Behavioral Finance Analysts tend to excessively extrapolate historical trends when forecasting May lead to unsustainably high P E ratios Overconfidence Anchoring Bias Earnings people become anchored to their ideas and will not update their expectations when new information arrives this underreaction leads to momentum in stock returns Framing Errors Mental accounting when cash is needed investors may spend dividends but refuse to sell a small portion of stock to raise the money This may lead to a preference for stocks that pay larger dividends even though tax liability may be greater Regret Avoidance in order to induce investors to buy out of favor stocks stocks with poor recent performance value sticks these stocks have a higher expected return Prospect Theory An alternative behavioral theory suggesting that investor utility satisfaction depends on the change in wealth from the start of the investment rather than on the starting level of wealth Standard utility theory Investors with more wealth and less risk Wealth provides diminishing marginal utility than the utility loss from losing 1000 This gives rise to risk aversion Why not arbitrage mispriced stocks If some investors are letting behavioral biases affect prices why don t other better trained investors engage in profitable arbitrage This is part of the reason for growth in hedge funds Limits to Arbitrage Fundamental Risk changes in fundamentals can wipe out any arbitrage profits making the strategy risky Short sale constraints make it difficult to arbitrage overpriced securities Model Risk How do you know your security is truly mispriced Your model may be giving you wrong signals Critiquing the Behavioral Critique It provides stories that fit individual situations but there is no coherent theory put forth and some behaviors contradict others Much of the empirical support for the behavioralist ideas in investments comes from one specific time period late 1990s The behavioral literature is very weak at providing solutions to these problems Technical Trading Rules 1 Conceptual basis all technical analysis assumes that there are recurring and predictable patterns in stock prices which can be exploited to earn abnormal returns 2 Technical analysts believe a Market Prices conform to new data only slowly giving rise to price trends b Prices are affected by predictable behavioral or psychological factors 3 Dow Theory a Three types of trends only two are important b Every stock has price peaks and troughs but if a series of peaks and troughs are rising it is a buy signal especially if volume is heavier during the peaks than the troughs 4 Relative Strength a A simple relative strength ratio could be constructed as b Increases in the relative strength ratio indicate the stock is outperforming the index and could indicate a buy or bullish signal 5 Breadth individual stocks a Breadth is the extent to which movements in a broad index are reflected widely in movements of b Measured as the difference between the number of advancing and declining stocks c Also used in industry indexes d Cumulative Breadth is found by adding the current day s net advances or declines to the previous day s total in order to gauge the trend a Odd Lot traders are mostly individual investors that are relatively uniformed Contrarian philosophy Do the opposite of the majority of the odd lot traders a Total number of shares of stock currently sold short b High short interest may indicate that a stock s price is expected to fall a Trin Volume declining Number declining Volume advancing Number advancing 6 Odd Lot Index 7 Shortest Interest 8 Trin Statistic Confidence Index Ratio of the average yield on 10 top rated corporate bonds divided by the average yield on 10 intermediate grade corporate bonds Put call ratio Call options give investors the right to buy at a fixed exercise price and put is the right to sell at a fixed exercise price Change in ratio can be given a bullish or bearish interpretation Warning about identifying trends difficulty in identifying common price patterns Equity Valuation Basic Types of Models Balance Sheet Models Dividend Discount Models Price Earnings Ratios Free Cash Flow Models Valuation Models using comparables look at the relationship between price and various determinants of value for similar firms The internet provides a convenient way to access firm data ex EDGAR and Yahoo Finance Valuation Methods 1 Book value Value of common equity on the balance sheet Based on historical values of assets and liabilities which may not reflect current values Some assets such as brand name or specialized skills are not on a balance sheet Is book value a floor value for market value of equity Not always If a firm is in deep distress it could be selling at only 20 of its book value 2 Market value Current market value of assets minus current market value of liabilities Market value of assets may be difficult to ascertain Market value based on stock price Better measure than book value of the worth of the stock to the investor Net amount realized from sale of assets and paying off all debt Firm becomes a takeover target if market value stock falls below this amount so liquidation value may serve as the floor to value 3 Liquidation value 4 Replacement Cost Cost of the assets less the liabilities May put a ceiling on market value in the long run because values above replacement cost will attract new entrants into the market Tobin s Q Market Value Replacement Cost should trend toward 1 over time Intrinsic Value vs Market Price Expected Holding Period Return The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one year holding period Intrinsic Value The present value of a firm s expected future net cash flows discounted by a risk adjusted required rate of return The cash flows on a stock are Dividends D1 Sale Price P1 Intrinsic Value today time 0 is denoted Vo and for a one year holding period may be found as Consensus value of all traders In equilibrium the current market price will equal intrinsic value Market Price Trading Signals Buy Sell or Short Sell Hold as it is Fairly Priced Dividend Discount Model Intrinsic value of a stock can be found from the following No Growth Model for stocks that have earnings and dividends that are expected to remain constant over time zero growth Constant Growth Model for stocks that have earnings and dividends that are expected to grow at a constant rate forever Price Earnings