FNCE 3020 Financial Markets and InstitutionsBeginning QuotesObjective for This Lecture SeriesFundamental AnalysisForecasting Assuming Efficient Financial MarketsBackground on Fundamental AnalysisCalculating the Value of Common Stock Through Fundamental AnalysisTop Down Fundamental ApproachFundamental Analysis: Importance of Appropriate ModelForecasting with Technical AnalysisDefinitions of Technical AnalysisHistory of Technical AnalysisHistory and Use of Technical AnalysisSummary of Technical AnalysisSlide 15Examples of Technical ApproachesMoving Average: DJIAMoving Average: Shanghai IndexMoving Average: FordOverbought/Oversold: AustraliaOverbought/Oversold: GEUse of Technical Analysis in Foreign Exchange MarketsFX Trading Floor, LondonJapanese Yen: Spot Against 90 Day Moving AverageBritish Pound: Bollinger BandsSources of Technical Charts and DiscussionsWhat can we Forecast if Markets are Efficient?TIPS: Inflation Linked BondsSlide 29A TIPS ExampleUsing TIPS to Measure Inflationary Expectations5 Year Nominal Versus 5 Year TIPSInflationary Expectations; 5 Year Nominal – 5 Year TIPSTIPS Data; Bloomberg.ComHistorical Relationship of TIPS to Observed Inflation DataWhat’s Wrong with TIPS as an Inflation Estimate?Inflation Risk PremiumIllustrating Inflation RiskLiquidity Premium on TIPSLiquidity Premium on TIPS During a Credit CrisisThe TIPS Liquidity Premium Affect During the 2008 Credit CrisisAdjusting for Liquidity Premiums and Inflation RiskThe Future of TIPSAppendix 1: Three Forms of Market Efficiency and ForecastingThree Forms of The Efficient Market HypothesisForecasting asset prices within the 3 Types of Efficient Markets:Appendix 2Interview with Graham in the 1970sAppendix 3Charles DowAppendix 4Head and Shoulders PatternsHead and Shoulder FormationHead and Shoulders: Archer DanielsTechnical Analysis: Foreign ExchangeFNCE 3020Financial Markets and Institutions Lecture 6; Part 2 Forecasting with Fundamental Analysis and Technical AnalysisBeginning Quotes“The only function of economic forecasting is to make astrology look respectable.” John Kenneth Galbraith “An economic [forecaster] is an expert who will know tomorrow why the things she/he predicted yesterday didn't happen today.” Laurence J. Peter “Isn't it interesting that the same people who laugh at science fiction listen to weather forecasts and economists?” Kelvin Throop IIIObjective for This Lecture SeriesTo introduce you to two different approaches to forecasting financial asset prices.(1) Fundamental analysisUses economic and financial data upon which identify undervalued assets and then to estimate the future price move of a particular financial asset.(2) Technical analysisForecasting future financial asset price movements based on past price (and volume) movements.Finally, if financial markets are efficient, is it possible to use this efficiency to determine what the market is expecting?Future interest ratesFuture rates of inflationFundamental AnalysisAttempts to identify “undervalued” financial assets.That is, a financial asset whose market price is below its intrinsic (true) value.Assumes that prices may be undervalued in the short term, but eventually the market will “catch up” and re-price the asset. However, if financial markets are efficient, financial assets are priced correctly, and thus there will be no undervalued assets. Warren Buffett on market efficiency (Fortune Magazine, April 3, 1995): “I'd be a bum in the street with a tin cup if the markets were efficient.”For an interesting account of Warren Buffett see: http://beginnersinvest.about.com/cs/warrenbuffett/a/aawarrenbio.htmForecasting Assuming Efficient Financial MarketsAccording to the Efficient Market Hypothesis, when new information hits the market, the news spreads very quickly and is incorporated into asset prices with little delay.If this this the case, then any technique (forecast) suggesting greater returns than the over-all market (or the individual security) is questionable at best.So as we work through the following forecasting approaches, consider how efficient markets would impact upon each technique.See Appendix 1 for a discussion of the three forms of market efficiency and their implications for forecasting.Background on Fundamental AnalysisTraced to the writings of Columbia University professors Benjamin Graham and David Dodd (1934, Security Analysis).Graham and Dodd argued that investors should buy undervalued stocks. Some indicators to look for are:Current assets exceeding current liabilities, and/orLow price/earnings (p/e) ratio.Graham and Dodd advocated searching out stocks which are undervalued by the market.Once an undervalued security is found, it's simply a matter of buying the stock and waiting for the market to realize the "more accurate" value of that security. Warren Buffett studied under Benjamin Graham at Columbia University in the early 1950s.Calculating the Value of Common Stock Through Fundamental AnalysisTwo general “fundamental” approaches to valuing common stock (i.e., for determining their intrinsic value) are:(1) Discounted Cash Flow: Assumes a stock’s value is based on the present value of its future cash flows, such as dividends, or earnings.Estimate future cash flows and discount to the present, and compare to market price.(2) Relative Valuation Approach: Assumes a stock’s value is determined by certain variables, such as the company's earnings, revenues or book value.Compare value to market price.Top Down Fundamental ApproachThe top-down approach is probably the most comprehensive of all fundamental techniques. It usually involves specific steps (and investment teams) such as: 1. Economic Forecast (global, national, regional)2. Industry SelectionWhich industries are likely to do well in the forecasted environment.3. Analysis of Companies within the IndustryLeaders, innovators, start-ups, etc.4. Company SelectionCompany’s plans and outlookNew product development, red flags (litigation, etc.)ManagementAnalysis of company’s financial statements.5. Determination of the intrinsic value of the stock.Fundamental Analysis: Importance of Appropriate ModelThe selection of an appropriate “pricing” model (i.e., independent variables) is critical to the forecasting procedure.Market price of long-term bondsInterest rate models with focus on