo trades as well as sale and purchase equity trades entered into by the RTS Clearing Center in the cases described in the Clearing Rules of RTS Clearing Center .RTS Standard Trading Members are Clearing Members of RTS Clearing Center who have made a contribution to the Contingency Fund. Trades are registered in sections opened in the positions register. Market participants are required to put up collateral on their positions. If based on the results of the intraday or the evening clearing session the collateral falls below the sufficiency level, the Clearing Member is obligated to pay off the debt until the next intraday or evening clearing session. Collateral is calculated twice a day, namely during the intraday and the evening clearing sessions, in compliance with the principles for calculation of collateral established by the RTS Clearing Center. Settlement documents are issued and submitted to Settlement Depositories and to the Settlement Company during the settlement clearing session (in accordance with the schedule of clearing sessions). Marking to market: During the intraday and the evening clearing sessions the Clearing Center revalues the market risks associated with the securities trades, which results in debiting and crediting of Collateral Deposits to the cash registers opened for the Clearing Members. All the amounts transferred as Collateral Deposits are subject to back transfer, if the secured obligations are duly satisfied on the settlement date. The procedure for calculation of Collateral deposits is set forth is the Clearing Rules. Settlement: On T+4 maturing obligations under trades and obligations to return the Collateral Deposits are included by the Clearing Center in the clearing pool of the settlement clearing session.

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The number of securities to be credited to the trading securities account for delivery purposes is calculated based on the net short position registered in this trading securities account including all trades to be settled using this trading securities account. The amount of cash to be credited to the trading securities account in satisfaction of the obligations to pay for the delivered securities is calculated based on the net long position registered in the trading securities account including all trades to be settled using this trading securities account with regard to payable/ receivable Collateral Deposits. Settlement accounts: For fulfillments of payment obligations as well as the obligations to register the transfer of title to securities traded on RTS Standard cash and securities are to be credited to the trading accounts by 9:00 am MSK on T+4. In order to replenish their trading cash accounts the Clearing Members credit cash funds to their main accounts with the Settlement Chamber within the timeframe specified in the Schedule of the Settlement Chamber. The Settlement Chamber then moves the cash funds from the main to the trading accounts. At the Clearing Memberâ&#x20AC;&#x2122;s request several trading accounts may be opened for one main account. In this case cash funds are credited to the trading accounts based on the corresponding payment order issued by the Clearing Member to the Settlement Chamber. On the initiative of the account holder withdrawal of cash funds from the main trading accounts is performed based on the corresponding payment orders submitted to the Settlement Chamber (during the entire period when client instructions are accepted including during trading sessions). Payment orders for withdrawal of cash funds from the main accounts submitted to the Settlement Chamber are executed in the real time mode in the amount of the clear cash balance registered by the Clearing Center in the trading account. Everyday after the settlements based on the trading results are performed, the Settlement Chamber transfers all the funds from trading accounts to the corresponding main accounts (nullifies the trading accountsâ&#x20AC;&#x2122; balance). On a daily basis the Settlement Chamber issues a main account statement and a list of debits and credits to the trading account for each account holder. Securities are withdrawn from the trading account only in the amount of the clear balance of securities registered by the Clearing Center in the trading account: (i) in the real time mode, unless the

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number of securities specified in the payment order exceeds the initial securities balance in the account; (ii) based on the results of the next settlement and clearing session if the number of securities specified in the payment order exceeds the initial balance of the securities. Withdrawal of securities form the Trading System is only possible if the clear securities balance registered in the trading account within the Trading System is sufficient as of the moment such instruction is submitted. If this condition is satisfied, the securities will be credited to the main section of the SDC member upon the end of the settlement & clearing session. 3.8. QUESTIONS Section - A Very Answer Short Questions: 1. What is marking to market? 2. Explain the Factors affecting capital market: 3. What is Gilt edged market? 4. What do understand by the term Rights Issue? 5. What is Book Building? 6. Write short note on Bonus shares Section - B Short Answer Questions: 1. Explain the Functions of new issue market 2. What is Private Placement? 3. Who are the Players in the secondary market? Section - C Essay type questions: 1. Briefly explain the concept of stock markets and their features 2. Explain the developments of securities markets in India 3. Give a brief note about regulations of securities markets 4. Explain briefly about primary market and secondary market 5. Give a brief note on clearing and settlement procedure 3.9. FURTHER READINGS 1. Dr.v.balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and portfolio management, shri venkateswara publications. 2. Introduction to security analysis, the Icfai University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house pvt ltd

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CHAPTER -04 SECURITY MARKET INDICATORS STRUCTURE 4.0. OBJECTIVES 4.1. INTRODUCTION 4.2. CONSTRUCTIONS OF SECURITY MARKET INDICES 4.3. TYPES SECURITY MARKET INDICES IN INDIA 4.4. EQUITY SHARE INDICES 4.5. LIMITATIONS OF VARIOUS INDICES 4.6. QUESTIONS 4.7. FURTHER READINGS

4.0. OBJECTIVES After studying this unit, you should be able to understand: 

Constructions of security market indices



Types security market indices in India



Equity share indices



Limitations of various indices

4.1. INTRODUCTION “How’s the market doing? Is frequently the first question investors ask their brokers? This interest in market movements results from the fact that the prices of individual securities tend to vary with market movements. The general movement of the stock market is usually measured by averages or indices consisting of groups of securities that are supposed to represent the entire stock market or particular segments of it. Thus, security Market Indices (or) security Market Indicators provides a summary measure of the behavior of security prices and the stock market. In this chapter, we will discuss in detail about the salient feature of the principal share price index numbers used in India

4.2. CONSTRUCTIONS OF SECURITY MARKET INDICES The Construction of an Index: An astute Fool on the message boards recently noted that the Nasdaq 100 has significantly outperformed the S&P 500 over the past ten years, yet more money was flowing into S&P 500 index mutual funds. From the end of 1988 to September 30, 1998, the Nasdaq 100 outperformed the S&P 500

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by almost 6 percentage points annually, based on returns of 23.1% and 17.3%, respectively. Why, this reader wondered, would investors be funneling more dollars into the fund with lower performance? There are several reasons for this phenomenon, but his question elicited an important investing point. There are many indices beyond the S&P 500. While the S&P 500 can be the bedrock of most portfolios, those wishing to devote more time to investing but not interested in individual stocks may find other indices that provide higher returns. Before venturing into index funds, it is helpful to understand the differences in how stocks are selected for inclusion in the indices and how the indices are calculated. Anyone can create an index to track the overall stock market or specific sectors within the market. Some consist of a large number of stocks, while others are quite limited. Perhaps the best known index is the Dow Jones Industrial Average (DJIA) , which is composed of 30 major stocks in various industries picked by the editors at Dow Jones as bellwethers of the U.S. stock market. The broadest-based index of large companies is the S&P 500. The 500 stocks in the index are selected by Standard and Poor's, based on the company's representation of the U.S. economy, stable financial profile, and liquidity (i.e., high level of trading activity). One of the best performing major indices in recent years is the Nasdaq 100, which tracks the performance of the largest stocks traded on the NASDAQ stock exchange. Inclusion in this index is based on a formula that selects those stocks with the greatest market capitalization (shares outstanding * price per share). When calculating indices, companies must decide how each stock in it will be weighted. The most popular methodology is based on market capitalization. In an index such as the S&P 500, a stock's weighting is based on the percentage of value of the entire index an individual company comprises. If the market capitalization of a company's stock is $1,000,000 and the market capitalization of all stocks in the index is $20,000,000, the stock would be included as 5% of the index. The DJIA uses a different methodology -- priced-based weighting. Not surprisingly, this means that the weighting of each individual stock is based on that stock's price relative to the sum of all the stock prices. Assuming that the sum of each stock in a price-based index is $500, a stock trading for $20 would comprise 4% of an index. An unusual impact of such a system is that a stock split has a noticeable effect on a price-based index. If the $20 stock mentioned above declares a 2-for-1 split, ceteris paribus, its weighting would fall to slightly over 2% despite no fundamental change in the companies in the index. For this reason, there aren't too many price-based indices. The NASDAQ 100 index just switched on December 21 from being a pure market-capitalization based index to a modified market capitalization index. This change will limit the weighting of securities that comprise over 4.5% of the portfolio to increase the portfolio's diversification. This change was

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implemented because the largest five stocks in the index totaled about 61% of its value. Under the adjustment mechanism, the weighting of these five stocks will be lowered to 40%. Why should the S&P 500 be the backbone of an indexing strategy? It consists of 500 of the largest U.S. companies across a wide spectrum of industries. The folks at Standard and Poor's who select stocks for the index go out of their way to ensure that the index substantially represents the U.S. economy. Included in this index are car makers, technology companies, pharmaceutical companies, retailers, financial companies, and Internet companies (starting Monday when America Online (NYSE: AOL) joins the index). With such broad diversification across the U.S. economy, the growth in profitability within companies in the index should roughly mirror the overall growth of corporate America's profitability. The NASDAQ 100, on the other hand, does not have the breadth of the S&P 500. Five stocks, all of them in technology or telecom, make up 40% of the index. In comparison, the S&P 500's top five industries total only 26% of the index. The focus of the Nasdaq 100 is terrific for investors when the included stocks are doing well, but it does not necessarily allow for participation in the overall growth of U.S. corporate profitability. Investing in the Nasdaq 100 is essentially making a bet that the stocks of some large technology and telecom companies are going to outperform the overall market. There is nothing wrong with having such an investment strategy, but it is quite different from investing in the S&P 500 and the growth in a diverse group of large capitalization U.S. stocks. Before investing in an index such as the Nasdaq 100, you should feel confident about the prospects for the specific sectors that are overweighted in the index. You are not making the less restrictive assumption (implicit with investing in the S&P 500) that the value of corporate America is going to increase over time. Investing in indexed funds is generally more profitable than investing in actively managed funds with similar objectives because of lower expense ratios and reduced stock turnover. An index fund lowers expenses because it doesn't have to pay fund managers to pick stocks. In addition, the lower turnover inherent in most index funds results in reduced trading costs (not to mention a lessened tax bite for taxable investors). To easily invest in corporate America in one fell swoop, an S&P 500 index fund is probably your best bet. If you want to invest in more specialized sectors, you can certainly beat that index. Before doing so, however, you should be willing to invest the time to learn about how the index is constructed and the prospects for the stocks of the companies or industries that are emphasized. A good place to start is our Index Center, which describes in detail the compositions of some major indexes you may be interested in.

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4.3. TYPES SECURITY MARKET INDICES IN INDIA Types of indices: Stock market indices may be classed in many ways. A 'world' or 'global' stock market index includes (typically large) companies without regard for where they are domiciled or traded. Two examples are MSCI World and S & P Global 100. A national index represents the performance of the stock market of a given nation—and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the British FTSE 100, the French CAC 40, the German DAX, the Japanese Nikkei 225, the American DJIA and S&P 500, the Indian Sensex, the Australian All Ordinaries and the Hong Kong Hang Seng inbox. The concept may be extended well beyond an exchange. The Dow Jones Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs) and most traded on the NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indices by launching the Russell Global index. More specialized indices exist tracking the performance of specific sectors of the market. The Morgan Stanley Biotech Index, for example, consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria — one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment

BSE Indices

NSE Indices

BSE Sensex

BSE Bankex

Equity Stock Watch

Derivative Futures

BSE 100 Index

BSE CG Index

Equity Top Gainers

Derivative Options

BSE 200 Index

BSE CD Index

Equity Top Losers

Most Active Contracts

BSE 500 Index

BSE FMCG Index

Most Active Securities

Most Active Calls

BSE

MIDCAP

BSE HC Index

Available Securities

Most Active puts

SMLCAP

BSE IT Index

Suspended Company

Most Active Underlying

BSE TECK Index

BSE Metal Index

Changed symbols

NSE Trading Terminats

BSE PSU Index

BSE Oil & Gas Index

Equity Turnover

Index BSE Index

BSE AUTO Index

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4.4. EQUITY SHARE INDICES Stock market index: A comparison of three major U.S. stock indices: the NASDAQ Composite, Dow Jones Industrial Average, and S&P 500. All three have the same height at March 2007. Notice the large dot-com spike on the NASDAQ, a result of the large number of tech companies on that index. A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used to benchmark the performance of portfolios such as mutual funds.

4.5. LIMITATIONS OF VARIOUS INDICES 1. Whenever a company issues rights in the form of CDs (to be converted at a later stage) or other instruments (warrants )entitling the holder the holder to acquire one equity share of the company at specified price at a notified future date, Secured Promissory Notes (SPNs) ,etc., The equity capital increases only on conversion of debentures or the exercise of warrants/SPN option for equity shares but the market adjusts the ex-rights price of the share immediately(on the day the share starts trading ex-rights) on the basis of the anticipated increased equity capital and likely reduced earnings per share , etc. Hence, some modification is needed to adjust the equity capital suitably in advance. But the exact procedure by which this can be done is very difficult to state since the internal market mechanism which adjusts the ex-rights share price is almost impossible to know precisely. Again, this is a common limitation of all the indices and so far, the increased equity capital is considered only after the debentures are converted into shares and are acquired for warrants/SPNs and the new shares are listed for trading on the stock exchange. 2. The coverage (in terms of number of scrips, number of stock exchange used and the respective weights assigned) is different for all the indices and hence,

4.6. QUESTIONS Section - A Very Short Answer Questions: 1. What is NASDAQ? 2. What do you understand by the term securities? 3. Explain the term market indicator 4. How many stock exchanges are functioning in India?

Section - B Short Answer Questions: 1. What are the limitations of various indices? 2. Briefly explain about BSE SENSEX.

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INVESTMENT ANALYSIS Section - C Essay type questions: 1. Explain the constructions of security market indices 2. What are the types security market indices in India 3. What do you understand by the term equity share indices

4.7. FURTHER READINGS 1. Dr.v.balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and portfolio management, shri venkateswara publications. 2. Introduction to security analysis, the Icfai University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house pvt Ltd

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CHAPTER -05 FUNDAMENTAL ANALYSIS STRUCTURE 5.0. OBJECTIVES 5.1. INTRODUCTION 5.2. OBJECTIVES AND BELIEFS OF FUNDAMENTAL ANALYSIS 5.3. FRAME WORK FOR FUNDAMENTAL ANALYSIS 5.4. CONCEPT OF INTRINSIC VALUE 5.5. CONCEPT OF MARKET VALUE 5.6. ECONOMIC ANALYSIS 5.7. QUESTIONS 5.8. FURTHER READINGS

5.0. OBJECTIVES After studying this unit, you should be able to understand: 

Objectives and beliefs of fundamental analysis



Frame Work for fundamental analysis



Concept of intrinsic value



Concept of market value



Economic analysis

5.1. INTRODUCTION The chapter now focuses on fundamental analysis, technical analysis and efficient market theories, with emphasis on the fundamental school of thought through economic, industrial and company analysis. The behavior of stock prices as well as forecasting the prices of stock help the investor to take certain decisions in the investment market. What factors should be analyzed? This is being dealt with here. The investor, while buying stock, has the primary purpose of gain. If he invests for a short period of time, it is speculative but when he holds it for a fairly long period of time, the anticipation is that he would receive some return on his investment.

5.2. OBJECTIVES AND BELIEFS OF FUNDAMENTAL ANALYSIS Fundamental analysis is a method of finding out the future price of a stock which an investor wishes to buy. The method for forecasting the future behavior of investments and the rate of return on

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them is clearly through an analysis of the broad economic forces in which they operate, the kind of industry to which they belong and the analysis of the companyâ&#x20AC;&#x2122;s internal working through statements like income statement, balance sheet and statement of changes of income. The significance of the economic indicators is primarily to try and form a strategy for making investments. Investors need not necessarily make their own economic forecasts but they must be able to find out the price movements in the economy to be able to invest effectively. Published forecasts may be used by the investor for this purpose. A look into the monetary, fiscal and demographic factors will give a basic idea into the trends in the economy. Economic analysis: Investors are concerned with those forces in the economy which affect the performance of organizations in which they wish to participate, through the purchase of stock. From their point of view, a discussion of economic environment is very important. This is so not from the point of view of a policymaker but an investor and this should be borne in mind. A study of the economic forces would give an idea about future corporate earnings and the payment of dividends and interest to investors. Some of the broad forces within which the factors of investment operate are: 1. Population: population gives an idea of the kind of labour force in a country. In some countries, the population growth has slowed down whereas in India and some other third world countries, there has been a population explosion. Population explosion will give demand for more industries like hotels, residences, service industries like health, consumer demands like refrigerators and cars. Increase in population, therefore, shows a greater need for economic development of the country. It does not show the exact industry which will be expanding but in those countries where there is a high rate of population growth, the Labour

intensive industries will have a generation of demand. Likewise, investors should

prefer to invest in industries which have a large amount of labour force. Capital being rare in these countries the labour intensive industries will grow. And from the point of view of rate of return in the future such industries will bring better rates of return. Those countries which have a high growth in capital intensive and labour scarce industries relating to investments are being considered. 2. Research and technological developments: The economic forces relating to a investment would be depending on the amount of resources spent by the Government on the particular technological development affecting the future. Broadly, the investor should invest in those industries which are getting a large amount of share in the funds of the development of the country. For example, in India, in the present context, automobile industries and space technology are receiving greater attention. These may be areas which the investor may consider for investment. 3. Capital formation: Another consideration of the investor should be the kind of investment which a company makes in capital goods and the capital it invests in modernization and replacements of assets. These, to a large extent are dependent on the economic factors of the country. The gross national product of a country should be carefully analysed. A particular industry or a particular company in which an investor would like to invest can also be viewed at with the help of the economic indicators such as the

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place, value and property position of the industry, group to which it belongs and the year-to-year returns through corporate profits. 4. Natural Resources and Raw Material: The natural resources are to a large extent responsible for a countryâ&#x20AC;&#x2122;s economic development and overall improvement in the condition of corporate growth. The discovery of oil in middle-east countries and the discovery of gas in America created great change in the general economic pattern and the investment of those countries. In Japan, the government found raw material in the form of labour force much suited to a developing country. Technological discoveries in recycling of material, nuclear and solar energy and new synthetics should give the investor an opportunity to invest in untapped or recently tapped resources which would also produce higher investment opportunity. Forecasting: All industries in an economy do not grow at same rate. After considering these broad economic forces which are demographical in nature, the investor should make an economic forecasting for taking a decision on investment n stocks. It is important to forecast the economic environment basically because if the investor purchases an investment at the right time and when it is getting the proper resources to help it grow, the investor will receive a gain on the amount which he has invested. Timing is crucial because if an investor operates his investment during the time of strike or during a distributed state of the capital market, then the rate of return which he will receive will not be high. Favourable conditions will give him a good rate of return because the profits in a company are based on the key economic factors like (a) labour, (b) government, (c) political climate, (d) developments in technology, (e) availability of finance and (f) tax treatment. Economic Indicators: Besides the demographic factors discussed above, there are other significant economic indicators. These indicators are sometimes identified as leading, coincidental and lagging indicators and their help is often sought in forecasting and madding an analysis of the economy. The leading indicators help us to assess the future course of action. The leading indexes of an economy relate to a countryâ&#x20AC;&#x2122;s fiscal policy, monetary policy, stock prices, and state of the capital market, labour productivity, consumer activity and gross national product (GNP). The coincidental indicators are the economic factors relating to employment position in a country and other GNP factors such as the state of industrial production, corporate profits and wholesale and producer price index. Coincidental indicators unlike leading indicators do not indicate the future of the economy but present a fairly accurate picture of the current state of the economy. The change in coincidental indicators make the lagging indicators turn. Lagging indicators are identified with consumer price index, capital expenses and commercial paper rates. The leading, coincidental and lagging factors are a useful insight into the economyâ&#x20AC;&#x2122;s current and future position. It is also important for an investor from the point of view of assessing long-term investment: (a) A Gross National product growth rate of 6% would positively affect the stock market.

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Growth in GNP without the associated evils of price increase and inflation is desirable for investment in bonds and equities. (b) Another indicator relates to reduced unemployment. A rise in employment is favourable for the economy. (c) Savings is a positive indicator during the inflationary period. An attempt should be made to effectively step it up. (d) Consumer activity in terms of increase in purchase and sales may also be considered a positive improvement in the economy. (e) High interest rates are unfavourable for the stock market and their effect on equity shares. It has a negative effect on equity shares. (f) Buoyancy in the stock market is a good economic indicator and shows growth in the economy. The following forecasting methods are suggested for preparing economic forecasts: Economic Forecasting: Economic forecasting, as already discussed, is a measure to find out the future prosperity of a pattern of investment. The technique of economic forecasting is to measure either short-term or longerterm economic developments well in advance. Long-term forecasts are usually for a period of above five years of ten or more years and a study to be made in advance. A period shorter than the long-term period may be divided into: (a) short-term period, (b) intermediate period. A short-term period generally ranges from one to three years. Economic forecasts are easier to find out during short-term period. Therefore, forecasting techniques are also built in such a way that the long-term forecasts are broken into shorter periods to forecast the long-term. Longer-term forecast would give a brief idea about the changing tax laws, government priorities and quick capital gains. Most of the economic forecasts are through the shortterm forecasting techniques.

5.3. FRAME WORK FOR FUNDAMENTAL ANALYSIS Fundamental analysis: The intrinsic value of an equity share depends on a multitude of factors. The earnings of the company, the growth rate and the risk exposure of the company have a direct bearing on the price of the share. These factors in turn rely on the host of other factors like economic environment in which they function, the industry they belong to, and finally companies' own performance. The fundamental school of thought appraised the intrinsic value of shares through 

Economic Analysis



Industry Analysis



Company Analysis

Economic analysis: The level of economic activity has an impact on investment in many ways. If the economy grows rapidly, the industry can also be expected to show rapid growth and vice versa. When the level of economic activity is low, stock prices are low, and when the level of economic activity is high, stock prices are high reflecting the prosperous outlook for sales and profits of the firms. The analysis of macro economic environment is essential to understand the behaviour of the stock prices. The commonly analyzed macro economic factors are as follows

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Gross domestic product (GDP): GDP indicates the rate of growth of the economy. GDP represents the aggregate value of the goods and services produced in the economy. GDP consists of personal consumption expenditure, gross private domestic investment and government expenditure on goods and services and net export of goods arid services. The estimates of GDP are available on an annual basis-. The rate of growth of GDP is around 6% in the nineties. The GDP growth in 1998-99 has accelerated to 5.8 percent compared, to 5 per cent of the previous year. The growth rate of economy points out the prospects for the industrial sector and the return investors can expect from investment in shares. The higher growth rate is more favourable to the stock market. Savings and investment: It is obvious that growth requires investment which in turn requires substantial amount of domestic savings. Stock market is a channel through which the savings of the investors are made available to the corporate bodies. Savings are distributed over various assets like equity shares, deposits, mutual fund units, real estate and bullion. The saving and investment patterns of the public affect the stock to a great extent. ]

Years

Savings

Investment

1996 – 97

24.4

25.7

1997-98

23.1

24.8

1998 – 99

21.5

22.6

1999 – 00

24.1

25.2

2000 – 01

24.0 (P)

24.0

2001 – 02

23.7#

P – Provisionals # - Estimated Inflation: Along with the growth of GDP, if the inflation rate also increases, then the real rate of growth would be very little. The demand in the consumer product industry is significantly affected. The industries which come under the government price control policy may lose the market, for example Sugar. The government control over this industry, affects the price of the sugar and thereby the profitability of the industry itself. If you are a mild level of inflation, it is good to the stock market but high rate of inflation is harmful to the stock market. Interest rates: The interest rate affects the cost of financing to the firms. A decrease in interest rate implies lower cost of finance for firms and more profitability. More money is available at a lower interest rate for the brokers who are doing business with borrowed money. Availability of cheap fund encourages

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speculation and rise in the price of shares. The bank rate of the RBI is given below.

Bank Rate

%p.a.

Bank Rate . Oct. 2000

April 1997 June 1997

Feb2001

7.5

October 1997

March 2001

7.0

January 1998

22 Oct 2001

6.5

March 1998

10.5

29 Oct2001

6.25

April 1998

April 2003

6.0

March 1999

Budget: The budget draft provides an elaborate account of the government revenues and expenditures. A deficit budget may lead to high rate of inflation and adversely affect the cost of production. Surplus budget may result in deflation. Hence, balanced budget is highly favourable to the stock market. The fiscal deficit and the revenue deficit as a percentage of the GDP are given in Table.

Years

Savings

Investment

1997-98

4.8

3.1

1998 – 99

5.1

3.8

1999 – 00

5.4

3.5

2000 – 01

5.7

4.1

2001 – 02

6.3

4.4

2002 – 03

5.3

4.4

2003 – 04

4.6

3.6

The tax structure: Every year in March, the business community eagerly awaits the Governments announcement regarding the tax policy. Concessions and incentives given to a certain industry encourage investment in that particular industry. Tax reliefs given to savings encourage savings. The Minimum Alternative Tax (MAT) levied by the Finance Minister in 1996 adversely affected the stock market. Ten years of tax holiday for all industries to be set up in the northeast is provided in the 1999 budget. The type of tax exemption has impact on the profitability of the industries.

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The balance of payment: The balance of payment is the record of a country's money receipts from and payments abroad. The difference between receipts and payments may be surplus or deficit. Balance of payment is a measure of the strength of rupee on external account. If the deficit increases, the rupee may depreciate against other currencies, thereby, affecting the cost of imports. The industries involved in the export and import are considerably affected by the changes in foreign exchange rate. The volatility of the foreign exchange rate affects the investment of the foreign institutional investors in the Indian stock market. A favourable balance of payment renders a positive effect on the stock market. Monsoon and agriculture: Agriculture is directly and indirectly linked with the industries. For example Sugar, Cotton, Textile and Food processing industries depend upon agriculture for raw-material. Fertilizer and insecticide industries are supplying inputs to the agriculture. A good monsoon leads to higher demand for input and results in bumper crop. This would lead to buoyancy in the stock market. When the monsoon is bad, agricultural and hydel power production would suffer. They cast a shadow on the share market. Infrastructure facilities: Infrastructure facilities are essential for the growth of industrial and agricultural sector. A wide network of communication system is a must for the growth of the economy. Regular supply of power without any powercut would boost the production. Banking and financial sectors also should be sound enough to provide adequate support to the industry and agriculture. Good infrastructure facilities affect the stock market favourably. In India even though infrastructure facilities have been developed, still they are not adequate. The government has liberalised its policy regarding the communication, transport and power sector. For example, power sector has been opened up to the foreign investors with assured rates of returns. Demographic factors: The demographic data provides details about the population by age, occupation, literacy and geographic location. This is needed to forecast the demand for the consumer goods. The population age indicates the availability of able work force. The cheap labour force in India has encouraged many multinationals to start their ventures. Indian labour is cheaper compared to the Western labour force. Population, by providing labour and demand for products, affects the industry and stock market. Economic forecasting: To estimate the stock price changes, an analyst has to analyse the macro economic environment and the factors peculiar to the industry he is concerned with. The economic activities affect the corporate profits, investors, attitude and the share prices. Fall in the GDP or slackness in the economic growth may lead to fall in corporate profit and consequently the security prices. For the purpose of economic analysis, an analyst should be familiar with the forecasting techniques. He should know the advantages and disadvantages of various techniques. The common techniques used are analysis of key economic indicators, diffusion index, surveys and econometric model building. These techniques help him to decide

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the right time to invest and the type of security he has to purchase i.e. stocks or bonds or some combination of stocks and bonds. Economic indicators: The economic indicators are factors that indicate the present status, progress or slow down of the economy. They are capital investment, business profits, money supply, GNP, interest rate, unemployment rate, etc. The economic indicators are grouped into leading, coincidental and lagging indicators. The indicators are selected on the following criteria 

Economic significance



Statistical adequacy



Timing



Conformity The leading indicators indicate what is going to happen in the economy. It helps the investor to

predict the path of the economy. The popular leading indicators are the fiscal policy, monetary policy, productivity, rainfall, capital investment and the stock indices. The fiscal policy shows what the government aims at and the fiscal deficit or surplus has an effect on the economy. The tax policy of the government may act as a boost or a deterrent to the industry. The sops given to the export oriented industries may improve the exports of the economy. Likewise the cheap money or the tight money policy adopted by the monetary authorities also indicates the future effects of the policy on the industry. The rise of BSE Sensex and NSE Nifty shows that the economy is heading for recovery.

The coincidental indicators indicate what the economy is. The coincidental indicators are gross national product, industrial production, interest rates and reserve funds". GDP is the aggregate amount of goods and services produced in the national economy. The gap between the budgeted GDP and the actual GDP attained indicates the present situation. If there is a large gap between the actual growth and potential growth, the economy is slowing down. Low corporate profits and industrial production show that the economy is hit by recession. The changes that are occurring in the leading and coincidental indicators are reflected in the lagging indicators. Lagging indicators are identified as unemployment rate, consumer price index and flow of foreign funds. These leading, coincidental and lagging indicators provide an insight into the economy's current and future position. Diffusion index: Diffusion index is a composite or consensus index. The diffusion index consists of leading, coincidental and lagging indicators. This type of index has been constructed by the National Bureau of Economic Research in USA. But the diffusion index is complex in nature to calculate and the irregular movements that occur in individual indicators cannot be completely eliminated.

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Econometric model building: For model building several economic variables are taken into consideration. The assumptions underlying the analysis are specified. The relationship between the independent and dependent variables is given mathematically.While using the model, the analyst has to think clearly all the inter-relationship between the variables. When these inter-relationships are specified, he can forecast not only the direction but also the magnitude. But his prediction depends on his understanding of economic theory and the assumptions on which the model has been built. The models mostly use simultaneous equations.

5.4. CONCEPT OF INTRINSIC VALUE One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock’s “real” value. In financial jargon, this true value is known as the intrinsic value. For example, let’s say that a company’s stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value. This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long “the long run” really is. It could be days or years.

5.5. CONCEPT OF MARKET VALUE Market Value: Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some circumstances. International Valuation Standards defines market value as "the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion”. Market value is a concept distinct from market price, which is “the price at which one can transact”, while market value is “the true underlying value” according to theoretical standards. The concept is most commonly invoked in inefficient markets or disequilibrium situations where prevailing market prices are not reflective of true underlying market value. For market price to equal market value, the market must be informationally efficient and rational expectations must prevail. Market value is also distinct from fair value in that fair value depends on the parties involved, while market value does not. For example, IVS currently notes fair value "requires the assessment of the price that is fair between two specific parties taking into account the respective advantages or disadvantages that each will gain from the transaction. Although market value may meet these criteria, this is not necessarily always the case.

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Fair value is frequently used when undertaking due diligence in corporate transactions, where particular synergies between the two parties may mean that the price that is fair between them is higher than the price that might be obtainable in the wider market. In other words "special value" may be generated. Market value requires this element of "special value" to be disregarded, but it forms part of the assessment of fair value. 5.6. ECONOMIC ANALYSIS Economic analysis: Economic analysis is a process whereby strengths and weaknesses of an economy are analyzed. Economic analysis is important in order to understand exact condition of an economy. It can cover a number of important economic issues that keep cropping up within a particular economy, which is being analyzed. Macroeconomics and economic analysis: Macroeconomic issues are important aspects of economic analysis process. However, economic analysis can also be done at a microeconomic level. Macroeconomic analysis helps in understanding fundamentals of an economy. Since such a form of analysis operates on a wide scale, it helps one to analyze strengths and weaknesses of particular economies. Macroeconomic analysis takes into account growth achieved by a particular economy or rather a particular sector of that economy. It tries to find out reasons behind particular economic phenomena like growth or reversal of economy. Inflation and economic analysis: Many countries of world are plagued by a rising rate of inflation. Economic analysis helps in providing an explanation of why inflation has taken place. It also suggests ways in which rate of inflation could be brought down, so that economic development could continue. Economic analysis and governmental policies: Governmental policies and plans, pertaining to economy, have always been an important part of economic analysis. Since policies and plans adopted by a particular government is responsible for shaping an economy, they are always closely scrutinized by various processes of economic analysis. Economic ratings and economic analysis: Economic rating is another important part of economic analysis, as it provides an accurate picture of

how

economy

was

faring

when

those

ratings

were

being

calculated

Economic analysis and comparison of economic policies: It is a good way to analyze an economy by comparing its policies with those followed by other economies. This is all more applicable in case of economies that are of similar types, for example developing economies.

5.7. QUESTIONS

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INVESTMENT ANALYSIS Section â&#x20AC;&#x201C; A i) Very Answer Short Questions: 1. What is meant by fundamental analysis? 2. What is meant by P/E ratio? 3. How is the economic growth related to stock prices? 4. What is SWOT analysis? 5. What are the factors that affect the earnings per share of the company? Section - B ii) Short Answer Questions: 1. Explain the concept of intrinsic value 2. Explain the concept of market value 3. What do you understand by the term economic analysis?

Section - C iii) Essay type questions: 1. What are the objectives of fundamental analysis? 2. Briefly explain the frame work for fundamental analysis

5.8. FURTHER READINGS

1. Dr.v.balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and portfolio management, shri venkateswara publications. 2. Introduction to security analysis, the Icfai University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house pvt ltd

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CHAPTER -06 INDUSTRY ANALYSIS STRUCTURE 6.0. OBJECTIVES 6.1. INTRODUCTION 6.2. CLASSIFICATION OF INDUSTRIES 6.3. INDUSTRY LIFE CYCLE 6.4. KEY CHARACTERISTICS OF INDUSTRY ANALYSIS 6.5. BUSINESS CYCLE ANALYSIS 6.6.

COMPANY ANALYSIS

6.7. QUESTIONS 6.8. FURTHER READINGS 6.0. OBJECTIVES After studying this unit, you should be able to understand: 

Classification of industries



Key characteristics of industry analysis



Industry life cycle



Business cycle analysis



Company analysis

6.1. INTRODUCTION An industry is a group of firms that have similar technological structure of production and produce similar products. For the convenience of the investors, the broad classification of the industry is given in financial dailies and magazines. Companies are distinctly classified to give a clear picture about their manufacturing process and products.

6.2.

CLASSIFICATION OF INDUSTRIES

S.No.

Industries

Food products

Beverages, Tobacco and Tobacco products

Textiles

Wood and wood products

Leather and leather products

Rubber and plastic products

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Chemical and chemical products

Non-metallic mineral products

Basic metals, Alloys and metal products

10.

Machinery and Machine tools

11.

Transport equipment and parts

12.

Other Miscellaneous manufacturing industries.

The above table shows that each industry is different from the other. Textile industry is entirely different from the steel industry or the power industry in its product and process. These industries can be classified on the basis of the business cycle i.e. classified according to their reactions to the different phases of the business cycle. They are classified into growth, cyclical, defensive and cyclical growth industry. Growth industry: The growth industries have special features of high rate of earnings and growth in expansion, independent of the business cycle. The expansion of the industry mainly depends on the technological change. For instance, inspite of the recession in the Indian economy in 1997-98, there was a spurt in the growth of information technology industry. It defied the business cycle and continued to grow. Likewise in every

phase

the

history

certain

industries

colour

televisions,

pharmaceutical

and

telecommunication industries have shown remarkable growth. Cyclical industry: The growth and the profitability of the industry move along with the business cycle. During the boom period they enjoy growth and during depression they suffer a set back. For example, the white goods like fridge, washing machine and kitchen range products command a good market in the boom period and the demand for them slackens during the recession. Defensive industry: Defensive industry defies the movement of the business cycle. For example, food and shelter are the basic requirements of humanity. The food industry withstands recession and depression. The stocks of the defensive industries can be held by the investor for income earning purpose. They expand and earn income in the depression period too, under the government's umbrella of protection and are countercyclical in nature. Cyclical growth industry: This is a new type of industry that is cyclical and at the same time growing. For example, the automobile industry experiences periods of stagnation, decline but they grow tremendously. The changes in technology and introduction of new models help the automobile industry to resume their growth path.

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6.3. INDUSTRY LIFE CYCLE The industry life cycle theory is generally attributed to Julius Grodensky. The life cycle of the industry is separated into four well defined stages such as a. Pioneering stage b. Rapid growth stage c. Maturity and stabilisation stage d. Declining stage Pioneering stage: The prospective demand for the product is promising in this stage and the technology of the product is low. The demand for the product attracts marry producers to produce the particular product. There would be severe competition and only fittest companies survive this stage. The producers try to develop brand name, differentiate the product and create a product image. This would lead to non-price competition too. The severe competition often leads to the change of position of the firms in terms of market shares and profit. In this situation, it is difficult to select companies for investment because the survival rate is unknown. Rapid growth stage: This stage starts with the appearance of surviving firms from the pioneering stage. The companies that have withstood the competition grow strongly in market share and financial performance. The technology of the production would have improved resulting in low cost of production and good quality products. The companies have stable growth rate in this stage and they declare dividend to the shareholders. It is advisable to invest in the shares of these companies. The pharmaceutical industry has improved its technology and the top companies in this sector are giving dividend to the shareholders. Likewise power industry and telecommunication industry can be cited as examples of expansion stage. In this stage the growth rate is more than the industry's average growth rate. Maturity and stabilization stage: In the stabilisation stage, the growth rate tends to 1ll0derate and the rate of growth would be more or less equal to the industrial growth rate or the gross domestic product growth rate. Symptoms of obsolescence may appear in the technology. To keep going, technological innovations in the production process and products should be introduced. The investors have to closely monitor the events that take place in the maturity stage of the industry. Declining stage: In this stage, demand for the particular product and the earnings of the companies in the industry decline. Now-a-days very few consumers demand black and white T.V. Innovation of new products and changes in consumer preferences lead to this stage. The specific feature of the declining stage is that even in the boom period; the growth of the industry would be low and decline at a higher rate during the recession. It is better to avoid investing in the shares of the low growth industry even in the boom period. Investment in the shares of these types of companies leads to erosion of capital.

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6.4. KEY CHARACTERISTICS OF INDUSTRY ANALYSIS Factors to be considered: Apart from industry life cycle analysis, the investor has to analyse some other factors too. They are as listed below  Growth of the industry  Cost structure and profitability  Nature of the product  Nature of the competition  Government policy  Labour  Research and development Growth of the industry: The historical performance of the industry in terms of growth and profitability should be analysed. Industry wise growth is published periodically by the Centre for Monitoring Indian Economy. The past variability in return and growth in reaction to macro economic factors provide an insight into the future. Even though history may not repeat in the exact manner, looking into the past growth of the industry, the analyst can predict the future. The information technology industry has witnessed a tremendous growth in the past so also the scrip prices of the IT industry. With the Y2K millennium bug creating a huge business opportunity even beyond the year 2000, the sector is expected to maintain its growth momentum. Cost structure and profitability: The cost structure, that is the fixed and variable cost, affects the cost of production and profitability of the firm. In the case of oil and natural gas industry and iron and steel industry the fixed cost portion is high and the gestation period is also lengthy. Higher the fixed cost component, greater sales volume is required to reach the firm's breakeven point. Once the breakeven point is reached and the production is on the track, the profitability can be increased by utilising the capacity to full. Once the maximum capacity is reached, again capital has to be invested in the fixed equipment. Hence, lower the fixed cost, adjustability to the changing demand and reaching the break even points are comparatively easier. Nature of the product: The products produced by the industries are demanded by the consumers and other industries. If industrial goods like pig iron, iron sheet and coils are produced, the demand for them depends on the construction industry. Likewise, textile machine tools industry produces tools for the textile industry and the entire demand depends upon the health of the textile industry. Several such examples can be cited. The investor has to analyse the condition of related goods producing industry and the end user industry

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to findout the demand for industrial goods. In the case of consumer goods industry, the change in the consumers' preference, technological innovations and substitute products affect the demand. A simple example is that the demand for the ink pen is affected by the ball point pen with the change in the consumer preference towards the easy usage of pen. Nature of the competition: Nature of competition is an essential factor that determines the demand for the particular product, its profitability and the price of the concerned company scrips. The supply may arise from indigenous producers and multinationals. In the case of detergents, it is produced by indigenous manufacturers and distributed locally at a competitive price. This poses a threat to the company made products. The multinationals are also entering into the field with sophisticated product process and better qualit: product. Now the companies' ability to withstand the local as well as the multinational competition counts much. If too many firms are present in the organised sector, the competition would be severe. The competition would lead to a decline in the price of the product. The investor before investing in the scrip of a company should analyse the market share of the particular company's product and should compare it with the top five companies. Government policy: The government policies affect the very nerve of the industry and the effects differ from industry to industry. Tax subsidies and tax holidays are provided for export oriented products. Government regulates the size of the production and the pricing of certain products. The sugar, fertiliser and pharmaceutical industries are often affected by the inconsistent government policies. Control and decontrol of sugar price affect the profitability of the sugar industry. In some cases entry barriers are placed by the government. In the airways, private corporates are permitted to operate the domestic flights only. When selecting an industry, the government policy regarding the particular industry should be carefully evaluated Liberalisation and delicensing have brought immense threat to the existing domestic industries in several sectors. Labour: The analysis of labour scenario in a particular industry is of great importance. The number of trade unions and their operating mode has impact on the labour productivity and modernisation of the industry. Textile industry is known for its militant trade unions. If the trade unions are strong and strikes occur frequently, it would lead to fall in the production. In an industry of high fixed cost, the stoppage of production may lead to loss. When trade unions oppose the introduction of automation, in the product market the company may stand to lose with high cost of production. The unhealthy labour relationship leads to loss customers' goodwill too. Skilled labour is needed for certain industries. In the case of Indian labour market, even in computer technology or in any other industry skilled and well-qualified labour is available at a cheaper rate. This is one of the many reasons attracting the multinationals to set up companies in India.

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Research and Development: For any industry to survive the competition in the national and international markets, product and production process have to be technically competitive. This depends on the R&D in the particular company or industry. Economies of scale and new market can be obtained only through R&D. The percentage of expenditure made on R & D should be studied diligently before making an investment. Pollution standards: Pollution standards are very high and strict in the industrial sector. For some industries it may be heavier than others; for example, in leather, chemical and pharmaceutical industries industrial effluents are more. SWOT analysis: The above mentioned factors themselves would become strength, weakness, opportunity and threat (SWOT) for the industry. Hence, the investor should carry out a SWOT analysis for the chosen industry. Take for instance, increase in demand for the industry's product becomes its strength, presence of numerous players in the market, i.e. competition becomes the threat to a particular company in the respective industry. The progress in the research and development in that particular industry is an opportunity and entry of multinationals in the industry and cheap imports of the particular products are threat to that industry. In this way the factors have to be arranged and analysed. To make the industry analysis more explanatory it has been carried out on the pharmaceutical industry and SWOT analysis results are also given. Pharmaceutical industry: Growth of the industry: The industry has witnessed healthy growth in the recent past and investment in pharmaceutical industry is continuing. The product output is also increasing and operational and business management efficiency also seems to have improved. This is shown by the increase in the output of the industry as given in table Table

Value

Production

Bulk

Drugs

and

Formulations

during

the

Years

1993-94 to 1997-98 (Rs, in Crs.) Thar

Bulk drugs

Growth %

Formulations

Growth %

1993-94 1994-95 1995-96 1996-97 1997-98

1,320 1,518 1,822 2,,186 2,623

14.8 15 20 19.9 20

6,900 7,935 9,125 10,494 12,068

15 15 15 15 15

Source: IDMA Annual 1998 Structure of the industry: Pharmaceutical industry adopts high technology and produces high value added products. The process is very complex in nature. The processes are classified into primary and secondary. The primary process requires uninterrupted power supply, maintaining of conditions under which the molecules react

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and yield a new product, excellent manufacturing conditions and well-trained personnel. A specific plant costs less but, they have the risk of obsolescence. Multipurpose plants are expensive and have no risk of obsolescence but, they have the risk of cross contamination. The secondary process is the conversion of bulk drugs into formulations. The secondary process is not much technology intensive mid has low capital cost. Hence, there are many players in the market. Nature of the product: The products of the pharmaceutical industry are broadly classified into bulk drugs, formulations and intravenous fluids. Bulk drugs are like Ciproflaxacin, Ibuprofen, Ranitidine, Ethanbutol, etc. The major manufactures of the products are Ranbaxy, Cipla, Cadilla, Dr.Reddys' Lab and Lupin. Some companies manufacture formulations from bulk drugs and market them under brands. Companies also manufacture formulations for other companies. Some of the companies in the formulation segment are Ranbaxy, Cipla, Wockhardt, Lupin etc. Intravenous fluids are preparations which aid in quick replenishment of body fluids. Bulk formulations companies produce intravenous fluids also. The formulations are produced h' over the country. Andhra Pradesh stands first in the production of bulk drugs. Demand for the product: The Indian pharmaceutical market which was worth.Rs.90 billion in 1997 is growing at 13.7% rate. But only three out of ten Indians have access to allopathic drug. Even in this segment vast majority of them belong to urban area. Investments in medical and public health declined from 2 % of the total capital outlay in the sixth five year plan to 1.75 % in the Eighth five year plan. In the year 1996-97, the portion in the annual budget was of 1.7%. The less than 15 age segment of the population is expected to grow at 0.5 % but the fastest growth is expected in the 50-59 groups. This has led to a shift in the demand from the life saving drugs to life enhancing drugs. It is referred to as a shift from age old diseases to old age diseases. Competition: The industry is having 2400 players within the organised sector, and around 15,000 in smallscale sector. The low entry barriers, government's encouragement given to small sector units and low capital cost are the reason for the presence of large number of units in the pharmaceutical sector. This has lead to price crash in the bulk drug. Apart from internal competition, the industry is facing international competition too. There is a large import of bulk drugs from China. The Chinese products are a significant competitor for the Indian pharmaceutical industry. Multinational corporations like Pfizer, Abbot Labs and Novartis also pose threat to the local producers. Government policy: The drug companies operate in a highly politicised environment. The product development, prices, safety are regulated by the government. The pharmaceutical industry functions under the Drug Price Control Order. The prices of drugs are regulated to make them available to the masses at

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affordable prices. The DPCO is issued from time to time to keep the policy in tune with the changing demands. The Patent Law in India provides patent only for process and there is no product patent. But, with signing of GATT, India is required to amend the Patent Law. Once the product patent comes into force, the reverse engineering route to introduce new moiecules will not be available to Indian companies. Research and development: The average sum spent by the 15 largest Indian pharmaceutical companies for R & D is around 2 percent of turnover. This is drastically low and research is mainly concentrated towards the area of process development rather than on new molecular searching. Strength: 

Despite economic slow down, the industry registered double digit growth rate.



Indian pharmaceutical market is growing at 13.7%



Net exporter of bulk drugs and formulations



Low cost in process development and R & D



Third largest scientific pool in the world

Weakness: 

Decline in plan investment in medical and public health.



Only three out of ten Indians have access to allopathic drugs.



Various price controls.

Opportunity: 

With increase in purchasing power, health care expenditure would increase.



Non Japan Asia's share of world health care spends will double.



Patent law will lead to consolidation of industry.

Threat:  Fall in the price of bulk drugs and imports from China. 

60 major products may lose patent protection.



Ambiguity regarding the timing and content of the Indian Patent Act amendment.

6.5. BUSINESS CYCLE ANALYSIS The Business Cycle: Over the long term, economies usually display an underlying positive rate of growth, sometimes known as the trend growth rate. This is likely to reflect, among other factors, the average level of investment. Investment also plays a key role in the business cycle, sometimes known as the "trade cycle", the pattern of fluctuations around the trend. A variety of different economic indicators

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shows cyclical movements of expansion and contraction in economic activity over time. Some of these indicators rise in periods of economic expansion. They are known as "pro-cyclical" indicators and include the rate of growth of consumer spending, job vacancies and investment. Other indicators (the so-called "counter-cyclical" indicators) fall in periods of economic expansion, such as unemployment and the number of bankruptcies. The sites below provide detailed information about business cycle analysis, in particular by reference to financial indicators and quantitative macroeconomic techniques. Quantitative Economics and Real Business Cycle: This is a very well resourced site - A collection of links to several resources about quantitative macroeconomics and especially real business cycle (RBC) theory on the World-Wide Web.The site is maintained by Christian Zimmerman, who also maintains EDIRC (Economics Departments, Institutes and Research Centers in the World), which can also be found in the Biz/ed Internet Resources Catalogue. Students are advised that this site contains some technical features which goes beyond the knowledge assumed in a course of elementary business economics. However, students with a strong technical background may find this site both challenging and stimulating. 6.6. COMPANY ANALYSIS Company analysis: In the company analysis the investor assimilates the several bits of information related to the company and evaluates the present and future values of the stock. The risk and return associated with the purchase of the stock is analysed to take better investment decisions. The valuation process depends upon the investors' ability to elicit information from the relationship and inter-relationship among the company related variables. The competitive edge of the company: Major industries in India are composed of hundreds of individual companies. In the information technology industry even though the number of companies is large, few companies like Tata Infotech, Sat yam computers, Infosys, NUT etc., control the major market share. Like-wise in all industries, some companies rise to the position of eminence and dominance. The large companies are successful in meeting the competition. Once the companies obtain the leadership position in the market, they seldom lose it. Over the time they would have proved their ability to withstand competition and to have a sizeable share in the market. The competitiveness of the company can be studied with the help of  The market share  The growth of annual sales  The stability of annual sales

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The market share: The market share of the annual sales helps to determine a company's relative competitive position within the industry. If the market share is high, the company would be able to meet the competition successfully. In the information technology industry, NIIT and Tata Infotech topped the list in terms of sales in 1997. While analysing the market share, the size of the company also should be considered because the smaller companies may find it difficult to survive in the future. The leading companies of today's market will continue to lead at least in the near future. The companies in the market should be compared with like product groups otherwise, the results will be misleading. A software company should be compared with other software companies to select the best in that industry. Growth of sales: The company may be a leading company, but if the growth in sales is comparatively lower than another company, it indicates the possibility of the company losing the leadership. The rapid growth in sales would keep the shareholder in a better position than one with the stagnant growth rate. The company of large size with inadequate growth in sales will not be preferred by the investors. Growth in sales is usually followed by the growth in profits. Investor generally prefers size and the growth in sales because the larger size companies may be able to withstand the business cycle rather than the company of smaller size. The growth in sales of the company is analysed both in rupee terms and in physical terms. Physical term is very essential because it shows the growth in real terms. The rupee term is affected by the inflation. Companies with diversified sales are compared in rupee terms and percentage of growth over time. Stability of sales: If a firm has stable sales revenue, other things being remaining constant, will have more stable earnings. Wide variation in sales leads to variations in capacity utilisation, financial planning and dividend. Periodically all the financial newspapers provide information about the market share of different companies in an industry. The fall in the market share indicates the declining trend of the company, even if the sales are stable in absolute terms. Hence, the stability of sales also should be compared with its market share and the competitors market shares. Sales forecast: The company may be in a superior position commanding more sales both in monetary terms and physical terms but the investor should have an idea whether it will continue in future or not. For this purpose, forecast of sales has to be done. He can forecast the sales in different ways. 1. The investor can fit a trend line either linear or non linear whichever is suitable. 2. Historical percentage of company sales to the industry sales can be analysed. Even simple least square technique could be used to find out the function C s = f (Is) Le. Cs â&#x20AC;&#x201C; Company sales; Is - Industry sales.

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3. The sales growth can be compared with the macro-economic variables like Domestic product, per capita income and population growth.

Gross

4. The different components of demand for the company's product have to be analysed because the demand may arise from different sources. For some product the demand may be from the consumers as well as from the industries. For example, steel and petroleum products are demanded by consumers and industries. 5. The demand for the substitutes and competitors' product also should be analysed using least square techniques. Earning of the company: Sales alone do not increase the earnings but the costs and expenses of the company also influence the earnings of the company. Further, earnings do not always increase with the increase in sales. The company's sales might have increased but its earnings per share may decline due to the rise in costs. The rate of change in earnings differs from the rate of change of sales. Sales may increase by 10% in a company but earnings per share may increase only by 5 %. Even though there is a relationship between sales and earnings, it is not a perfect one. Sometimes, the volume of sales may decline but the earnings may improve due - to the rise in the unit price of the article. Hence, the investor should not depend only on the sales, but should analyse the earnings of the company. The income for the company is

generated through operating sources and non-operating

sources. The sources of operating income vary from industry to industry. For the service industry no tangible product is involved and income is generated through sale of services. Take the case of commercial bank, its income is the interest on loans and investments. Interest income is referred to operating income. But in the case of industries producing tangible goods earnings arise from the sale of goods. The companies, in addition to the revenue from sales, may get revenue from other sources too. The nonoperating income may be generated from interest from bonds, rentals from lease, dividends from securities and sale of assets. The investor should analyse the income source diligently whether it is from the sale of assets or it is from investments. Sometimes earning per share may seem to be attractive in a particular year but in actual case the revenue generated through sales may be comparatively lower than in the previous year. The earnings might have been generated through ~e sale of assets. The investor should be aware that income of the company may vary due to the following reasons. 

Change in sales.



Change in costs.



Depreciation method adopted.



Depletion of resources in the case of oil, mining, forest products, gas etc.



Inventory accounting method.

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Replacement cost of inventories.

ď&#x20AC;

Wages, salaries and fringe benefits.

ď&#x20AC;

Income taxes and other taxes.

Capital structure: The equity holders' return can be increased manifold with the help of financial leverage, i.e. using debt financing along with equity financing. The effect of financial leverage is measured by computing leverage ratios. The debt ratio indicates the position of the long term and short term debts in the company finance. The debt may be in the form of debentures and term loans from financial institutions. Preference shares: In the early days the preference share capital was never a significant source c: capital. At present, many companies resort to preference shares. The preference shares induct some degree of leverage in finance. The leverage effect of the preference shares is comparatively lesser than the debt because the preference share dividends are not tax deductible. If the portion of preference share in the capital is larger, it tends to create instability in the earnings of the equity shares when the earnings of the company fluctuate. Sometimes the preference share may be convertible preference share. if dilutes the earnings per share. So the investor should look into the preference share component of the capital structure. Debt: Long term debt is an important source of finance. It has the specific benefit of low cost of capital because interest is tax deductible. The leverage effect of debt is highly advantageous to the equity holders. During the boom period the positive side of the leverage effect increases the earnings of the share holders. At the same time, during recession the leverage effect inducts instability in earnings per share and can lead to bankruptcy. Hence, it is important to limit the debt component of the capital to a reasonable level. The limit depends on the firm's earning capacity and its fixed assets. i) Earnings limit of debt: The earnings determine whether the debt is excessive or not. The earnings indicate the probability of insolvency. The ratio used to find out the limit of the debts is the interest coverage ratio i.e. the ratio of net income after taxes to interest paid on debt. The ratio shows the firm's ability to pay the interest charges, the number of times interest is covered by earnings. ii) Asset limit to debt: This asset limit is found out by fixed assets to debt ratio. The financing of fixed assets by the debt should be within a reasonable limit. For industrial units the' recommended ratio level is below 0.5. Management: Good and capable management generates profit to the investors. The management of the firm should efficiently plan, organise, actuate and control the activities of the company. The basic objective of management is to attain the stated objectives of company for the good of the equity holders, the public and the employees. If the objectives of the company are achieved, investors will have a profit. A

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management that ignores profit does more harm to the investors than one that over emphasises it. The good management depends on the qualities of the manager. Koontz and O'Donnell suggest the following as special traits of an able manager: 

Ability to get along with people Leadership



Analytical competence Industry Judgement



Ability to get things done

Since the traits are difficult to measure, managerial performance is evaluated against setting and accomplishing verifiable objectives. If the investor needs greater proof of excellence of management, he has to analyse management ability. The analysis can be carried out on the following ways:  The background of managerial personnel contributes much to the success of the management. The manager's age, educational background, advancement within the company, levels of responsibility achieved and the activities in the social sphere can be studied.  The record of management over the past years has to be reviewed. For several companies what the top management has done during its tenure in office is given in the financial weeklies and monthlies along with critical comments. This gives an insight into the ability of the top management.  The management's skill to have market share ahead of others is a proof of managerial success. The investor can rely on this type of management and choose the stock.  The next criterion the investor should analyse is the company's strength to expand. A firm may expand from within and diversify products in the known lines. Sometimes it may acquire another company to expand its market. The horizontal or vertical expansion of the production is a healthy sign of an efficient management.  The management's ability to maintain efficient production by proper utilisation of plant and machinery has to be analysed. Suitable inventory planning and scheduling have to be drafted and worked out by the management.  The management's capacity to finance the company adequately has to be studied. Accomplishing the financial requirement is a direct reflection of managerial ability. The management should adopt a realistic dividend policy in relation to earnings. A realistic dividend policy boosts the image of the company's stock in the market.  The functional ability of management to work with employees and union is another area of concern Unions poses a threat to the smooth functioning of the firm. In this context the management should be able to maintain harmonious relationship with the employees and unions.

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 The management's adaptability to scientific management and quality control techniques should be analysed. The management should be able to give due weightage to maintain technical competence. After analysing the above mentioned factors, the investor should select companies that possess excellent management and maintain the competitive position of the company in the market. The investor should also remember that the individual traits of a single manager alone cannot make the company profitable and there should be a strong management system to do so. Operating efficiency: The operating efficiency of a company directly affects the earnings of a company. An expanding company that maintains high operating efficiency with a low break-even point earns more than the company with high break-even point. If a firm has stable operating ratio, the revenues also would be stable. Efficient use of fixed assets with raw materials, labour and management would lead to more income from sales. This leads to internal fund generation for the expansion of the firm. A growing company should have low operating ratio to meet the growing demand for its product. Operating leverage: If the firm's fixed cost is high in the total cost the firm is said to have a high degree of operating leverage. Leverage means the use of a lever to raise a heavy object with a small force. High degree of operating leverage implies, other factors being held constant, a relatively small change in sales result in a large change in return on equity. This can be explained with the help of the following example. Let us take firm A and B. The firm A has relatively small amount of fixed charges say, Rs 40,000. Firm A would not have much automated equipment, so its depreciation and maintenance costs are low. The variable cost per cent is higher than it would be if the firm used more automated equipments. In the other case firm B has high fixed costs, Rs 1,20000. Here the firm uses automated equipment (with which one operator can turn out many units at the same labour cost) to a much larger extent. The break-even occurs at 40,000 units in firm A and 60,000 units in firm B. The selling price (P) is Rs4; the variable cost is Rs 3 for firm A and Rs 2 for firm B per unit. The break-even occurs when ROE (return on equity) =0, and hence, when earnings before interest taxes (EBIT) = 0. EBIT = 0 = PQ – VQ - F Here P is the average sales price per unit of output, Q is units of output, V is the variable cost per unit, and F is the fixed operating costs. The break-even quantity is = F/P-V For

Firm A = Rs40,000 / Rs. 4 – Rs.3 = 40,000 units Firm B = Rs1,20,000 / Rs. 4 – Rs. 2 = 60,000 unIts To a large extent, operating leverage is determined by technology. For example,

telephone'companies, iron and steel companies, and electric utilities have heavy investments in fixed assets leading to high fixed costs and operating leverage. On the other hand cosmetics companies and

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consumer goods producing companies may need significantly lower fixed costs, and hence lower operating leverage. The investor should understand the operating leverage of the firm because the firm with high operating leverage is affected much by the 'cyclical decline. The operating efficiency of the firm determines the profit expectation of the company. Financial analysis: The best source of financial information about a company is its own financial statements. This is a primary source of information fur evaluating the investment prospects in the particular company's stock. Financial statement analysis is the study of a company's financial statement from various viewpoints. The statement gives the historical and current information about the company's operations. Historical financial statement helps to predict the future. The current information aids to analyse the present status of the company. The two main statements used in the analysis are: ď&#x20AC;

Balance sheet

ď&#x20AC;

Profit and loss accouny

Balance Sheet: The balance sheet shows all the company's sources of funds (liabilities and stockholders' equity) and uses of funds at a given point of time. The balance sheet can either be in the horizontal form or vertical form. T The Profit and Loss Account: Analysis of the financial condition of the company requires a report on the flow of funds too. The income statement reports the flow of funds from business operations that take place in between two points of time. It lists down the items of income and expenditure. The difference between the income and expenditure represents profit or loss for the period it is also called income and expenditure statement. The investor should be aware of the limitations of the financial statements.

6.7. QUESTIONS Section - A i)

Very Short Questions: 1. Explain the term leverage 2. What are the major types of shares? 3. What is balance sheet? 4. What is the difference between profit and loss a/c and receipts and payments a/c?

Section - B ii)

Short Answer Questions: 1. State the different classification of industries 2. State the meaning of company analysis

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3. Give the meaning of the financial analysis

Section - C iii)

Essay type questions: 1. Explain varies stages of industry life cycle 2. Briefly explain the key characteristics of industry analysis 3. Give a brief note on business cycle analysis

6.8. FURTHER READINGS

1. Dr.v.balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and

portfolio

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CHAPTER -07 TECHNICAL ANALYSIS STRUCTURE 7.0. OBJECTIVES 7.1. INTRODUCTION 7.2. CONCEPT OF TECHNICAL ANALYSIS 7.3. TOOLS FOR TECHNICAL ANALYSIS 7.4. THE DOW THEORY 7.5.

EFFICIENT MARKET THEORY

7.6.

RANDOM WALK THEORY

7.7. ADVANTAGES AND LIMITATIONS OF TECHNICAL ANALYSIS 7.8. QUESTIONS 7.9. FURTHER READINGS

7.0. OBJECTIVES After studying this unit, you should be able to understand: 

Concept of technical analysis



Tools for technical analysis



The Dow theory



Efficient market theory



Random walk theory



Advantages and limitations of technical

analysis

7.1. INTRODUCTION The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians (sometimes

called

chartists)

are

only

interested

the

price

movements

the

market.

7.2. CONCEPT OF TECHNICAL ANALYSIS Technical analysis: The share price movement is analyzed broadly with two approaches, namely, fundamental approach and the technical approach. Fundamental approach analyses the share prices on the basis of

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economic, Industry and company statistics. If the price of the share is lower than its intrinsic value, investor buys it. But, if he finds the price of the share higher than the intrinsic value he sells and gets profit. The technical analyst mainly studies the stock price movement of the security market. If there is an up trend in the price movement investor may purchase the scrip. With the onset of fall in price he may sell it and move from the scrip. Basically, technical analysts and the fundamental analysts aim at good return on investment. Technical analysis: It is a process of identifying trend reversals at an earlier stage to formulate the buying and selling strategy. With the help of several indicators they analyse the relationship between price - volume and supply-demand for the overall market and the individual stock. Volume is favourable on the upswing i.e. the number of shares traded is greater than before and on the downside the number of shares traded dwindles. If it is the other way round, trend reversals can be expected. Assumptions:  The market value of the scrip is determined by the interaction of supply and demand.  The market discounts everything. The price of the security quoted represents the hopes, fears and inside information received by the market players. Inside information regarding the issuing of bonus shares and right issues may support the prices. The loss of earnings and information regarding the forthcoming labour problem may result in fall in price. These factors may cause a shift in demand and supply, changing the direction of trends.  The market always moves in trend. Except for minor deviations, the stock prices move in trends. The price may create definite patterns too. The trend may be either increasing or decreasing. The trend continues for sometime and then it reverses.  Any layman knows the fact that history repeats itself. It is true to the stock market also. In the rising market investors' psychology has up beats and they purchase the shares in greater volumes, driving the prices higher. At the same time, in the down trend they may be very eager to get out of the market by selling them and thus plunging the share price further. The market technicians assume that past prices predict the future. History of technical analysis: The technical analysis is based on the doctrine given by Charles H.Dow in1984, in the Wall Street Journal. He wrote a series of articles in the Wall Street Journal. A.J. Nelson, a close friend of Charles Dow formalised the Dow theory for economic forecasting. The analysts used charts of individual stocks and moving averages in the early 1920's. Later on, with the aid of calculators and computers, sophisticated techniques came into vogue. Dow Theory: Dow developed his theory to explain the movement of the indices of Dow Jones Averages. He

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developed the theory on the basis of certain hypotheses. The first hypothesis is that, no single individual or buyer can influence the major trend of the market. However, an individual investor can affect the daily price movement by buying or selling huge quantum of particular scrip. The intermediate price movement also can be affected to a lesser degree by an investor. His second hypothesis is that the market discounts everything. Even natural calamities such as earthquake, plague and fire also get quickly discounted in the market. The Pokhran blast affected the share market for a short while and then the market returned back to normalcy. His third hypothesis is that the theory is not infallible. It is not a tool to beat the market but provides a way to understand it better. The theory: According to Dow Theory the trend is divided into primary, intermediate and short term trend. The primary trend may be the broad upward or downward movement that may last for a year or two. The intermediate trends are corrective movements, which may last for three weeks to three months. The primary trend may be interrupted by the intermediate trend. The short term trend refers to the day to day price movement. It is also known as oscillations or fluctuations. These three types of trends are compared to tide, waves and ripples of the sea. Trend: Trend is the direction of movement. The share prices can either increase or fall or remain flat. The three directions of the share price movements are called as rising, falling and flat trends. The point to be remembered is that share prices do not rise or fall in a straight line. Every rise or fall in price experiences a counter move. If a share price is increasing, the counter move will be a fall in price and vice-versa. The share prices move in zigzag manner. The trend lines are straight lines drawn connecting either the tops or bottoms of the share price movement. To draw a trend line, the technical analyst should have at least two tops or bottoms. Trend reversal: The rise or fall in share price cannot go on forever. The share price movement may reverse its direction. Before the change of direction certain pattern in price movement emerges. The change in the direction of the trend is shown by violation of the trend line. Violation of the trend line means the penetration of the trend line. If a scrip price cuts the rising trend line from above, it is a violation of trend line and signals the possibility of fall in price. Primary Trend: The security price trend may be either increasing or decreasing. When the market exhibits the increasing trend, it is called bull market. The bull market shows three clear-cut peaks. Each peak is higher than the previous peak. The bottoms are also higher than the previous bottoms. The reactions following the peak used to halt before the previous bottoms. The phases leading to the three peaks are revival, improvement in corporate profit and speculation. The revival period encourages more and more investors to buy scrips, their expectations about the future being high. In the second phase, increased

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profits of corporate would result in further price rise. In the third phase, prices advance due to inflation and speculation. The reverse is true with the bear market. Here, the first phase of fall starts with the abandonment of hopes. The chances of prices moving back to the previous high level seemed to be low. This would result in the sale of shares. In the second phase, companies are reporting lower profits and dividends. This would lead to selling pressure. The final phase is characterised by the distress sale of shares. During the bear phase of 1996, in the Bombay Stock Exchange more than 2/3 of stocks were inactive. Most of the scrips were sold below their par values. The Secondary Trend: The secondary trend or the intermediate trend moves against the main trend and leads to correction. In the bull market the secondary trend would result in the fall of about 33-66% of the earlier rise. In the bear market, the secondary trend carries the price upward and corrects the main trend. The correction would be 33 % to 66 % of the earlier fall. Intermediate trend corrects the overbought and oversold condition. It provides the breathing space to the market. Compared to the time taken for the primary trend, secondary trend is swift and quicker. Minor Trends: Minor trends or tertiary moves are called random wriggles. They are simply the daily price fluctuations. Minor trend tries to correct the secondary trend movement. It is better for the investors to concentrate on the primary or secondary trends than on the m.inor trends. The chartist plots the scrip's price or the market index each day to trace the primary and secondary trend. Support and Resistance Level: Anybody interested in the technical analysis should know the support and resistance level. A support level exists at a price where considerable demand for that stock is expected to prevent further fall in the price level. The fall in the price may be halted for the time being or it may result even in price reversal. In the support level, demand for the particular scrip is expected. In the resistance level, the supply of scrip would be greater than the demand and further rise in price is prevented. The selling pressure is greater and the increase in price is halted for the time being. Support and resistance usually occur whenever the turnover of a large number of shares tends to be concentrated at several price levels. When the stock touches a certain level and then drops, this is called resistance and if the stock reaches down to certain level and then rises there exists a support. The levels constantly switch from one to another i.e. from support to resistance, or from resistance to support. This can be explained numerically say, for example, if a scrip price hovers around Rs 150 for some weeks, then it may rise and reach Rs 210. At this point the price: halts and then falls back. The scrip keeps on falling back to around its original price Rs 150 and halts. Then it moves upward. In this case Rs 150 becomes. the support level. At this point, the scrip is cheap and investors buy it and demand makes the price move upward. Whereas Rs 210 becomes the resistance level, the price is high and there would be selling pressure resulting in the decline of the price.

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If the scrip price reverses the support level and moves downward, it means that the selling pressure has overcome the potential buying pressure, signalling the possibility of a further fall in the value of the scrip. It indicates the viloation of the support level and bearish market. If the scrip penetrates the previous top and moves above, it is the violation of resistance level. At this point, buying pressure would be more than the selling pressure. If the scrip was to move above the double top or tripple top formation, it indicates bullish market. The support and the resistance level need not be formed only on tops or bottoms. They can be on the trend lines or gaps of the chart. Gaps are defined as those points or price levels where the scrip has not changed hands. In the rising or falling price level gaps are formed. If the prices are in the upward move and the high of any day is lower than the next day's low, the gap is said to have occurred. For example, if the high price of the Instant Companyâ&#x20AC;&#x2122;s scrip on March 1 st is Rs 200 and on March 2nd low is 225, a gap is said to have occurred on the bar chart. This indicates that the stock is not traded between the level Rs 200 and Rs .225. This gap indicates further rise in price level. Likewise in a falling price, a gap is formed if the low price on day 1 is higher than the high price of day 2. Suppose the low price on Monday is Rs 150 and the high price on the Tuesday is Rs 130, a gap is said to have occurred and indicates rhat there was no transaction between the level of R,s 150 andRs 130. Indicators: Technical indicators are used to find out the direction of the overall market. The overall market movements affect the individual share price. Aggregate forecasting is considered to be more reliable than the individual forecasting. The indicators are price and volume of trade. The volume of trade is influenced by the behaviour of price. Volume of trade Dow gave special emphasis on volume. Volume expands along with the bull market and larrows down in the bear market. If the volume falls with rise in price or vice versa, it is a matter of concern Dr the investor and the trend may n.ot.persist for a longer time. Technical analyst used volume as an excellent lethod of confirming the trend. The market is said to be bullish when small volume of trade and large volume o trade follow the fall in price and the rise in price. Large rise in price or large fall in price leads to large increase in volume. Large volume with rise in price indicates bull market and the large volume with fall in price indicates bear market. If the volumes decline for five consecutive days, then it will continue for another four days and the same is true in increasing volume. The breadth of the market: The breadth of market is the term often used to study the advances and declines that have occurred in the stock market. Advances mean the number of shares whose prices have increased from the previous day's trading. Declines indicate the number of shares whose prices have fallen from the previous day's trading. This is easy to plot and watch indicator because data are available in all business dailies.

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The net difference between the number of stock advanced and declined during the same period is the breadth of the market. A cumulative index of net differences measures the market breadth. The following table gives the breadth of the market. Breadth 712

BSE Index 5876.89

1056

5883.33

-327 17

729 746

5642.46 5810.17

-348

398

Day 21-02-00

Advance 1486

Declines 774

Net 712

22-02-00

1310

966

344

23-02-00 24-02-00

898 1108

1225 1091

25-02-00

931

1279

5623.08 . The advance / decline can be drawn as a graph. The AID line does not exactly show when a

reaction will occur but it indicates that it will occur soon. The AID line is compared with the market index. Generally in a bull market, a bearish signal is given when the AID line slopes down while the BSE Sensexis rising. In a bear market, a bullish signal is given when the AID line begins rising as the Sensex is declining to a new low. Harvey A.Krow has computed advances and declines as a ratio. He divided the advances by the declines. Any number greater than 1.00 indicates advances are exceeding decline. Values below 0.99 indicate declines are more than the advances. Ten day and 200 day moving average of the AID ratios are also computed. A ratio of 0.75 signals short term buying opportunity and there will be intermediate rally in the beginning of the bearish trend. In the later stages of bear market the ratio declines below 0.5. Except in the first phase of bull market a rise above 1.25 indicates selling opportunities. Short Sales: Short selling is a technical indicator known as short interest. Short sales refer to the selling of shares that are not owned. The bears are the short sellers who sell now in the hope of purchasing at a lower price in the future to make profits. The short sellers have to cover up their positions. Short positions of scrips are published in the business newspapers. When the demand for a particular share increases, the outstanding short positions also increase and it indicates future rise of prices. These indications cannot be exactly correct, but they show the general situations. Short sales of a particular month is selected and compared with the average daily volume of the preceding month. This ratio shows how many days of trading it would take to use up total short sales. If the ratio is less than 1, market is said to be weakor overbought and a decline can be expected. The value between 1 and 0.5 shows neutral condition of the market. Values above 1 indicate bullish trend and if it is above 2 the market is said to be oversold. At market tops, short selling is high and at market bottoms short selling is low. Odd lot trading: Shares are generally sold in a lot of hundred. Shares, sold in smaller lots, fewer than 100 are called odd lot. Such buyers and sellers are called odd lotters. Odd lot purchases to odd lot sales

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(Purchase % Sales) are the odd lot index. The increase in odd lot purchase results in an increase in the index. Relatively more selling leads to fall in the index. It is generally considered that the professional investor is more informed and stronger than the odd lotters. When the profesSional investors dominate the market, the stock market is technically strong. If the odd lotters dominate the market, the market is considered to be technically weak. The notion behind is that odd lot purchase is concentrated at the top of the market cycle and selling at the bottom. High odd lot purchase forecasts fall in the market price and low purchases/sales ratios are presumed to occur toward the end of bear market. Several studies have indicated that the odd lotters do not move into the market at the peak and move out at bottom. In October 1987, Newyork stock market crashed. During the weeks prior to the crash contrary to the odd lot theory, odd lotters were selling more shares than they bought when market prices increased. After the crash, odd-lotters sensibly became big buyers when stock prices were near their lows. These rational trading patterns defy the opinion about odd lot theory. Moving average: The market indices do not rise or fall in straight line. The upward and downward movements are interrupted by counter moves. The underlying trend can be studied by smoothening of the data. To smooth the data moving average technique is used. The word moving means that the body of data moves ahead to include the recent observation. If it is five day moving average, on the sixth day the body of data moves to include the sixth day observation eliminating the first day's observation. Likewise it continues. In the moving average calculation, closing price of the stock is used. The moving averages are used to study the movement of the market as well as the individual scrip price. The moving average indicates the underlying trend in the scrip. The period of average determines the period of the trend that is being identified. For identifying short-term trend, 10 day to ~O day moving averages are used. In the ~ase of medium term trend 50 day to 125 day are adopted. 200 day moving average is used to identify long term trend. Index and stock price moving average: Individual stock price is compared with the stock market indices. The moving average of the stock and the index are plotted in the same sheet and trends are compared. If NSE or BSE index is above stock's moving average line, the particular stock has bullish trend. The price may increases above the market average. If the Sensex or Nifty is below the stock's moving average, the bearish market can be expected for the particular stock. If the moving average of the stock penetrates the stock market index from above, it generates sell signal. Unfavourable market condition prevails for the particular scrip. If the stock line pushes up through the market average, it is a buy signal. Comparison of the two moving averages: When long term and short term moving averages are drawn, the intersection of two moving

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averages generates buy or sell signal. When the scrip price is falling and if the short term average intersects the long term moving average from above and falls below it, the sell signal is generated. But, if the short term average moves above the long term average and the long term average are falling, investor should treat intersection with suspicion. The short term movement may not hold long. Hence, the investor should wait for the long term average to turn up before buying the scrip. Similarly, if the short term average moves below the long term average before the long term average has flattened out or before it reverses its direction, the investor should wait for the fall in the long term average for reversal of direction before moving out of the scrip. Oscillators: Oscillators indicate the market momentum or scrip momentum. Oscillator shows the share price movement across a reference point from one extreme to another. The momentum indicates: 

Overbought and oversold conditions of the scrip or the market.



Signalling the possible trend reversal.



Rise or decline in the momentum.

Generally, oscillators are analysed along with the price chart. Oscillators indicate trend reversals that have to be confirmed with the price movement of the scrip. Changes in the price should be correlated to changes in the momentum, and then only buy and sell signals can be generated. Actions have to be taken only when the price and momentum agree with each other. With the daily, weekely or monthly closing prices oscillators are built. For short term tra~ing, daily price oscillators are usefull. Relative strength MDEX (RSI): If RSI falls in the overbought zone, it gives a clear signal of 'sell'. The term 'overbought' describes the price level at which momentum can no longer be maintained and the price has to go down. This condition occurs after a sharp rise in price during a period of heavy buying. When the RSI is in the oversold region, it generates the buy signal. The term oversold is used to describe a security or market that has declined to an unreasonably low level. This condition is characterised by an increase in sales and excess of net declines. Rate of Change: Rate of change indicator or the ROC measures the rate of change between the current price and the price 'n' number of days in the past. ROC helps to find out the overbought and oversold positions in scrip. It is also useful in identifying the trend reversal. Closing prices are used to calculate the ROC. Daily closing prices are used for the daily ROC and weekly closing prices for weekly ROC. Calculation of ROC for 12 week or 12 month is most popular. Procedure: ROC can be calculated by two methods. In the first method, current closing price is expressed as a percentage of the twelve days or weeks in past. Suppose the price of AB Company’s share is Rs.12 and price twelve days ago was Rs.10 then the ROC is obtained by using the equation: 12110 x 100 = 120%. In the second method, the percentage variation between the current price and the price twelve

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days in the past is calculated. It is nothing but 12110 x 100-100 = 20%. By this method both positive and negative values can be arrived. ROC graph ROC can be plotted in a graph, x-axis representing days or months and y-axis the values of ROC. If the first method is adopted, ROC oscillates across the hundred lines. If the second method is used, the ROC oscillates around the zero line. ROC = Today's Price / Price 'n' days back x 100 ROC = Today's Price / Price' n' days back x 100 – 100

The main advantage of ROC is the identification of overbought and oversold region. The historic high and low values of the ROC should be identified at first to locate the overbought and oversold region. If the scrip's ROC reaches the historic high values, the scrip is in the overbought region and a fall in the value can be anticipated. Likewise, if the scrip's ROC reaches the historic low value, the scrip is in the oversold region, a rise in the scrip's price can be anticipated. Investor can §ell the scrip in the overbought region and buy it in the oversold region.

7.3. TOOLS FOR TECHNICAL ANALYSIS Throughout the last several weeks I've dedicated several articles to a discussion of how I combine various information sources to create a comprehensive swing trading system. For streaming real-time quotes I rely on Interactivebrokers, and for streaming real-time charts I employ Livecharts. To spot opportunities in a consistent group of stocks and analyze them with multiple indicators, I use Stock charts, for sector analysis and overall market indicators such as the McClellan Oscillator. In addition to these paid sources, there are three free websites at which I find myself a regular visitor. By far the most important for me is Yahoo. Typically I first check the news stories because so much that happens in the geopolitical arena has an immediate impact on the financial markets. If you haven't already bookmarked the "Finance" section of Yahoo, I suggest you do so. I find it useful in innumerable ways and would pay to use the site if required (but please don't let them know that!). Yahoo is primitive as a technical analysis site, but great for fundamental research. There are eight sections that I check regularly: 

World Indices -- Late in the evening I will look at the S&P futures on Livecharts. I will then often check how the foreign financial markets are trading and what insight I can gain about the next day's opening. Since I am on Mountain Time, Tokyo, Hong Kong and Taiwan have been trading for several hours by about 11 P.M. my time. If I retire late, Frankfurt, Paris and even London let me know how world markets are trending.

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Briefing.com -- Typically my first pre-market opening stop of the morning is Briefing.com's "InPlay" which is found on Yahoo. In-Play summarizes the overnight foreign market activity, the U.S. futures and early stock headlines such as earnings activity and news releases. "In Play" becomes active about 6 AM Eastern Time and updates on a delayed basis throughout the day. I will often correlate "In Play's" stories with the CNBC ticker tape to see if there are any newsdriven trading opportunities. Once you have found "In Play," make sure to bookmark it since it can be tricky to return.

To do in-depth research on a specific stock, enter that symbol in the box at the top of the Finance page. There are six sections of stock-specific information I frequently investigate: 

Historical Prices -- There are times I want to find exact support and resistance levels on a stock and can do this by consulting the historical prices. This section contains data on the open, low, high and close of a stock daily. Information on sector indices and broader indices such as the S&P 500 is also available.



Profile -- There are occasions I find an interesting chart pattern and want to understand what sector the company is in and what its products or services are. The profile section provides a quick snapshot of company activity.



Headlines -- Large changes in prices are often explained by unexpected news the market has not yet discounted. I will consult this section both intra-day and after the close to find out what fundamental factors have driven an unusual move in share price. Headlines are archived for several years so historical research can also be done.



Key Statistics -- This section contains fundamental information such as Price toSales and Price to Earnings (P/E) ratios. While a bull market will often ignore fundamental overvaluation, a bear market is seldom forgiving. A technical observation of a downtrend, corroborated by fundamental overvaluation, gives additional evidence that a correct judgment of the stock is being formed.



Analyst Estimates -- While I disregard brokerage analyst's stock ratings, I pay a lot of attention to consensus estimates, as they are reasonably accurate. This page also lists past earnings surprises, which is important information if you are holding a stock immediately before earnings are released. When I am doing in-depth fundamental analysis on a company, a ratio I use is calculated by dividing the current P/E by the one-year estimated growth rate. This ratio gives me a quick snapshot of under or overvaluation--a ratio of below one is positive and over two means the stock is pricey.



Insider Transactions -- Insider buying and selling can tell you a great deal how they feel about the company. If insiders are going onto the open market to buy shares in significant numbers,

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they probably believe the company is undervalued. Conversely, if there is a pattern of persistent selling, they may know something most traders don't. Yahoo has many other sections I use on occasion. If you haven't spent much time on the site, it is well worth exploring the finance section. Yahoo also has a good news summary, but I find an even better one on CBS Marketwatch. If I have not watched CNBC during the day, I will almost always check this site to catch up on the important news events of the day. Key stories are presented in separate articles and are commented on in detail. There are frequently articles on technical analysis. The site also summarizes trends in overseas trading starting in the early evening. Finally, I will mention Kitco, a site I visit when gold or silver bullion are affecting the market. Kitco is a gold-bugs site, so expect its commentary to be biased in favor of the precious metals. What I value about the site is that it provides free near real-time updates on precious metals and the price of crude oil. Free charts are also available. While I consult many financial websites and am always checking out new ones, the ones I have described --both paid and free -- are "my best friends." In totality they give me the information I need to stay abreast of the markets and spot emerging trends. Hopefully, in this series on financial websites, I've introduced you to some new buddies as well. 7.4. THE DOW THEORY Introduction: The Dow Theory has been around for almost 100 years, yet even in todays volatile and technology-driven markets, the basic components of Dow Theory still remain valid. Developed by Charles Dow, refined by William Hamilton and articulated by Robert Rhea, the Dow Theory addresses not only technical analysis and price action, but also market philosophy. Many of the ideas and comments put forth by Dow and Hamilton became axioms of Wall Street. While there are those who may think that it is different this time, a read through The Dow Theory will attest that the stock market behaves the same today as it did almost 100 years ago. The Dow Theory presented below has been taken from Robert Rhea's book, The Dow Theory. Although Dow Theory is attributed to Charles Dow, it is William Hamilton's writings that serve as the corner stone for this book and the development of the theory. Also, it should be noted that most of the theory was developed with the Dow Jones Rail and Industrial averages in mind. Even though many concepts can be applied to individual stocks, please keep in mind that these are broad concepts and best applied to stocks as a group or index. When possible, we have also attempted to link some of the realities of today's market with the Dow Theory as explained by Dow, Hamilton and Rhea. Background Charles Dow developed the Dow Theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street

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Journal. Although he never wrote a book on the subject, he did write some editorials that reflected his views on speculation and the role of the rail and industrial averages. Even though Charles Dow is credited with developing the Dow Theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term "Dow theory." Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail. In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (19021929) conveyed their thoughts on the market. Rhea also referred to Hamilton's The Stock Market Barometer. The Dow Theory presents the Dow Theory as a set of assumptions and theorems. Assumptions: Before one can begin to accept the Dow Theory, there are a number of assumptions that must be accepted. Rhea stated that for the successful application of the Dow Theory, these assumptions must be accepted without reservation. Manipulation: The first assumption is: The manipulation of the primary trend is not possible. When large amounts of money are at stake, the temptation to manipulate is bound to be present. Hamilton did not argue against the possibility that speculators, specialists or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day and possibly even secondary movements could be prone to manipulation. These short movements, from a few hours to a few weeks, could be subject to manipulation by large institutions, speculators, breaking news or rumors. Today, Hamilton would likely add message boards and day-traders to this list. Hamilton went on to say that individual shares could be manipulated. Examples of manipulation usually end the same way: the security runs up and then falls back and continues the primary trend. Examples include: 

Pair Gain Technology rose sharply due to a hoax posted on a fake Bloomberg site. However, once the hoax was revealed, the stock immediately fell back and returned to its primary trend.



Books-A-Million rose from 3 to 47 after announcing an improved web site. Three weeks later, the stock settled around 10 and drifted lower from there.



In 1979/80, there was an attempt to manipulate the price of silver by the Hunt brothers. Silver skyrocketed to over 50$ per ounce, only to come back down to earth and resume its long bear market after the plot to corner the market was unveiled.

While these shares were manipulated over the short term, the long-term trends prevailed after about a month. Hamilton also pointed out that even if individual shares were being manipulated, it would be virtually impossible to manipulate the market as a whole. The market was simply too big for this to occur.

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Averages Discount Everything: The market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum total of all the hopes, fears and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else are already priced into the market. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected. Theory Not Perfect: Hamilton and Dow readily admit that the Dow Theory is not a sure-fire means of beating the market. It is looked upon as a set of guidelines and principles to assist investors and traders with their own study of the market. The Dow Theory provides a mechanism for investors to use that will help remove some of the emotion. Hamilton warns that investors should not be influenced by their own wishes. When analyzing the market, make sure you are objective and see what is there, not what you want to see. If an investor is long, he or she may want to see only the bullish signs and ignore any bearish signals. Conversely, if an investor is out of the market or short, he or she may be apt to focus on the negative aspects of the price action and ignore any bullish developments. Dow Theory provides a mechanism to help make decisions less ambiguous. The methods for identifying the primary trend are clear-cut and not open to interpretation. Even though the theory is not meant for short-term trading, it can still add value for traders. No matter what your time frame, it always helps to be able to identify the primary trend. According to Hamilton (writing in the early part of the 20th century), those who successfully applied the Dow Theory rarely traded more than four or five times a year. Remember that intraday, day-to-day and possibly even secondary movements can be prone to manipulation, but the primary trend is immune from manipulation. Hamilton and Dow sought a means to filter out the noise associated with daily fluctuations. They were not worried about a couple of points, or getting the exact top or bottom. Their main concern was catching the large moves. Both Hamilton and Dow recommended close study of the markets on a daily basis, but they also sought to minimize the effects of random movements and concentrate on the primary trend. It is easy to get caught up in the madness of the moment and forget the primary trend. After the October low, the primary trend for Coca-Cola remained bearish. Even though there were some sharp advances, the stock never forged a higher high. Market Movements: Dow and Hamilton identified three types of price movements for the Dow Jones Industrial and Rail averages: primary movements, secondary movements and daily fluctuations. Primary moves last from a few months to many years and represent the broad underlying trend of the market. Secondary (or reaction) movements last from a few weeks to a few months and move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.

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Primary Movement: Primary movements represent the broad underlying trend of the market and can last from a few months to many years. These movements are typically referred to as bull and bear markets. Once the primary trend has been identified, it will remain in effect until proved otherwise. Many traders and investors get hung up on price and time targets. The reality of the situation is that nobody knows where and when the primary trend will end. The objective of Dow Theory is to utilize what we do know, not to haphazardly guess about what we don't know. Through a set of guidelines, Dow Theory enables investors to identify the primary trend and invest accordingly. Trying to predict the length and the duration of the trend is an exercise in futility. Hamilton and Dow were mainly interested in catching the big moves of the primary trend. Success, according to Hamilton and Dow, is measured by the ability to identify the primary trend and stay with it. Secondary Movements: Secondary movements run counter to the primary trend and are reactionary in nature. In a bull market a secondary move is considered a correction. In a bear market, secondary moves are sometimes called reaction rallies. Dow Theory Note: There is still debate as to whether the crash of 1998 was a bear market or merely a secondary move within the confines of a larger bull market. In hindsight, it would appear to be a secondary move. Even though the DJIA recorded a lower low on August 4 and had lost just over 20% by September 4, the twomonth time frame makes it difficult to justify as a bear market. Hamilton characterized secondary moves as a necessary phenomenon to combat excessive speculation. Corrections and counter moves kept speculators in check and added a healthy dose of guesswork to market movements. Because of their complexity and deceptive nature, secondary movements require extra careful study and analysis. Investors often mistake a secondary move for the beginning of a new primary trend. How far does a secondary move have to go before the primary trend is affected? This issue will be addressed in Part 3 of this article, when we analyze the various signals based on Dow Theory. Daily Fluctuations: Daily fluctuations, while important when viewed as a group, can be dangerous and unreliable individually. Due to the randomness of the movements from day to day, the forecasting value of daily fluctuations is limited at best. At worst, too much emphasis on daily fluctuation will lead to forecasting errors and possibly losses. Getting too caught up in the movement of one or two days can lead to hasty decisions that are based on emotion. It is vitally important to keep the whole picture in mind when analyzing daily price movements. Think of the pieces of a puzzle. Individually, a few pieces are meaningless, yet at the same time they are essential to complete the picture. Daily price movements are important, but only when grouped with other days to form a pattern for analysis. Hamilton did not disregard daily fluctuations, quite to the contrary. The study of daily price action can add valuable insight, but only when taken in

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context of the larger picture. There is little structure in one, two or even three days' worth of price action. However, when a series of days is combined, a structure will start to emerge and analysis becomes better grounded. The Three Stages of Primary Bull Markets and Primary Bear Markets Hamilton identified three stages to both primary bull markets and primary bear markets. These stages relate as much to the psychological state of the market as to the movement of prices. A primary bull market is defined as a long sustained advance marked by improving business conditions that elicit increased speculation and demand for stocks. A primary bear market is defined as a long sustained decline marked by deteriorating business conditions and subsequent decrease in demand for stocks. In both primary bull markets and primary bear markets, there will be secondary movements that run counter to the major trend. Primary Bull Market - Stage 1 â&#x20AC;&#x201C; Accumulation: Hamilton noted that the first stage of a bull market was largely indistinguishable from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is out of stocks, the news from corporate America is bad and valuations are usually at historical lows. However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is the stage of the market when those with patience see value in owning stocks for the long haul. Stocks are cheap, but nobody seems to want them. This is the stage where Warren Buffet stated in the summer of 1974 that now was the time to buy stocks and become rich. Everyone else thought he was crazy. In the first stage of a bull market, stocks begin to find a bottom and quietly firm up. When the market starts to rise, there is widespread disbelief that a bull market has begun. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that careful analysis is warranted to determine if the decline is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed. Primary Bull Market - Stage 2 - Big Move: The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is considered the easiest stage to make money as participation is broad and the trend followers begin to participate. Primary Bull Market - Stage 3 â&#x20AC;&#x201C; Excess: The third stage of a primary bull market is marked by excessive speculation and the appearance of inflationary pressures. (Dow formed these theorems about 100 years ago, but this scenario is certainly familiar.) During the third and final stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image to the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to offer tips, the top cannot be far off.

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Primary Bear Market - Stage 1 â&#x20AC;&#x201C; Distribution: Just as accumulation is the hallmark of the first stage of a primary bull market, distribution marks the beginning of a bear market. As the "smart money" begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is still involved in the market at this stage and become willing buyers. There is little in the headlines to indicate a bear market is at hand and general business conditions remain good. However, stocks begin to lose a bit of their luster and the decline begins to take hold. While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move) that retraces a portion of the decline. Hamilton noted that reaction rallies during bear markets were quite swift and sharp. As with his analysis of secondary moves in general, Hamilton noted that a large percentage of the losses would be recouped in a matter of days or perhaps weeks. This quick and sudden movement would invigorate the bulls to proclaim the bull market alive and well. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market. Primary Bear Market - Stage 2 - Big Move: As with the primary bull market, stage two of a primary bear market provides the largest move. This is when the trend has been identified as down and business conditions begin to deteriorate. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues. Primary Bear Market - Stage 3 â&#x20AC;&#x201C; Despair: At the top of a primary bull market, hope springs eternal and excess is the order of the day. By the final stage of a bear market, all hope is lost and stocks are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news from corporate America is bad, the economic outlook bleak and not a buyer is to be found. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again. Signals: Through the writings of Dow and Hamilton, Rhea identified 4 separate theorems that addressed trend identification, buy and sell signals, volume, and trading ranges. The first two were deemed the most important and serve to identify the primary trend as bullish or bearish. The second two theorems, dealing with volume and trading ranges, were not considered instrumental in primary trend identification by Hamilton. Volume was looked upon as a confirming statistic and trading ranges were thought to identify periods of accumulation and distribution. 7.5. EFFICIENT MARKET THEORY Efficient market theory: Efficient market theory states that the share price fluctuations are random and do n. ot follow any

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regular pattern. Meanwhile technical analysts see meaningful patterns in their charts. This raises the question as to whether the intrinsic value of stocks has any meaning. Are they related to the security prices? The following section explains the process that determines the security price. Basic concepts: Before understanding the theory certain concepts and phrases like market efficiency, liquidity traders and information traders should be understood. Market efficiency: The expectations of the investors regarding the future cashflows are translated or reflected on the share prices. The accuracy and the quickness in which the market translates the expectation into prices are termed as market efficiency. There are two types of market efficiencies: - Operational efficiency - Informational efficiency Operational efficiency: At stock exchange operational efficiency is measured by factors like time taken to execute the order and the number of bad deliveries. Investors are concerned with the operational efficiency of the market. But efficient market hypothesis does not deal with this efficiency. Informational efficiency: It is a measure of the swiftness or the market's reaction to new information. New information in the form of economic reports, company analysis, political statements and announcement of new industrial policy is received by the market frequently. How does the market react to this? Security prices adjust themselves very rapidly and accurately. They never take a long time to adjust to the new information. For instance the announcement of bonus shares of any company would result in a hike in price of that stock. Like-wise major changes in the policy decisions of the Government are also reflected in the stock index movement. Liquidity traders: These traders' investments and resale of shares depend upon their individual fortune. Liquidity traders may sell their shares to pay their bills. They do not investigate before they invest. Information traders: Information traders analyse before adopting any buy or sell strategy. They estimate the intrinsic value of shares. The deviation between the intrinsic vaiue and the market value makes them enter the market. They sell if the market value is higher than the intrinsic value and vice -versa. The buying and selling of the shares through the demand and supply forces bring the market price back to its intrinsic value. 7.6. RANDOM WALK THEORY The Random Walk theory: In 1900, a French mathematician named Louis Bachelier wrote a paper suggesting that security price fluctuations were random. In 1953, Maurice Kendall in his paper reported that stock price series is a

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wandering one. They appeared to be random; each successive change is independent of the previous one. In 1970, Fama stated that efficient markets fully reflect the available information. If marlcets are efficient, securities' prices reflect normal returns for their level of risk. Fama suggested that efficient market hypothesis can be divided into three categories. They are "weak form" the "semi-strong form" and the "strong form". The level of information being considered in the market is the basis for this segregation. Weak form of EMH: The type of information used in the weak form of EMH is the historical prices. According to it, current prices reflect all information found. in the past prices and traded volumes. Future prices cannot be predicted by analysing the prices from the past. Everyone has the access to the past prices, even though some people can get these more conveniently than others. Liquidity traders may sell their stocks with out considering the intrinsic value of the shares and cause price fluctuations. Buying and selling activities of the information traders lead the market price to align with the intrinsic value. The dotted line represents the intrinsic value. The intrinsic value changes at times, t and t + 1. In the weak form of market the price of the stock and its intrinsic value diverges substantially. In the weak efficient market short term traders may earn a positive return. On an average, short term traders will not out perform the blind folded investor picking the stock with a dart. That is traders may earn by the naive buy and hold strategy while some may incur loss, the average buy and hold strategy can not be beaten by the chartist. Many studies of the market analysts have proved the weak form of the EMH. Empirical tests of the weak form are presented here. Filter rule: To earn returns technical trading strategies based on historical prices have been used. Filter rule is one among such strategies. According to this strategy if a price of a security rises by atleast x per cent, investor should buy and hold the stock until its price declines by atleast x per cent from a subsequent high. Short sellers can use the filter to earn profits by liquidating their holdings when the price decreases from a peak level by x per cent. They can take up short position as the price declines till the price reaches a new low and then increases by 'x' percentage. Different filter rules are used by different traders. It ranges from as small as .5 per cent to as large as 50 per cent. The filter rule can be explained with the help of an example. Take a hypothetical company XY and assume the filter to be 10 per cent. The price fluctuates between Rs 20 to 30. Assume the starting point to be Rs 20. When there is an increase in the price of the share to Rs 22 i.e. (10 per cent rise) one has to buy it. The rally may continue up to Rs 30 and decline. If the price falls the sell signal is given at Rs 27 i.e. 10% of Rs 30 and the trader can take up the short position till it reaches its low level. When there is a rise in price the same exercises have to be followed. Several studies have found that after commissions the average gains produced by the filter rules were much below normal than the gains of the simple buy and hold strategy adopted by the investor. Runs Test: Runs test is used to find out whether the series of price movements have occurred by chance. A

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run is an uninterrupted sequence of the same observation. If a coin is tossed the following sequence may occur. Here occurrence of H H is a run and T T is another run. When the sequence of the observations change we count it as a run The consecutive rise in prices would be counted as a positive run and the decline would be counted as a negative run. According to the probability theory, 95 per cent of the area under the normal curve lies within +1.96 standard deviation of the mean. Since the calculated value - 0.565 is less than -1.96, the runs have occurred by chance. Published results of the studies using runs test have suggested that the runs in the price series of stocks are not significantly different from the runs in the series of random numbers. Serial Correlation: To test the independence between successive price changes serial correlation technique is used. Serial correlation or auto-correlation measures the correlation co-efficient in a series of numbers with the lagging values of the same series. Price changes in period t + 1 (or t + any number) are correlated with the price changes of the preceding period. Scatter diagrams can be used to find out the correlation. If there is correlation between the price of t and t + 1 period, the points plotted in the graph would form a straight line. If the price rise (or fall) in period t is followed by price rise (or fall) in period t + 1 then the correlation co-efficient would be + I. But many studies conducted on the security price changes have failed to ~how any significant correlations. Fama computed serial correlations for 30 stocks for the period 1958 - 62 with varying t periods from t + I to t + 10. The results of the autocorrelations were generally found to be insignificant, with most fallirig with in the range of +. 10 to - . 10. If there is little correlation between stocks price over time, chart analyses cannot be of much use in predicting the future. A study: predictability of stock returns: The National Stock Exchange has carried out research regarding the working of the market. The research deals with the serial correlation factor in the index returns. This study checks if the Indian Stock Market is predictable by using returns of S & P CNX Nifty index. Serial correlation with lag one is calculated. If markets are informational efficient the serial correlation will not be statistically significant. Semi strong form: The semi-strong form of the efficient market hypothesis states that the security price adjusts rapidly to all publicly available information. In the semi-strongly efficient markets, security prices fully reflect all publicly available information. The prices not only reflect the past price data, but also the available information regarding the earnings of the corporate, dividend, bonus issue, right issue, mergers, acquisitions and so on. In the semi-strongly efficient market a few insiders can earn a profit on a short run price changes rather than the investors who adopt the naive buy and hold policy. In the case of a competitive market, price is fixed by the supply and demand force. The price at

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the equilibrium level of the supply and demand represents the consensus opinion of the market. The intrinsicva!l!e of the stock and the equilibrium price are the same. Whenever new information arrives at the market, the supply and the demand factors react to it. If the market processes the new information quickly, a new price would come out of it. If the market has to be semi-strongly efficient; timely and correct dissemination of information and assimilation of news are needed. Only then, the market can reflect all the relevant information quickly. It is stated that the stock markets in US strongly supports the semi-strong hypothesis because the prices adjust rapidly to the new information. Empirical evidence: Fama, Fisher, Jensen and Roll were the fore runners in examining the semistrong form of EMH. They analysed the effect of stock split on share prices. Their study was important because (a) it provided evidence to semi-strong form of markets (b) it analysed whether the stock splits increase the wealth of the shareholders and (c) they developed a research method to test the market efficiency. The authors have developed a method to compute abnormal returns by using the simple regression technique. The average of abnormal return can be obtained by adding the abnormal returns over time and dividing it by n. The AAR can be measured around a date of event or the announcement date of stock split or bonus issue. CAAR = ď&#x20AC; ď &#x201C;AAR. The CAAR (Cumulative Average Abnormal Return) is computed by adding the AAR for each period. Period generally begins several weeks before the event and ends several weeks after the event. The cumulative average of abnormal return provides a picture of average price behaviour of securities over time. If the markets are efficient, the CAAR should be close to zero. The authors have reviewed hundreds of cases of efficient corporations and dissimilar sample periods to study the effect of the stock splits. They have examined 940 stock splits from 1927-1959 in the Newyork Stock Exchange. The price behaviour is analysed 29 months prior and after the date of the stock split. They found out the CAAR for all the 940 observations. They found out the level of CAAR very insignificant and essentially fall from the date of split announcement. According to them the simple strategy of buying shares after a stock split would not appear to produce abnormal returns. The studyresults of the authors provide evidence for the semistrong form of EMH. Market ability to absorb the reported annual earning per share was analysed by Ball and Brown. Their study has shown that the actual good price earnings were higher than the predicted good price earnings and at the same time the low price earnings were lower than the predicted low price earnings. Ball and Brown have found out that even before the announcement of the good report, the respective shares experienced a rise in price. Likewise even before the announcement of the negative earning report, the share prices decreased. Both the groups generated only normal returns after the announcement providing support for semi-strong form. Scholes in his study had found out that the market is efficient enough to identify the type of seller too. He analysed the price effects of large secondary offerings. Generally, price tends to decline

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beforethe secondary offering. This is mainly due to the information effect not due to the selling pressure. If the large selling is associated with the corporate members and officers, the prices tend to decline at a faster rate. But if it is sold by some other groups who are not considered under this, then decline in price is small. Strong form: The strong form EMH states that all information is fully reflected on security prices. It represents an extreme hypothesis which most observers do not expect it to be literally true. The strong form of the efficient market hypothesis maintains that not only the publicly available information is useless to the investor or analyst but all information is useless. Information whether it is public or inside cannot be used consistently to earn superior investors' return in the strong form. This implies that security analysts and portfolio managers who have access to information more quickly than the ordinary investors would not be able to use it to earn more profits. Empirical evidence: Many of the tests of the strong form of the efficient market hypothesis deal with mutual fund performances. Financial analysts have studied the risk adjusted rates of return from hundreds of mutual funds and found out that the professionally managed funds are not able to out perform the naive -buy hold strategy. Jensen had studied 115 funds over a decade. He concluded that even though the analysts are well endowed with wide ranging contacts and associations in both the business and financial committees, they are unable to forecast returns accurately enough to recover the research and transaction costs. He holds this, as a striking piece of evidence for the strong form of the efficient market hypothesis. The essence of the theory: According to the theory, the successive price changes or changes in return are independent and these successive price changes are randomly distributed. Random Walk Model argues that all publicly available information.is fully reflected on the stock prices and further the stock prices instantaneously adjust themselves to the available new information. The theory mainly deals with the successive changes rather than the price or return levels. According to them, the market may have imperfections like transaction cost and delays in disseminating relevant information to all market investors but these sources of inefficiency may not result in excess returns above the normal or equilibrium returns. The equilibrium return is defined as the return earned by naive buy and hold strategy. The investors should note that the random theory says nothing about the relative price changes that are the changes that are occurring across the securities. Some securities may out perform others. Again, it does not make any remark on the decomposing of price into market, industry or firm factors. All these factors are concerned with the relative prices but not with the absolute price changes. The random walk hypothesis deals with the absolute price changes and not with the relative prices. The prices may move at random but this does not indicate that there would not be any upward or

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downward movement in the price. The random walk hypothesis is entirely consistent with the upward and downward movements of the stock prices. Market inefficiencies: Many studies have proved the prevalence of the market efficiency. At the same time, several study results contradict the concept of market efficiency. For example, the studies conducted Joy, Litzenberger and Mc. Enally over the period of 1963-1968 gave different results. The authors have examined the quarterly earnings of the stock prices. The earning of one quarter was compared with the same quarter of the previous year. If the current year's earnings were 40% or more high than the earnings for the same quarter in the previous year, the earnings were classified as good earnings than anticipated. If the current quarter's earnings were below 40% of the previous year's earnings, they are classified as bad than expected. Then the abnormal returns were calculated from 13 weeks prior to the announcement of the earnings to 26 weeks after the announcemt of the earnings. The stocks whose earnings are substantially greater than anticipated gave positive abnormal returns. The stocks whose earnings are below the anticipated earnings generated negative abnormal returns. The authorsâ&#x20AC;&#x2122; main claim is that after the announcement of the earnings, stocks that reported earnings substantially above those of the previous year continued to earn positive abnormal returns. According to the study, the investors could have earned positive abnormal returns of around 6.5 per cent over the next 26 weeks simply by buying stocks that have reported earnings 40% above the previous quarterly earnings. Mean while for those stocks with earnings substantially below the previous year, the cumulative average abnormal return remained relatively stable. This shows evidence against the semistrong market hypothesis because it states that when the information is made public the analyst could not earn abnormal profits. A study made by C.P. Jones, R.S. Rendleman for the period 1971-1980 had also given similar results to those of JLM. Low PE effect: Many studies have provided evidences that stocks with loW" price earnings ratios yield higher returns than stocks with higher PEs. This is known as low PE effect. A study made by Basu in 1977 wasÂˇ risk adjusted return and even after the adjustment there was excess return in the low price-earnings stocks. If historical information of PIE ratios is useful to the investor in obtaining superior stock returns, the validity of the semi-strong form of market hypothesis is questioned. His results stated that low PIE portfolio experienced superior returns relative to the market and high PIE portfolio performed in an inferior manner relative to the overall market. Since his result directly contradicts semi-strong form of efficient market hypothesis, it is considered to be important. Small firm effect: The theory of the small firm effect maintains that investing in small firms (those with low capitalisation) provides superior risk adjusted returns. Banz found that the size of the firm has been highly correlated with returns. Banz examined historical monthly returns of NYSE common stocks for the period

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1931-1975. He formed portfolios consistIng of 10 smallest firms and the 10 largest firms and computed the average return for these portfolios. The small firm portfolio has out performed the large firm portfolio. Several other studies have confirmed the existence of a small firm effect. The size effects have given rise to the doubts regarding the risk associated with small firms. The risks associated with them are underestimated and they do not trade as frequently as of the large firms. Correct measurement of risk and return of small portfolios tends to eliminate at least 50% of the small firm effect. The weekend effect: French in his study had examined the returns generated by the Standard and Poor Index for each day of the week. Stock prices tend to rise all week long to a peak on Fridays. The stocks are traded on Monday at reduced prices, before they begin the next week's price rise. Buying on Monday and selling on Friday from 1953 to 1977 would have generated average annual return of 13.4% while simple buy and hold would have yielded 5.5% annual return. If the transaction costs are taken into account, the naive buy and hold strategy would have provided higher return. Yet the knowledge of the weekend effect is still of value. Purchases planned on Thursday or Friday can be delayed until Monday, while sale planned for Monday can be delayed until the end of the week. The weekend effect is a small but significant deviation from perfectly random price movements and violates the weekly efficient market hypothesis. Similar to this Venkatesh B. of the BL Research Bureau has stated that the Bombay Stock Exchange reveals a discernible pattern. Usually, Monday, is characterised by trading blues, and Friday by frenzied activity. The Friday rush is more to do with speculators covering their open position. If the short sellers fail to cover their position within this period, their open positions are called to auction where prices are dear.

7.7. ADVANTAGES AND LIMITATIONS OF TECHNICAL ANALYSIS Benefits of Technical Analysis: Technical analysis involves the use of charts and technical indicators to predict the price movement of a currency. Many people (called technicians) swear by this approach to price forecasting while others (called fundamentalists) won’t touch it. Most traders know that technical analysis has its advantages and strong points, but that it also has limitations. Many Forex traders use charting methods alone while others use a combination of approaches. Let’s examine the benefits of technical analysis. 

Technical analysis focuses on price movement: The primary focus of technical analysis is on the

movement of prices. Charts show how prices are moving (or not moving), when prices are trending, and the strength of those trends. Volume, oscillators and momentum give a clearer picture of market action. And this information can be obtained at a glance. Unlike fundamentalists, technicians do not use economic reports that analyze the demand for a currency.

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Trends are easily found: Taking a look at a moving average line quickly displays a price that is

trending or stuck in a range. Whether it is up, down, or sideways, a chart can quickly display a currency that is exhibiting a trend. Trends are critical to technicians because a currency is likely to continue moving in the direction of the trend. Charts show them clearly and quickly. 

Patterns are easily identified: One of the basic tenets of market action is that it repeats itself in clear,

unmistakable patterns. Using charts helps the trader to find patterns and predict price movements based on these patterns. Like star constellations, patterns can be complex and complicated. Head-and-shoulders patterns, rounding tops and bottoms, ascending and descending triangles, and double and triple tops are proven patterns that many currency prices will follow. Hence, they have strong predictive powers. They can be impossible to detect without using a chart. 

Charting is quick and inexpensive: Computers have relieved us from the burden of performing

complex mathematical operations. The Internet has a wealth of different technical indicators available that can help the trader to make more profitable and more reliable trades. Many brokers offer these types of technical indicators to their clients as part of their package. Technical analysis is less time consuming and less costly than fundamental analysis. It can be performed in less than five minutes and the services are very often offered for free or at a nominal cost. 

Charts provide a wealth of information: Charts and indicators can provide a huge amount of

information in only a few moments. Trends are easily found. Support and resistance levels are quickly identified. Momentum, volatility, and trading patterns appear quickly and easily. There are more than fifty kinds of indicators and they each provide information on different aspect of how a currency is moving. This information is critical to technicians to make sound and profitable trades. Charts tell a story about the personality and price movement of a currency. The story can be complex with many different plots and twists or quite simple with only a few characters and single narrative. Charts are the same way. They can provide only the most basic information on a trend or support and resistance. However, they go much deeper to provide information on the strength of a trend, how momentum is building, and whether formations are developing that the can be traded. Limitations of TA: There are several limitations of technical analysis that you have to consider when using the methods of technical analysis. One of the most important limitations for most technical analysis methods is the fact that there are so many people using the basic technical analysis methods already, and the number is increasing every day, making it harder for a single trader to make money on the market with the methods. Because of these methods are so widely spread and there is so much money riding on the methods, some also claim that technical analysis has become self-fulfilling prophecy, as people tend to

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enter the market and put their stops on the same places, increasing the volatility towards the technical analysis method being correct. Another side to technical analysis is that the methods typically give a lot of false signals. The risk of ruin by betting on all the signals the same way is very real. This is why most traders have developed a comprehensive money management system to accompany the trading system, to take into account the fact that the trader needs to conserve capital to the situations where the system makes its money. In terms of money management, you have to consider that many technical analysis systems provide only information on entry and exit signals. If you're using a trend trading system, your main focus may be on end-of-day values of the financial product. In that case it is very important to use stops, so that extreme intraday volatility and outlier days in performance do not wipe out your capital. Most technical analysis methods also leave the idea of pyramiding out of the picture. Pyramiding refers to the fact that if your system has identified a trend, it may be beneficial to invest further into the trend as the trend continues. Pyramiding techniques should also be accompanied by strong money management systems and typically with trailing stops, to limit the increased risk from increasing the risk placed on any one trend. Finally, technical analysis systems usually do not take into account correlation between different markets. If you are analyzing several markets and they all give similar signals, they may have close correlations, meaning that the risk profile for each is very similar, and that the prices of the assets move in close steps with each other. That is why many traders recommend keeping a close eye on the correlations of the assets in your portfolio, and diversifying so that you get the benefits from having non-correlating assets, which should decrease the overall riskiness of your portfolio. 7.8. QUESTIONS Section - A i) Very Short Answer Questions: 1. What is technical analysis? 2. What do you understand by the term arbitrage process in portfolio management? 3. What is CAPM? 4. What is efficient frontier? Section - B ii) Short Answer Questions: 1. What are difference between fundamental analysis and technical analysis?

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2. State the advantages of technical analysis 3. What are the limitations of technical analysis Section -C iii) Essay type questions: 1. Explain in detail about the tools for technical analysis 2. Briefly explain the Dow Theory 3. Give a brief note about efficient market theory 4. State the forms and implications of Random walk theory

7.9. FURTHER READINGS 1. Dr.v.balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and

portfolio

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CHAPTER -08 CHARTING TECHNIQUES STRUCTURE 8.0. OBJECTIVES 8.1. INTRODUCTION 8.2. MEANING OF CHARTS 8.3. METHODS OF PREPARING CHARTS 8.4. TREND LINES 8.5. MOVING AVERAGES 8.6. CONTRARY OPINION THEORIES 8.7. ELLIOTT WAVE THEORIES 8.8. QUESTIONS 8.9. FURTHER READINGS

8.0. OBJECTIVES After studying this unit, you should be able to understand: 

Meaning of charts



Methods of preparing charts



Trend lines



Moving averages



Contrary opinion theories



Elliott wave theories

8.1. INTRODUCTION The basic tool in technical analysis is movement in prices; measured by charts .it is for this reason that technical analyst is sometimes called the chartist.

8.2. MEANING OF CHARTS Charts: Charts are the valuable and easiest tools in the technical analysis. The graphic presentation of the data helps the investor to [rod out the trend of the price without any difficulty. The charts also have the following uses - Spots the current trend for buying and selling. - Indicates the probable future action of the market by projection - Shows the past historic moveIhent

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- Indicates the important areas of support and resistance. The charts do not lie but interpretation differs from analyst to analyst according to their skills and experience. A leading technician, James Dines said, " charts are like fire or electricity. They are brilliant tools if intelligently controlled and handled but dangetdus to a novice". Chart Patterns: Charts reveal certain patterns that are of predictive value. Chart patterns are used as a supplement to other information and confirmation of signals provided by trend lines. Some of the most widely used and easily recognisable chart patterns are discussed here. V Formation: The name itself indicates that in the 'V' formation there is a long sharp decline and a fast reversal. The 'V' pattern occurs mostly in popular stocks where the market interest changes quickly from hope to fear and vice-versa. In the case of inverted' A' the rise occurs first and declines. There are extended 'V's. In it, the bottom or top moves mote slowly over a broader area. Tops and bottoms: Top and bottom formation is interesting to watch but what is more important, is the middle portion of it. The investor has to buy after up trend has started and exit before the top is reached. Generally tops and bottoms are formed at the beginning or end of the new trends. The reversal from the tops and bottoms indicate sell and buy signals. Double top and bottom: This type of formation signals the end of one trend and the beginning of another. If the double top is formed when a stock price rises to a certain level, falls rapidly, again rises to the same height or more, and turns down. Its pattern resembles the letter 'M'. The double top may indicate the onset of the bear market. But the results should be confirmed with volume and trend. In a double bottom, the price of the stock falls to a certain level and increase with diminishing activity. Then it falls again to the same or to a lower price and turns up to a higher level. The double bottom resembles the letter 'W'. Technical analysts view double bottom as a sign for bull market. The double top and bottom figures are given below with illustrations. Head and Shoulders: This pattern is easy to identify and the signal generated by this pattern is considered to be reliable. In the head and shoulder pattern there are three rallies resembling the left shoulder, a head and a right shoulder A neckline is drawn connecting the lows of the tops. When the stock price cuts the neckline from above, it signals the bear market. The upward movement of the price for some duration creates the left shoulder. At thetop of the left shoulder people who bought during the up trend begin to sell resulting in a dip. Near the bottom there would be reaction and people who have not bought in the first up trend start buying at relatively low prices thus pushing the price upward. The alternating forces of demand and supply create new ups and lows. The following figures explain the head and shoulders pattern.

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Inverted head and shoulders: Here the reverse of the previous pattern holds true. The price of stock's falls and rises that makes a inverted right shoulder. As the process of faIl and rise in price continues the head and left shoulders are created. Connecting the tops of the inverted head and shoulders gives the neckline. When the price pierces the neckline from below, it indicates the end of bear market and me beginning of the bull market. These patterns have to be confirmed with the volume and trend of the market. Triangles: The triangle formation is easy to identify and popular in technical analysis. The triangles are of symmetrical, ascending, descending and inverted. Symmetrical Triangle: This pattern is made up of series of fluctuations, each fluctuation smaller than the previous one. Tops do not attain the height of the previous tops. Likewise bottoms are higher than the previous bottoms. Connecting the lower tops that are slanting downward forms symmetrical triangles. Connecting the rising bottom, which is slanting upward, becomes the lower trend line. His is not easy to predict the break away either way. The symmetrical triangle does not have any bias towards the bull and bear operators. It indicates the slow down or temporary halt in the direction of the original trend. A probability of the original trend to continue after the completion of the triangle is always there. Ascending triangle: Here, the upper trend line is almost a horizontal trend line connecting the tops and the lower trend line is a rising trend line connecting the rising bottoms. When the demand for the scrip overcomes the supply for it, then there will be a break out. The break will be in favour of the bullish trend. This pattern is generally spotted during an up move and the probability of the upward move is high here. Descending triangle: Here, connecting the lower tops forms the upper trend line. The upper trend line would be a falling one. The lower trend line would be almost horiwntal connecting the bottoms. The lower line indicates the support level. The possibility for a downward breakout is high in this pattern. The pattern indicates that the bear operators are more powerful than the bull operators. This pattern is seen during the downtrend. Flags: Flag pattern is commonly seen on the price charts. These patterns emerge either before a fall or rise in the value of the scrips. These patterns show the market corrections of the overbought or oversold situations: The time taken to form these patterns is quick. Each rally and setback may last only three to four days. If the pattern is wider it may take three weeks to complete the pattern. A flag resembles a parallelogram. A bullish 路flag is formed by two trend lines that stoop downwards. The break out would occur on the upper side of the trend line. In a bearish flag both the trend lines would be stooping upwards. The breakout occurs in the downward trend line. Pennant:

Pennant looks like a symmetrical triangle. Here also there are bullish and bearish pennants.

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In the bullish pennant, the lowertops form the upper trend line. The lower trend line connects the rising bottoms. The bullish trend occurs when the value of scrip moves above the upward trend line. Likewise in the bearish pennant, upward trend line is falling and the lower trend line is rising.

8.3. METHODS OF PREPARING CHARTS Three types of charts that are commonly used are 

Line chart



Point and figure chart



Bar chart

Line chart: Line charts are simple graphs drawn by plotting the closing pricing of the stock on a given day and connecting the points thus plotted over a period of time .the charts are easily drawn and widely used in technical analysis. Point and Figure Charts: Technical analyst to predict the extent and direction of the price movement of a particular stock or the stock market indices uses point and figure charts. This PF charts are of one-dimensional and there is no indication of time or volume. The price changes in relation to previous prices are shown. The change of price direction can be interpreted. The charts are drawn in the ruled paper.

In spite of the simplicity in drawing the PF charts, they have some inherent disadvantages also. 1) They do not show the intraday price movement. 2) Whole numbers are only taken into consideration. This may result in the loss of information regarding the minor fluctuations. 3) Volume is not mentioned in the chart. Volume and trend of transactions are an important guide to make investment decision. In a bull market, price rise is accompanied by high volume of trading. The bear market is related to low volume of trading. Bar Charts: The bar chart is the simplest and most commonly used tool of a technical analyst. To build a bar a dot is entered to represent the highest price at which the stock is traded on that day, week or month. Then another dot is entered to indicate the lowest price on that particular date. A line is drawn to connect both the points a horizontal nub is drawn to mark the closing price. Line charts are used to indicate the price movements. The line chart is a simplification of the bar chart.

8.4. TREND LINES A trend line is formed when you can draw a diagonal line between two or more price pivot points. They are commonly used to judge entry and exit investment timing when trading securities. A trend line is a bounding line for the price movement of a security. A support trend line is formed

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when a securities price decreases and then rebounds at a pivot point that aligns with at least two previous support pivot points. Similarly a resistance trend line is formed when a securities price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points. The following chart provides an example of support and resistance trend lines. Trend lines are a simple and widely used technical analysis approach to judging entry and exit investment timing. To establish a trend line historical data, typically presented in the format of a chart such as the above price chart, is required. Historically, trend lines have been drawn by hand on paper charts, but it is now more common to use charting software that enables trend lines to be drawn on computer based charts. There is some charting software that will automatically generate trend lines, however most traders prefer to draw their own trend lines. When establishing trend lines it is important to choose a chart based on a price interval period that aligns with your trading strategy. Short term traders tend to use charts based on interval periods, such as 1 minute (i.e. the price of the security is plotted on the chart every 1 minute), with longer term traders using price charts based on hourly, daily, weekly and monthly interval periods. However, time periods can also be viewed in terms of years. For example, below is a chart of the S&P 500 since the earliest data point until April 2008. Please note that while the Oracle example above uses a linear scale of price changes, long term data is more often viewed as logarithmic: e.g. the changes are really an attempt to approxiamate percentage changes than pure numerical value. If we were to view this same chart linearly, we would not be able to see any detail from 1950 to about 1990 simply because all the data would be compressed to the bottom. Trend lines are typically used with price charts; however they can also be used with a range of technical analysis charts such as MACD and RSI. Trend lines can be used to identify positive and negative trending charts, whereby a positive trending chart forms an up sloping line when the support and the resistance pivots points are aligned, and a negative trending chart forms a down sloping line when the support and resistance pivot points are aligned. Trend lines are used in many ways by traders. If a stock price is moving between support and resistance trend lines, then a basic investment strategy commonly used by traders, is to buy a stock at support and sell at resistance, then short at resistance and cover the short at support. The logic behind this is that when the price returns to an existing principal trend line it may be an opportunity to open new positions in the direction of the trend, in the belief that the trend line will hold and the trend will continue further. A second way is that when price action breaks through the principal trend line of an existing trend, it is evidence that the trend may be going to fail, and a trader may consider trading in the opposite direction to the existing trend, or exiting positions in the direction of the trend.

8.5. MOVING AVERAGES Moving Averages: While trends in share prices can be studied for possible patterns, sometimes it may so happen

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that the prices appear to move rather haphazardly, and be very volatile. Using moving averages can help under such circumstances. A moving average is a summary measure of price movement which reduces the distortions to a minimum by evening out the fluctuations in share prices. The underlying trend in prices is thus clearly discernible when moving averages are used. There are three basic types of moving averages: a.Simple moving average b.Weighted moving average c.Exponential moving average. Simple Moving Average (SMA): A simple moving average is easy to construct and is widely used by technical analysts. To construct a moving average the time span of the average has to be first determined. A 30-day moving averages out every fluctuation occurring over all the possible 30-day time spans over the period under observation. To construct a 100-day SMA for instance, the prices observed over the first 100 days are first summed up and divided by hundred to obtain a simple average. This is the first value for constructing a 100-day SMA. To obtain the next value, the price prevailing on the 1 st day is excluded, while including the price on the 101 st day. This represents the next 100-day period. The average of these observations is the next value of 100-day SMA. This process is repeated for the time period one intends to cover. The choice of time span is very important in constructing moving averages. If prices move in cycles, say over 2 years, a 750-day moving average will smoothen out all intermediate trends. A 10-day moving average will represent many minor fluctuations present on the price line, and would be oflittle use in determining tops and bottoms of a trend. Lesser the time span, more sensitive the moving average and vice-versa. A moving average, therefore, should provide an optimum trade off between oversensitivity and lateness in identifying reversals. A 200-day moving average is widely used by analysts, and is believed to represent an optimum span.

v. If the moving average is flat or has already begun to change direction, a crossover by the price line is a fairly reliable indicator of trend reversal. v. The significance of a crossover signal depends, to a large extent, on the time span covered by a moving average. A moving average covering a longer time span-is actually smoothening a long-term trend, and its crossover is more significant than a crossover of an average of shorter time span. Some technicians use more than one moving average to smoothen the same price trend. This procedure smoothen the data twice, and provides warning signals for trend reversals, comparatively more quickly after they have taken place. It is common for analysts to use I DO-day and 300-day averages simultaneously. When the 100 -day average moves below the declining 300-day average, a trend reversal is signalled. Multiple moving averages are useful because shorter-span averages reach the turning points earlier than the longer-span averages, and are very useful in confirming a trend reversal. (See figure 36).

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A point of caution is in order. Simple moving averages always invariably provide signals to buy or sell, after the trend reversal has begun. They are neither lead indicators, nor juncture points for change in trends. Simple moving averages, therefore, should only be used along with other indicators. In an accumulation/ distribution phase, a series of crossovers can occur when the market is moving sidewards, and provide misleading signals. Weighted Moving Averages: It can be observed that the moving average invariably changes direction after the price chart and lags the reversal in trend. This is because the moving average line is so constructed as to plot the average of a given period at its end (A 1 DO-day moving average is plotted from the lOOth day onwards). This methodology leads to shifting the average, which can be assumed to occur in the middle (50th day) to the end of the period. Such a technique of centering would not be of utility in stock price analysis because if this technique is used, the analyst has to wait for the next half period (50 days in case ofa IOO-day average) to ascertain ifthere is a trend reversal. Such waiting can prove costly in terms of lost profitable opportunities as stock prices fluctuate rapidly. One way of overcoming this problem is to use weighted moving averages. A weighted moving average is weighted in favor of the most recent observations, and therefore, turns earlier than the simple moving average. One of the simpler methods of weighing, which is also widely used, is to multiply the first set of observations by I, the next set by 2, the third by 3 and so on. The values thus obtained are added, and the sum is divided not by the number of observations, but by the total of the weights. This method, however, gets cumbersome and laborious when the time span of the average is long. Another method is to double the weight of the last observation. For a 30-day moving 'lverage, for instance, the price on the thirtieth day is doubled and the sum is divided only by 31. The weighted moving average being more sensitive than that of a simple average, a change in its direction rather than a crossover confirms a trend reversal. Exponential Moving Average (EMA): As noted earlier, averages constructed over a longer time span have higher utility in technical analysis. But a simple moving average constructed over a long time span lags the price trend, while construction of a weighted average on the lines just discussed is time consuming. An exponential moving average provides a short cut method of weighting. This method also provides more weightage to the recent data The procedure for computing the EMA can be explained with the help of an example. 100-day EMA for the BSE Sensitive Index is computed in Table 3. To construct a 100-day moving average, the first step is to compute a simple average for the first 100 days (the first value in column 5). The value is used as a starting point at column 2. The index value for the 101 st day is computed with this value and the difference is shown in column 3. The exponent for

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the 100-day EMA is calculated as 2 = 0.02. The difference obtained in column 3 is multiplied by the exponential 0.02, and posted in column 4. The EMA value for the next 100 days (excluding the first day and including the 101st day) would be the EMA value in column 2 plus or minus the product obtained in column 4, depending upon whether the difference in column 2 is negative or positive. The procedure is repeated for each succeeding day. Figure 39 shows the 100-day EMA for the BSE Sensitive Index (calculated as explained above)

The EMA thus provides a smooth base for analyzing price trends. Since the exponent is used, it should be remembered that a 100-day EMA would be thrice as sensitive as a 300-day EM A, the exponent ofthe former being twice the exponent of the latter. If it is found that the EMA is very sensitive, the time span can be extended. Alternatively, the EMA can be further smoothened by constructing another EMA for the values first obtained, using a further exponent. The Filter Rules: The filter rules, many a time, define the mechanical trading schemes. An x% filter implies that a downtrend is indicated as soon as a stock moves down by x% from the most recent peak, and uptrend is indicated whenever a stock moves up by x% from the most recent low point. Let us apply a 4% filter rule to Tata Steel between February 19 and February 23, 1998 (Table 4). The share touched a low of Rs.120.70 on February 20. A 4% filter, that is, 120.70 (l + 0.04) = 125.53, would have given a buy signal on February 26, when the price touched Rs.l26.20. Then the scrip touched a peak of Rs.138.00. Therefore, the same filter that is, 138.00 (l - 0.04) = 132.42 would give a signal to sell on March 3, when the price touched Rs.132.10 (that is about 4% below the peak). The net gain to a person, before transaction costs, and had he been able to transact precisely at the prices indicated by the rule, would have been Rs.5.90 per share. It is clear that smaller filters are likely to result in larger number of transactions and therefore larger transaction costs. In general, these rules can be effectively used in the market only if the transaction costs are very low. Since these rules can be easily mechanized, they are widely used for computerized trading. In fact, the October, '87 crash of Wall Street and the other developed capital markets has been ascribed to such 'mindless' trading rules. It is also obvious that infinitely large number of filter rules can be (and are) used by operators in the market. Do these trading rules work? Do they indeed provide extra-normal returns to investors? Envelopes: We have already noted that moving averages can be looked upon as smoothened trend lines, which function as support and resistance feels for the prices. A moving average with a longer time span would serve this purpose better. On drawing envelopes, moving averages can also be looked upon as juncture points around which stock prices fluctuate in cycles. We can draw parallel lines to the moving average to envelop the cyclical movement around the average (See figure 40). Envelopes represent moving averages as the center of a trend, with the envelopes enclosing points of maximum and minimum divergence from that

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trend. Depending upon the volatility of the chart being monitored, and the time span of the moving average, the distance of the envelope from the moving average is determined. An envelope is useful in developing a 'feel' for the overall trend, and to discern when a rally or reaction has over-extended. It cannot be said with certainty that the envelopes would act as the eventual turning point, though a good probability of reversal exists when the price chart breaches an envelope. The technical analyst however, assesses the other technical characteristics before taking action. Breadth of the Market: The extent of a trend is monitored by breadth. Breadth refers to the extent to which share issues move along with the market trend and is generally measured in terms of number of issues whose prices are advancing, declining, and remaining unaltered in the period over which a trend persists. A reversal in trend is imminent if the number of issues moving with the trend is fewer than those moving against. Breadth also measures the underlying strength of the market. Ifthe index continues to move up, when most listed shares are declining, a reversal can be read from the breadth of the market statistics. I n other words, if a price trend does not receive a follow up from the broad market, it is vulnerable, and may not persist for long. Numerous methods exist for measuring the breadth of the market. One of the simplest is to compare the number of issues whose prices advanced on a particular day, to the number of issues whose prices declined on the same day. The net advances or declines thus obtained, is cumulated over the period under observation. The cumulated figures are also plotted on a graph, preferably along with a market index. The Advance-Decline line (A-D line) and the index generally move in tandem. However a divergence in the A-D line is indicative of a turning point, and technical analysts look for such signals from the A-D line. For example, consider the following table showing net advances or declines for issues traded on the Bombay Stock Exchange, during a certain period. The breadth of the market- statistics in the last column is simply the cumulative value of net advances or declines. The value becomes negative when number of declines exceeds the number of advances. This in itself need not cause concern because the value of the cumulative advances/declines depend on the value obtaining on the first data from which observations were made. However, the change in direction of the breadth statistics is to be noted. It is the direction of the statistics that is more important than the magnitude. The A-D line drawn from a simple cumulation of the net advances or declines is generally used to observe the breadth of the market over short periods of a month or two. For long run observations, the AD line is drawn after considering the number of issues also whose prices remain unaltered. The A-D line is drawn by cumulating the value of

ď&#x192;&#x2013;A/u â&#x20AC;&#x201C; D/u, where A = number of stocks whose prices are

advancing; D = number of stocks whose prices are declining; and u = number of stocks whose prices remain unaltered. It is possible for the value Diu to be higher than A/u when declines are more than advances. Such a tendency signals change in direction of the A-D line. Therefore in such cases the value

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ď&#x192;&#x2013;A/u â&#x20AC;&#x201C; D/u,is computed, and the resulting answer is subtracted from the cumulative total (note that square root of a negative number cannot be mathematically computed). Table 6 illustrates this method for the issues traded on the Bombay Stock Exchange during the above mentioned period. Inclusion of the issues whose prices remain unaltered provides additional information on the market following for a certain trend, and can also indicate in advance, a trend reversal. If the trend to advance or decline is very strong, the number of unchanged issue should diminish. By giving weightage to such stocks in computing the A-D line, any slow down in the momentum of the A-D line can be gauged earlier, because extreme movements would be restrained by an increasing number of unchanged issues. As already noted, breadth of the market is studied primarily to observe whether price trends are supported by the issues trading in the market. The utility of the A-D line in this context lies in its movement as compared to a market average. The divergence of the A-D line from the market index provides vital clues on the future course the market is expected to take. Technical analysts, therefore, attach a lot of value to the divergence of A-D line from the market index. The following principles of divergence have been found to apply universally: i. In a bull market the A-D line generally peaks ahead of the market index. Two important reasons behind this phenomenon are: a.The market, as a whole, discounts the business cycle, and generally attains the peak at least 6 to 9 months before the economy peaks out. However, certain leading sectors like consumer durables peak out earlier than the business cycle. Stocks representing such sectors, therefore, will logically peak out ahead of the market. b.At the end of a bull market, it is observed that the stocks of Blue Chip companies are the last to be unioaded. Since most indices include many Blue Chip stocks, it is natural for the A-D line to peak out before the indices, which may continue to rise even after the broad market has peaked out. ii. The longer and greater the divergence, the implied reversal may be expected to be deeper and more substantial. In the United States, for instance, the weekly A-D line peaked almost 2 years ahead of the Dow Jones Industrial Average in 1971. The ensuing bear market was the most severe one, after the depression of 1930. The converse of this principle is not always true. That is, every bear market need not necessarily be preceded by a divergence. iii.

At market bottoms, the A-D line generally coincides with, or lags behind the market index

and has no forecasting significance until its downtrend reversal is signalled by a breakout from a price pattern. However, where the A-D line persistently refuses to confirm a new low in the market index, a downtrend reversal is imminent. Technical analysts always confirm whether the A-D line has made the final advance by waiting for a downside trend line penetration or a moving average crossover. Other methods for analyzing market breadth: Breadth of the market is popularly studied using A-D lines. Other techniques are also used along

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with the A-D lines by technical analysts. The four popular methods are i.

Stocks in positive trends

ii.

Percentage of stocks over a moving average

iii. Diffusion indexes iv. High-Low statistics Stocks in Positive Trends: A stock which rallies after a decline to reach a new high is said to be in an uptrend; a stock that reacts to reach a new low is said to be in a downtrend. The percentage of stock in an uptrend to the total stock traded is computed and plotted on a graph. A rising market is expected to have an increasing percentage of uptrend stock. Reversal is signalled when stock in positive trend begin to diminish. Percentage of Stock over a Moving Average: A specific moving average for a number of stocks is first computed, and the percentage of the number that is above the average is ascertained. The percentage of stocks over a moving average increases in a bull market, and generally moves along with the positive trend index computed in (i) above. When the percentage of stocks over a moving average reaches an extreme of 90-100 percent or 10-15 percent, it indicates that a substantial proportion of the prevailing move has taken place and that reversal is imminent. When the percentage index reverses direction, the reversal in market trend is almost immediate. Diffusion Index: A diffusion index is computed by calculating the rate at which a certain group of stocks change price over a given period of time. It is generally calculated on either a wide number of stocks, or a number of industry indexes. Also called the momentum index, a rise in the index signals the onset of a bull market and vice versa. High-Low Statistics: Technical analysts also study the high-low statistics to confirm market trends. A rising market should be accompanied by a healthy number of net new highs. A graph of net new highs can be plotted to be read along with a market index. If net new highs trace a series of declining peaks while the index continues to rise, a reversal is imminent. Similarly, a graph of net new lows can be expected to signal the end of a bear market, when it does not confirm the new trough reached by the market index. This is because, a declining number of stocks reaching new lows implies that larger number of stocks are resisting the downtrend in the market index, and thus signifies the end of a bear market. Breadth of the market, thus, is an important indicator of the depth of the prevailing trend, and is of immense utility to the analyst in identifying trend reversals. Volume: Technical analysts confirm a price reaction by looking at the volume of shares traded. Volume generally moves along with price, and is indicative of the intensity of a price reaction. Study of volumes also helps in forecasting reversals in trend. It has been found by technical analysts that volume leads the

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trend of prices, and indicates the trend reversals in advance. A study by William Gord0 in the United States found that â&#x20AC;&#x153;betweenâ&#x20AC;? 1877 to 1966, in 84% of the bull markets, the volume high did not occur at the price peak, but some months before. Of the 18 bull markets during the period, 2 ended with volume and price reaching a peak simultaneously, and in one uptrend, volume lagged by a month. The lead time of volume in the remaining 15 cycles was from 2 months to 24 months. The average for all cycles was 9 months. The volume curve has an almost consistent tendency to peak out ahead of price, both during bull and bear phases. Momentum: We have so far discussed the application oftrendlines, moving averages and price patterns to analyze the movement of share prices. In most cases, a trend reversal can be identified with the help of these techniques only sometime after the reversal has actually taken place. The concept of momentum is used to overcome this weakness in technical analysis, by identifying a reversal much before a trend peaks or bottoms out. Momentum measures the rate at which prices rise or fall and is based on the principle that prices usually rise at the fastest pace well ahead of their peak, and decline at their greatest speed before their trough. The concept of momentum can be explained with the help of an example. A ball thrown into the air, generally shoots up with speed, but subsequently slows down considerably before it turns to come down again. The loss of upward momentum that occurs before the ball changes course can be seen in the stock market also. Before peaking out, share prices register a noticeable decrease in momentum. Similarly, the behavior of prices in a downtrend can be compared to the course of a car that is pushed over the top of hill. Though the speed decreases, the car continues to move, till it comes to a halt. Share prices behave in a similar manner and the loss of momentum in a downtrend shows much before the final low is reached. Momentum, thus, is an important lead indicator of the quality of price movement. There is, however, an exception to the above behavior of prices. Sometimes momentum and price may peak simultaneously, just like a ball hitting the ceiling even when its momentum is rising, and turning course with speed. When a ceiling of selling resistance is met, or buying power is temporarily exhausted, momentum does not provide any advance indications of the reversal, but peaks along with the price. Similarly in a downtrend, when prices meet a major level of support, momentum and price turn together. Despite these exceptions, momentum has been found to lead price in most occasions, to be used as a reliable lead indicator of trend reversals. Momentum can be looked upon from two angles: As a measure of rate of change, and as a measure of internal market vitality. Rate of change indices are widely used to measure the speed of advance or decline of market indices and stock prices. Measures of internal strength are generally applied to market indicators the breadth of the market, and are known as oscillators. In order to determine the quality ofa certain price trend, momentum indices are used. We shall discuss the construction and application of these indices in this section. Rate of Change Index (ROC INDEX): One of the simplest and widely used methods to measure

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momentum is to compute the rate at which the price of a stock, or market index, changes over a certain period of time. The ROC Index is an index constructed to measure such price changes. Assume for instance that a ROC Index is to he constructed for measuring 50-day rate of change in prices. The price prevailing on a certain day is compared to the price 50 days earlier. The resulting ratio is the ROC Index value for that day. The ROC Index value is computed as the ratio of the index on that date and 50 days earlier (382.6/377.19) x 100 (Note that index values are available only on the days trading actually took place in the market, and not for all days in a month. The index computed is, therefore, for rate of change over 50 trading days and not 50 calendar days). The reading 101.43 means that the price has increased by 143 points since the level prevailing 50 trading days earlier. The ROC Index thus oscillates around 100, which would be the index value if the price did not undergo any change during the period under observation. A rising ROC Index indicates a growth in momentum (a bullish factor) and falling index a loss in momentum (a bearish factor). The line drawn at level 100 functions as a reference line to study the movement of the index. When the ROC Index is above the reference line, the market price is at a higher level than the prevailing 50 days earlier. If the ROC Index is above the reference line and is also rising, the rate at which price is increasing is growing. Any fall in the ROC represents drop in momentum. If the index is failing but is still above reference line, it indicates a slow down in the rate of increase in price. When the index falls below the reference line, a future loss of momentum is indicated. The point at which the momentum index crosses the reference line, marks the onset of a trend reversal (Note that the ROC Index reaches its peak much before it crosses the reference line). When the index is below the reference line, but is rising, this is indicative of an increase in upward momentum. The ROC Index turning upward, even while it lies below the reference line, marks a reversal of bearish trend. It is common practice to use a filter along with moving average curves to make trading decisions. Moving average convergence and divergence (MACD): MACD like ROC is an oscillator which measures momentum. This oscillator is called as Moving Average Convergence and Divergence Oscillator, as it continuously converges and diverges away from the horizontal reference line. It is constructed by taking the difference or the ratio of short-term and the long-term moving average. The points obtained are plotted against a horizontal reference line. The reference line represents the points, where the two EMAs have identical values. From the movement of the MACD indicator it can be known, whether the shoner term moving average is above or below the longer term moving average. The points of crossing between the oscillator and the reference line act as signals to buy and sell the stock. In the figure, at the points 'G' and 'H', since the indicator crosses the reference line from below, we interpret those points as signals for buying the stock, whereas at point 'K' since the indicator crosses the reference line from above, we interpret that point as a sell signal. In addition to this, we can superimpose a third EMA or a moving average obtained from the oscillator itself. This is referred

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to as a "Signal line" as it acts as a trigger which alerts the trader to take an appropriate buy or sell decision. The other objective achieved by plotting the third EMA is to get an overall view of the market trend. In this technique, a buy signal will occur when the indicator moves above the reference line and the signal line as at point 'H' and a sell signal when the indicator crosses below the reference line and the signal line as at point "N". Relative Strength Index: Here we study about another oscillator which measures momentum called Relative Strength Index (RSI). Opposed to what we have studied above, this indicator measures the relative internal,strength of a stock or a market against itself. The RSI is calculated by the formula given below. RSI= 100 â&#x20AC;&#x201C; 100/1+RS Where RS is the ratio of the average of X day's up closes to the average of X day's down closes. We require the first point (day 0) to decide whether the closing price following it (that is, the price on the first day) is either greater or lower. Since the closing price 119.00 on the first day is lower than the preceding closing price, we count it as a down closing, whereas the price on the second day 128.75 being higher than the closing price of 119.00 on the first day, we count it as upclosing. Therefore, the prices 119.00 and 125.80 are considered to be downclosing prices, and the prices 128.75 and 127.25 are considered as up closing prices. In this case RSI will be calculated as follows: From the formula it should be evident that the values of the RSI indicator fluctuate between 0 and 100. A graph is plotted using the RSI values. On this graph, the oversold and the overbought positions are drawn at 30 and 70 levels on a scale of o to 100. When the indicator crosses the overbought or oversold position line, it is a warning signal to the trader. At this stage, it presents an opportunity to the trader to consider either to buy or sell. When the indicator crosses the oversold position at 30 from above, it signals that one should sell the stock, while at the same position if the indicator crosses it from below it is taken as a signal for buying. At the overbought position at 70, the opposite of this holds true. Though the RSI indicates that a buy/sell action is required, the actual buying or selling should be done only after the price line also shows a trend reversal. The oversold position is defined as a situation when there are more buyers in the market who are willing to take delivery than the number of shares available for delivery. In other words, the demand for that stock outstrips its supply. This happens only when there is more of speculative selling than speculative buying. The overbought position is exactly the opposite of oversold position. The Confidence Index: The Confidence Index is supposed to reveal how willing investors are to take a chance in the market. It is the ratio of high-grade bond yields to low-grade bond yields. When bond investors grow more confident about the economy, they shift their holding from high-grade to low-grade bonds in order to obtain the higher yield. This change bids up the prices of low-grade bonds, lowers their yields relative to

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high-grade bonds, and increases the confidence index. Markets for bonds are frequented mostly by large institutional investors who are believed to be less emotional about their portfolio decisions than many investors in the market. In an effort to measure the market expectations some chartists study the confidence index. The Confidence Index published weekly by Barron's, attempts to measure investor optimism and pessimism by examining investor actions in the bond market. It is calculated as follows: Confidence Index = Yield on 10 high-grade corporate bonds / Average yield on 40 Dow Jones bonds Since high-grade bonds should always yield less than lower quality bonds, the Confidence Index should always be less than 1.0. As investors become more optimistic about the future, the difference between the two yields in the index decreases (i.e., the default risk premium narrows and the ratio increases). As investors become more pessimistic about the future, the difference between the two yields increases (i.e., the default risk premium rises) and the ratio decreases. Because the bond market tends to be dominated by institutional investors, the Confidence Index is viewed by some as a barometer of sophisticated investors' expectations (and behavior). Advocates of the Confidence Index believe that it should move in the same direction as the stock market because increased confidence in the bond market should lead to increased confidence in the stock market. Therefore, an increase (decrease) in the index is a buy (sell) signal. If the Confidence Index leads the market, it can be useful as an indicator. Because it is available weekly in Barron's, it is a convenient and accessible indicator. Although the bond and stock markets generally move together, there is no theoretical reason that confidence in the bond market should precede confidence in the stock market. The latter is considered by most observers to be the preeminent discounter of future events. In fact, the Confidence Index does not always lead the market and has given a number of false signals. Thus, its record as a predictor is mixed at best.

8.6. CONTRARY OPINION THEORIES Contrary Opinion Theories: Several indicators are based on the theory of contrary opinion. The idea is to trade contrary to most investors, who supposedly almost always lose - in other words, to go against the crowd. This is an old idea on Wall Street, and over the years technicians have developed several measures designed to capitalize on this concept. Odd-lot theory: According to the odd-lot theory small investors who often buy or sell odd lots (less than 100 shares of stock) are usually wrong in their actions at market peaks and troughs. Supposedly, such investors typically buy (sell) when the market is at or close to a peak (bottom).

To take advantage of the (wrong) actions of these investors, an indicator must be calculated. A

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commonly used Odd-lot index is defined as: Odd-lot index = Odd-lot sales / Odd-lot purchases A decline in this index would indicate more purchases in relation to sales by small investors, suggesting they are optimistic. According to contrary opinion, it is time to sell - to go against the 'man in the street.' Conversely, a rise in this index would indicate more sales relative to purchases, a sign of pessimism by small investors but an opportune time for a contrarian to buy. A variation of the odd-lot index is the odd-lot short sales ratio, defined as follows: Odd-lotshort sales ratio = Odd-lot short sales / Total Odd-lot sales. As short sales by odd-lotters increase (decrease), these investors are becoming more pessimistic (optimistic). For a contrarian, it is time to buy (sell). The rationale for this ratio is the same as before. Oddlotters are expected to sell short at precisely the wrong time; that is, prior to a rise in prices. Regardless of which odd-lot indicator is used, odd-lot theories have not been particularly successful. Small investors have often been correct in their judgments, particularly since the 1970s. This analysis seems to have proved incorrect at least as often as it has proved accurate. Many market professionals today do not believe in odd-lot theories. Mutual fund liquidity: It is interesting to note that mutual fund liquidity can be used as a contrary opinion technique. Under this scenario, mutual funds are viewed in a manner similar to odd-lotters - they are presumed to act incorrectly before a market turning point. Therefore, when mutual fund liquidity is low because the funds are fully invested, contrarians believe that the market is at, or near, a peak. The funds should be building up cash (liquidity); instead they are extremely bullish and are fully invested. Conversely, when funds hold large liquid reserves, it suggests that they are bearish; contrarians would consider this a good time to buy because the market may be at, or near, its low point. Oscillators: The Rate of Change (ROC) Index is widely used to measure the momentum of price changes. In order to measure the momentum inherent in indicators of intrrnal market strength, like volume and breadth, oscillators are more widely used.

Stochastic: Stochastic is a price velocity technique based on the theory that as prices increase, closing prices have a tendency to be ever nearer to the peaks reached during that period. Similarly, as prices tend to fall, closing prices tend to be closer and closer to the troughs reached during that period. This approach was developed by George C Laire. Calculation of Stochastics based on the simple formula that follows: %K = C-L/H â&#x20AC;&#x201C; L x 100 Where, % K is Stochastics

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C is the latest closing price L is the low price during the last N periods H is the high price during the last N periods N can be any number of periods. Laire suggests 5 to 21 periods % K is then smoothened to derive % D by using the simple moving average technique. When plotted, the resultant lines will show where the closing price is relative to the range of prices for a given period of time (N). The principal method of interpreting Stochastics for buy and sell signals is through divergence analysis. A bearish divergence occurs when the security's price makes a high then corrects moving lower and subsequently reaches a higher high. At the same time, corresponding dealersâ&#x20AC;&#x2122; ofthe % D lines make a high followed by a lower high. A bullish divergence occurs when the security's price makes a low, then corrects moving higher, and subsequently, reaches a lower low. At the same time, corresponding bottoms of the %D line makes a low followed by a higher bottom. In the final analysis, in bearish divergence, a sell signal occurs when %K lines move below %D line. Success rate will be high in the 85 to 90 percent range. In a bullish divergence a high signal occurs when %K line moves above the %D line. Sometimes %K line might touch 0 or 100 percent. This only suggests great weakness (0%) or great strength (100%) of the scrip. A warning signal: When %K line reverses direction sharply from the previous direction say for 2 to 12 percent, the prices would be reversing their direction in one or two periods (N).

8.7. ELLIOTT WAVE THEORIES Elliott Wave Theory: The Elliott Wave Principle is difficult to grasp and somewhat intimidating. The principles behind the theory are actually relatively simple. You will notice that many of the points covered sound very familiar. This is because much of the Elliott material fits very nicely with the principles of the Dow theory and traditional charting techniques. Elliott Wave Theory, however, goes beyond traditional charting by providing an overall perspective to market movement that helps to explain why and where certain chart patterns develop and why they mean what they do. It also helps the market analyst to determine where the market is in its overall cycles. Much of technical analysis is trend-following in nature. Dow Theory, despite all its merits, tends to give its signals well after trend has been established. Elliott Wave Theory gives the analyst more advanced warning of tops and bottoms, which can then be confirmed by the more traditional approaches. We will cover the Elliott Wave Principle very briefly without going into all the finer points. Basic tenets: The most important element of wave theory is wave patterns or formations. The other important

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aspect is ratio analysis which is useful in determining retracement points and price objectives by measuring the relationships between the different waves. Finally, time relationships also exist and can be used to confirm the wave patterns and ratios, but are considered by some Elliotticians to be less reliable in market forecasting. Elliott Wave Theory was originally applied to the major stock market averages, particularly the Dow Jones Industrial Average. In its most basic form, the theory says that the stock market follows a repetitive rhythm of a five-wave advance followed by a three-wave decline. Shows one complete cycle. If you count the waves, you will find that one complete cycle has eight waves - five up and three down. In the advancing portion of the cycle, notice that each of the five waves are numbered. Waves, 1, 3, and 5 called impulse waves - are rising waves, while waves 2 and 4 move against the uptrend. Waves 2 and 4 are called corrective waves because they correct waves 1 and 3. After the five-wave numbered advance has been completed, a three-wave correction begins. The three corrective waves are identified by the letters a, b, and c.

Along with the constant form of the various waves, there is the important consideration of degree. There are many different degrees of trend. Elliott, in fact, categorized nine different degrees of trend (or magnitude) ranging from a Grand Supercycle spanning two hundred years to a subminute degree covering only a few hours. The point to remember is that the basic eight-wave cycle remains constant no matter what degree of trend is being studied. Each wave subdivides into waves of one lesser degree which, in turn, can also be subdivided into waves of even lesser degree. It also follows that each wave is itself part of the wave of the next higher degree. Connection between Elliott wave and Dow Theory: In Elliott theory, three up waves, with two intervening corrections, fit nicely with the Dow Theory. While Elliott was no doubt influenced by Dow's analysis, it also seems clear that Elliott believed he had gone well beyond Dow's theory and had in fact improved on it. It's also interesting to note the influence of the sea on both men in the formulation of their theories. Dow compared the major, intermediate, and minor trends in the market with the tides, waves, and ripples on the ocean. Elliott referred to 'ebbs and flows' in the writing and named his theory the 'wave' principle. Wave personalities: Another area where the two theories overlap to some extent is in the description of the three phases of a bull market. Knowledge of these wave personalities can be helpful, especially when wave counts are unclear. It's also important to remember that these wave personalities remain constant in all the different degrees of trend. Wave 1 About half of the first waves are part of the basing process and often appear to be nothing more than a rebound from very depressed levels. First waves are usually the shortest of the five waves. These

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first waves can sometimes be dynamic, especially if they occur from major base formations. Wave 2 Second waves usually retrace or give back, all or most of wave 1. The ability of wave 2, however, to hold above the bottom of wave 1 is what produces many of the traditional chart patterns, such as double or triple bottoms and inverse head and shoulders bottoms.

Wave 3 The third wave is usually the longest and the most dynamic, at least in the common stock area. The penetration of the top of wave 1 registers all kinds of traditional breakouts and Dow Theory buy signals. Virtually, all technical trend following systems have jumped on the bull bandwagon by this point. Volume is usually the heaviest during this wave and gaps prevail. Not surprisingly, the third wave is also the most likely to extend. Wave 3 can never be the shortest in a fivewave advance. By this time, even the fundamentals are looking good. Wave 4 The fourth wave is usually a complex pattern. Like wave 2, it is a corrective or a consolidation phase, but usually differs from wave 2 in its construction. Triangles usually occur in the fourth wave. One cardinal rule of Elliott analysis is that the bottom of wave 4 can never overlap the top of wave 1. Wave 5 In stocks, wave 5 is usually much less dynamic than wave 3. In commodities, wave 5 is often the longest wave and the one most likely to extend. It is during wave 5 that many of the confirming technical indicators, such as On Balance Volume (OBV), being to lag behind the price action.' It is also at this point that negative divergences begin to develop on various oscillators, warning of a possible market top. Wave A Wave A of the corrective phase is usually misinterpreted as just a normal pull-back in the uptrend. Having already spotted several oscillator divergences on the prior advance, the alert technician may also notice a shift in the volume pattern at this point. Heavier volume may now have shifted to the downside, although that is not necessarily a requirement. Wave B Wave B, the bounce in the new downtrend, usually occurs on light volume and usually represents the last chance to exit old long positions gracefully and a second chance to initiate new short sales. Depending on the type of correction taking place, the rally may test the old highs (forming a double top) or even exceed the old highs before turning back down.

Wave C Wave C leaves little doubt that the uptrend has ended. Again, depending on the type of correction in progress, wave C will often decline well below the bottom of wave A, registering all kinds of traditional

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technical sell signals. In fact, by drawing a trend line under the bottoms of wave 4 and wave A, the familiar head and shoulders top sometimes appears. Recent developments: Technical analysis is by definition based on the assumption that past prices can be used to predict future prices. But as a perceptive reader you would have noticed 'something strange about the methods of technical analysis discussed so far. None of these methods bear any resemblance to the standard statistical methods of predicting the future from the past. If a technical analyst were to approach a statistician for advice, the statistician in all likelihood would recommend regression analysis, particularly auto-regressions and ARIMA (BOX-Jenkins) analysis. However, chartists do not use these techniques and the methods that they do use would be totally alien to a statistician trained in classical prediction theory. It is well known that the standard statistical methods are the best linear prediction techniques possible. For charting techniques to make sense it is therefore, necessary not merely that future prices depend on past prices but that they depend on past prices in a highly non-linear manner so as to make standard statistical techniques irrelevant. In this section, we shall very briefly cover some recently developed mathematical techniques for dealing with highly non-linear process which have been used for charting. Chaos theory has been proposed to study highly non-linear processes which exhibit the following features: a.The processes appear to be totally random and unpredictable. b.The processes are in fact predictable using non-linear prediction techniques. c.The accuracy of prediction drops rapidly as the prediction horizon is increased. d.The processes are highly sensitive to initial conditions. These features make chaos theory an attractive tool for technical analysts who have powerful computers at their disposal to perform the complex calculations required by the theory. These analysts hope to detect subtle patterns in price movements which would not have been observed by people who employ less sophisticated mathematics. Neural network, originally designed on the basis of an analogy with the network of neurons in the human brain, is another computer based technique for detecting subtle patterns in voluminous data. Neural networks today do not attempt anything as ambitious as imitating the human brain. They are instead highly versatile pattern recognizers. Given large amounts of data to train on, a neural network can learn to recognize highly complex patterns. The network learns the pattern by a sophisticated form of trial and error known as back-propagation technique that has led to the rapid growth of the neural network technology since the early 1980s. As far as chartist is concerned, neural network is just another tool that allows him to search for patterns in the prices and the success of the technique depends to a great extent on the experience and

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ingenuity of the chartist himself. The neural network has another major disadvantage in that it is a black box which gives no reasons or explanation for its buy or sell recommendations. Just as you and I would find it impossible to explain how we balance ourselves while walking, so also the neural network is unable to explain how it works. The use of these techniques in technical analysis dates back only to the 1980s and it is still too early to say whether they are worthwhile charting techniques or whether they are merely a passing fad. Academic perspective of technical analysis: Academics have consistently been sceptical about Technical Analysis, as all their attempts to unravel the golden rule that consistently provides extra-normal returns have failed. A large number of studies, both in the Indian as well as m~rkets the world over, using a variety of statistical procedures and trading rules have invariably concluded that no single rule can earn consistently above average returns from the market over long periods oftime. A rule may work very well for a short time, but would fail miserably in the next time span, in which some other rule would have yielded extra normal returns. No one has been able to predict with certainty as to which rule is to be applied when for consistently outperforming the market. Academics also argue that even if knowledge for always earning superior returns exists, it would never be disclosed as the one who possesses the knowledge could use. it profitably. The argument goes a step further: if the knowledge (to out-perform the market) were to be made public, then that very act would destroy its effectiveness because if everyone in the market were to act according to that, no one will be able to make extra profits. Therefore, it is impossible that a trading rule which yields extra normal profits with certainty would ever be known. Charting and Technical Analysis are, therefore, an attempt to build an edifice without foundation. These arguments comprise what is known as 'market efficiency'. The thesis is that the presence of large number of experts in the stock market, who are constantly trying to outwit each other to make the extra buck, would ensure that the market is very efficient in pricing of securities. In the long run, therefore, an investor would earn the returns commensurate with the risks assumed, no more no less. The search for patterns in the prices on the assumption that there is future in the history of prices is meaningless. The view appears too fatalistic as it seems to do away with the need to manage our portfolios. Well, that is not entirely true, because the risk one assumes in the market, which depends on the composition of the portfolio, is still a decision that needs to be made and constantly reviewed by an investor. That would necessitate transactions and reshuffle of portfolios.

8.8. QUESTIONS Section - A i)

Very Answer Short Questions: 1. What is meant by charts? 2. What is point and figure chart and how is it used

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INVESTMENT ANALYSIS 3. Explain the semi-strong form of EMH 4. Can stock prices have a support level and resistance level? If so explain

Section - B ii)

Short Answer Questions: 1. Write short note on Elliott wave theories 2. How do volume and breadth of the market indicate the trend of the market? 3. Stock prices are like random numbers â&#x20AC;&#x153;.examine

Section - C iii)

Essay type questions: 1. Explain the methods of preparing charts 2. Briefly explain the trend lines under technical analysis 3. Explain the concept and types of moving averages 4. Write short note about contrary opinion theories

8.9. FURTHER READINGS 1. Dr. V.Balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and portfolio management, shri venkateswara publications. 2. Introduction to security analysis, the Icfai University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house pvt ltd

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CHAPTER -09 INVESTMENT STRATEGIES STRUCTURE 9.0. OBJECTIVES 9.1. INTRODUCTION 9.2. GROWTH SHARES 9.3. MEANING OF GROWTH SHARES 9.4. SPECULATIONS IN SHARES 9.5. ACTIVE STRATEGIES AND PASSIVE STRATEGIES 9.6. REASONS FOR FLUCTUATIONS IN PRICE 9.7. QUESTIONS 9.8. FURTHER READINGS

9.0. OBJECTIVES After studying this unit, you should be able to understand: 

Growth shares



Meaning of growth shares



Speculations in shares



Active strategies and passive strategies



Reasons for fluctuations in price

9.1. INTRODUCTION A better understanding of investment practices and principles will be useful to the casualty actuary in at least two ways: in understanding the asset side of the balance sheet and in understanding how property/casualty operations are viewed by the owners. It provides a process that is applicable to all types of investments, including bonds, derivatives and currencies. The manager has been given a certain amount of assets and is charged with investing it in a certain asset class (for example, domestic large capitalization stocks). The manager's performance will be judged against a benchmark such as the Standard & Poor's 500 Index. If the manager's estimates are at least a little bit better than the consensus estimates, the manager can add value to the investment decision by overweighting the investments where he/she expects higher than consensus returns. Of course, this added value can be dissipated by inefficient portfolio construction and transaction costs.

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9.2. GROWTH SHARES Shares issued by a firm with a consistent record of above average earnings. Such shares are expected to trade at an increasing value over an extended period Called growth stock in the US. Growth Shares: Shares of fast â&#x20AC;&#x201C; growing companies which show increasing and higher than average earnings per share than the industry. Good for long term investment, although the current yield of such shares can be insignificant because of their high P/E RATIOS. 9.3. MEANING OF GROWTH SHARES Growth shares: Shares issued by a firm with a consistent record of above average earnings. Such shares are expected to trade at an increasing value over an extended period Called growth stock in the US. Shares of fast â&#x20AC;&#x201C; growing companies which show increasing and higher than average earnings per share than the industry. Good for long term investment, although the current yield of such shares can be insignificant because of their high P/E RATIOS

9.4. SPECULATIONS IN SHARES The act of knowingly investing funds in a venture carrying higher-than-average risks in the hope of making above-average profits. Speculators expect to make a profit because of price changes Stock market speculation, by definition, involves taking a position that will benefit from a certain outcome. It is not concerned, necessarily, with underlying value, nor is it a view that tries to forecast the future for a particular industry or company purely beyond its short-term price action. You see, when investors become speculators they are purchasing a stock with the sole purpose of selling it to someone else at a higher price. Of course everyone wants to make a profit on the stocks they buy but there is a big difference between speculation and investing. The Speculator: He doesn't care about the inherent value of the stock. He or she only cares about whether or not they think it will go up in price as more and more speculators accumulate the stock. 9.5. ACTIVE STRATEGIES AND PASSIVE STRATEGIES A Comparison of Active and Passive Investment Strategies: Active management might best be described as an attempt to apply human intelligence to find "good deals" in the financial markets. Active management is the predominant model for investment strategy today. Active managers try to pick attractive stocks, bonds, mutual funds, time when to move into or out of markets or market sectors, and place leveraged bets on the future direction of securities and markets with options, futures, and other derivatives. Their objective is to make a profit, and, often without intention, to do better than they would have done if they simply accepted average market returns. In pursuing their objectives, active managers search out information they believe to be valuable, and often develop complex or proprietary selection and trading systems. Active management encompasses

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hundreds of methods, and includes fundamental analysis, technical analysis, and macroeconomic analysis, all having in common an attempt to determine profitable future investment trends. What is passive management? Passive investment management makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Passive managers invest in broad sectors of the market, called asset classes or indexes, and, like active investors, want to make a profit, but accept the average returns various asset classes produce. Passive investors make little or no use of the information active investors seek out. Instead, they allocate assets based upon empirical research delineating probable asset class risks and returns, diversify widely within and across asset classes, and maintain allocations long-term through periodic rebalancing of asset classes. What is index investing? Index investing is a form of passive investing in which portfolios are based upon securities indexes which sample various market sectors and are constructed by committee. Best known is the Dow Jones Industrial index, a basket of thirty very large U.S. companies. Indexes are available for most domestic and international markets, and rise and fall as individual securities within the index rise and fall. Which works best? Research supporting passive management comes from the nation's universities and privately funded research centers, not from Wall Street firms, powerful banks, insurance companies, active managers, and other groups with a vested interest in the huge profits available from active management. The results from this research are very clear: Active investment management is an appealing mirage which substantially boosts costs and decreases returns

9.6. REASONS FOR FLUCTUATIONS IN PRICE Three case of price fluctuation: Equilibrium stock price fluctuations This particular stock theory explains how the stock price of a large, publicly held corporation is determined in times without changes in corporate control and without speculation. The central idea is that the stock price is determined by some weighted average of investment acts from investors applying informational diversified investment strategies. The dynamics behind the price fluctuation is as follows: The higher the share of uninformed investors, the more uncertain the market price is relative to the fundamental stock value. This compares to larger fluctuations around this fundamental value and/or more frequent fluctuations. The picture is reversed when the share of informed investors increase and/or this share become better informed. In the exhibition the fluctuations are smooth. However, this needs not be the case. The fluctuation may be much more irregular. One should remember that the advantage of being an informed investor is to be more able to buy cheap and sell expensive because they have a better idea about the fundamental value of the stock. It should be obvious that this advantage increases the more the actual stock price fluctuates around the fundamental stock value. Altogether, this suggests that there

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exist an equilibrium stock price associated with a particular level of fluctuations around the true stock value. The text below explains that this equilibrium level of price fluctuations is restored if it is disrupted for some reason. Two cases must be considered; one with excessive fluctuation and one with understated fluctuation. Disequilibrium (excessive) stock price fluctuations: Imagine that the market price for some reason begins to fluctuate more than its equilibrium level. This is illustrated in the exhibition by the large swings. This implies that the informed investors start earning abnormally high returns on their investments because the average benefits from being informed increases and the average cost of being informed remains the same. Furthermore, the uninformed investors bear the full burden of the higher risk following higher degrees of fluctuations, and they face lower mean returns because the higher returns the informed investors are making have to come from lower returns made by the uninformed investors. The higher risk does not hit the informed investors equally hard because they are more able to buy when the price is low and sell when it is high. They are therefore able to avoid some of the negative risk while maintaining most of the positive risk. Therefore as time passes, some investors discover that it pays to pursue informed investment strategies and the share of informed investors starts to increase. This mechanism restores the equilibrium fluctuation level.

Disequilibrium (understated) stock price fluctuations: Consider the situation where the market price starts to fluctuate less than the equilibrium level. This situation is illustrated by the small waves in the exhibition. In this case, the benefit from being an informed investor fall but the cost remains the same so that informed investors begin to earn abnormally low profits. At the same time the uninformed investors benefit from the reduced risk that follows less fluctuation. This benefit is larger than the benefit that accrues to informed investors because the latter already has an advantage in handling risk (see above). The result is that the share of uninformed investors begins to rise at the expense of informed investors, and this process restores the equilibrium level of price fluctuations.

9.7. QUESTIONS Section - A i)

Very Answer Short Questions: 1. What is active management? 2. What is passive management? 3. What is index investing? 4. Who is a speculator?

Section - B

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INVESTMENT ANALYSIS ii)

Short Answer Questions: 1. Who are the players in the stock market? 2. Briefly explain about index

Section - C iii)

Essay type questions: 1. Explain the meaning of growth shares 2. Briefly explain about speculations in shares 3. Explain the difference between active strategies and passive strategies 4. What are the reasons for fluctuations in price?

9.8. FURTHER READINGS 1. Dr.V.Balu & Dr.M.Sakthivelmurugan &Dr.P.S.R.murthy, security analysis and portfolio management, shri venkateswara publications. 2. Introduction to security analysis, the Icfai University press. 3. Preeti Singh, investment management, Himalaya publishing house. 4. V.k.bhalla, investment management 5. Punithavathy Pandian, security analysis and portfolio management, vikas publishing house PVT ltd

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