Security Analysis

Fundamental Analysis is based on the assumption that share prices depend upon the future dividends expected by the shareholders. The price the shareholders are prepared to pay for a share is nothing but the present value of future stream of dividends discounted at the required rate of return.

Gordon’s Dividend Growth Model and the PE Multiple:

Assuming constant dividend growth rate $$g < k$$:

Financial analysts relate price to earnings via the P/E multiple. If a company pays out a fraction $$b$$ of earnings as dividends (Dividend Payout Ratio $$b = D/E$$):

This demonstrates that the P/E multiple depends directly on dividend payout ($$b$$), required return ($$k$$), and growth rate ($$g$$).

1.2 Economic Analysis: First stage of the EIC framework. Analyzes macro factors determining market-wide earnings:

• Factors Affecting Economy: Growth rates of national income (GDP), Inflation rates, Interest rates, Monsoon & Agriculture, Infrastructure development, Fiscal & Monetary policies, Economic deficits (Fiscal & Current Account).
• Techniques Used in Economic Analysis:
  1. Anticipatory Surveys: Surveying consumer and business capital expenditure intentions.
  2. Barometric or Indicator Approach: Analyzing statistical time series categorized as:
     • Leading Indicators: Turn ahead of aggregate economy (e.g. Stock prices, New orders for capital goods).
     • Coincidental / Roughly Coincident Indicators: Move in tandem with aggregate economy (e.g. GDP, Industrial production IIP, Employment).
     • Lagging Indicators: Turn after aggregate economy shifts (e.g. Unemployment rate, Corporate debt levels).
  3. Econometric Model Building: Formulating simultaneous regression equations linking endogenous and exogenous macroeconomic variables.

1.3 Industry Analysis: Second stage. Factors determining industry profitability:

• Industry Life Cycle (ILC): Four distinct stages:
  1. Pioneering Stage: High risk, rapid experimentation, high mortality of weak entrants.
  2. Expansion Stage: Rapid volume growth, established product demand, strong financial returns.
  3. Stagnation Stage: Growth slows to GDP rates, market saturation, intense price competition.
  4. Decay Stage: Demand obsolescence due to technological substitutes.
• Michael Porter’s Five Forces: Rivalry among existing competitors, Threat of new entrants, Threat of substitute products, Bargaining power of buyers, Bargaining power of suppliers.

1.4 Company Analysis: Final stage. Micro-level financial and operational evaluation:

• Financial Ratios: Profitability (ROCE, ROE, Net Margin), Financial Leverage (DER, Interest Coverage), Operating Efficiency (Asset Turnover, Working Capital Cycle).
• Competitive Edge & Moat: Patents, brand loyalty, low-cost distribution networks, management integrity.

The Funnel of Fundamental Analysis (Top-Down Approach):

An investor does not start by picking individual stocks blindly. They examine the macroeconomic environment ($$E$$) to determine whether market conditions favor equity investments. Next, they screen for thriving sectors ($$I$$) positioned in the expansion stage of the industry life cycle. Finally, within the shortlisted industry, they identify the market leader with superior financial metrics ($$C$$). If Intrinsic Value ($$V_0$$) calculated via fundamental models exceeds Market Price ($$P_0$$), the security is Undervalued (BUY).

Technical Analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. It assumes that market value is determined solely by the interaction of demand and supply.

2.2 Core Assumptions of Technical Analysis:

1. Market Value is determined solely by Supply & Demand: Reflects rational and irrational investor expectations.
2. Supply & Demand are governed by numerous factors: Economic, political, psychological.
3. Stock Prices tend to move in Trends: Prices move in persistent trends that persist over appreciable intervals.
4. History repeats itself: Human psychology never changes; past chart patterns recur predictably.

2.4 Theories of Technical Analysis:

2.4.1 The Dow Theory (Charles H. Dow):

Formulated by Charles Dow, editor of Wall Street Journal. Postulates that the market exhibits three concurrent price movements:

• Primary Trend: The broad, overarching macro trend lasting from 1 to several years (Bull Market or Bear Market).
• Secondary / Intermediate Trend: Counter-trend corrections retracing 33% to 66% of the primary move, lasting from 3 weeks to 3 months.
• Minor / Tertiary Trend: Day-to-day noise lasting less than 3 weeks; insignificant for strategic investing.

Two Vital Dow Principles:

1. Confirmation: A primary bull trend in Dow Industrial Average must be confirmed by a matching new high in the Dow Transportation Average.
2. Volume confirms the Trend: Trading volume should expand in the direction of the primary trend and contract during counter-trend reactions.

2.4.2 Elliot Wave Theory (Ralph Nelson Elliot):

States that market price action unfolds in recurring cyclical waves driven by collective human psychology. Every market cycle comprises an 8-wave fractal cycle:

• Five Motive / Impulsive Waves (1, 2, 3, 4, 5): Moves in the direction of the main primary trend. Waves 1, 3, 5 are impulse moves; Waves 2 and 4 are corrective dips. (Rule: Wave 3 is never the shortest wave; Wave 4 never overlaps Wave 1).
• Three Corrective Waves (a, b, c): Moves against the primary trend. Waves a and c move down; Wave b is a counter-rally.

Wave retracements and projections correspond precisely to Fibonacci Ratios (0.382, 0.500, 0.618, 1.618).

2.4.3 Random Walk Theory: Argues that successive stock price changes are completely independent and identically distributed random variables. Stock prices have no memory; historical price charts cannot be used to predict future prices.

Visualizing the Dow Trend Hierarchy:

Think of the market as an ocean. The Primary Trend is the rising or falling tide; the Secondary Trend represents the waves rushing against or with the tide; and the Minor Trend represents the tiny surface ripples. Technical analysts never trade against the tide!

2.5 Four Charting Techniques:

1. Line Charts: Connects successive closing prices over time. Simplest representation; filters out intraday extremes.
2. Bar Charts (OHLC): Shows Open, High, Low, and Close for each trading period. Vertical bar spans High to Low; left tick is Open, right tick is Close.
3. Candlestick Charts (Japanese origin):
   • Real Body: Difference between Open and Close.
   • Upper & Lower Shadows (Wicks): Highest and Lowest trades of the session.
   • Color Code: Bullish Green/White when Close > Open; Bearish Red/Black when Close < Open.
4. Point and Figure (P&F) Charts: Pure price movement chart ignoring time and volume. Uses 'X' for price increases and 'O' for price declines. Key parameters:
   • Box Size: Minimum price move required to plot an X or O (e.g. ₹ 1).
   • Reversal Criteria: Minimum number of boxes required to start a new column in opposite direction (standard 3-box reversal).

2.7 Support and Resistance Levels:

• Support: Price level where demand is strong enough to halt or reverse a downward trend.
• Resistance: Price level where selling pressure exceeds buying demand, capping price rallies.
• Role Reversal Principle: Once a strong support level is decisively broken downwards, it flips into a major future resistance level!

2.8 Interpreting Price Patterns:

A. Reversal Patterns: Signal that the prevailing trend is about to reverse:

• Head and Shoulders Top: Left Shoulder $\rightarrow$ Head (higher peak) $\rightarrow$ Right Shoulder (lower peak). Connecting swing troughs forms the Neckline. A downward break below the neckline with high volume triggers a sell signal. Minimum price target = Neckline break minus distance between Head and Neckline.
• Inverse Head and Shoulders: Bullish reversal pattern at market bottoms.
• Double Tops (M-shape) & Double Bottoms (W-shape): Price tests resistance or support twice and fails to break through.

B. Continuation Patterns: Signal that the market is consolidating before resuming its prevailing trend:

• Triangles: Symmetrical (consolidation), Ascending (bullish bias), Descending (bearish bias).
• Flags and Pennants: Short-term consolidations resembling flags on a flagpole after sharp vertical moves.

Head and Shoulders Neckline Math:

Moving Averages: Smooth out price fluctuations to confirm trends.

• Simple Moving Average (SMA): Arithmetic average of closing prices over $$N$$ days.
• Exponential Moving Average (EMA): Assigns greater weight to recent prices. Formula: $$\mathbf{\text{EMA}_{\text{today}} = \text{EMA}_{\text{yesterday}} + \alpha \times (\text{Price}_{\text{today}} - \text{EMA}_{\text{yesterday}})}$$ $$\text{Smoothing Factor } \alpha = \frac{2}{N + 1}$$

Moving Average Convergence Divergence (MACD): Developed by Gerald Appel. Computes the difference between 12-day EMA and 26-day EMA (the MACD Line). A 9-day EMA of the MACD line acts as the Signal Line.

• Buy Signal: MACD line crosses above the Signal line.
• Sell Signal: MACD line crosses below the Signal line.

Relative Strength Index (RSI): Developed by J. Welles Wilder. Momentum oscillator ranging from 0 to 100:

• RSI > 70: Security is Overbought (Potential downward reversal / Sell signal).
• RSI < 30: Security is Oversold (Potential upward rally / Buy signal).

Bollinger Bands: Consists of a 20-day Simple Moving Average (middle band) and two volatility bands placed 2 standard deviations above and below:

Lagging vs Leading Indicators: Moving averages and MACD are trend-following (lagging) indicators that confirm trend direction. RSI and Stochastic oscillators are leading indicators that signal impending turning points before price reversals materialize on charts.

Efficient Market Hypothesis (Eugene Fama): An informationally efficient market is one where security prices fully and instantaneously reflect all available information.

4.2 Misconceptions about EMH:

• Misconception 1: Random walk means irrational market behavior. In reality, price changes are random precisely because prices adjust instantaneously to new, unpredictable information.
• Misconception 2: Market efficiency means superior investors do not exist. EMH implies that consistent superior risk-adjusted performance after transaction costs cannot be achieved purely through luck or publicly available data.
• Misconception 3: Market efficiency implies perfect forecasting. Efficiency means prices are an unbiased estimate of intrinsic value, not that the market is clairvoyant.

4.3 Three Levels of Market Efficiency:

4.7 Market Anomalies (Challenges to EMH):

• January Effect: Stocks (especially small caps) tend to show abnormally high returns during January (tax-loss harvesting rebound).
• Weekend / Monday Effect: Returns on Mondays are systematically lower than other days of the week.
• P/E Anomaly (Basu): Portfolios of low P/E ratio stocks systematically outperform high P/E stocks on a risk-adjusted basis.
• Size Effect (Banz): Small-cap stocks earn higher risk-adjusted returns than large-cap stocks.

Understanding the Run Test for Weak Form Efficiency:

A "run" is defined as an uninterrupted sequence of price changes of the same sign ($$+, +, +$$ or $$-, -$$). If price changes are random (weak form efficient), the total observed number of runs ($$r$$) should not differ significantly from the expected mean number of runs ($$\mu_r$$) under a random binomial distribution.

Question: Explain the Efficient Market Theory and what is the major misconception about this theory?

Answer:

Efficient Market Theory: Formulated by Eugene Fama, the Efficient Market Hypothesis states that an efficient market is one where stock prices fully, accurately, and instantaneously reflect all available information. Prices follow a random walk because news arrives unpredictably.

Three Levels of Efficiency:

1. Weak Form: Prices reflect all past trading history. Technical analysis is ineffective.
2. Semi-Strong Form: Prices reflect all public information. Fundamental analysis is ineffective.
3. Strong Form: Prices reflect all information including private insider information. Insiders cannot earn abnormal profits.

Major Misconceptions:

• Misconception 1: Market Randomness implies Irrationality. Prices fluctuate randomly not because markets are irrational, but because new information arrives randomly.
• Misconception 2: Market has Perfect Forecasting Foresight. EMH asserts that prices are an unbiased estimate of intrinsic value, not that future events can be predicted without error.
• Misconception 3: No investor can ever beat the market. EMH implies that outperformance cannot be achieved consistently on a risk-adjusted basis after factoring in transaction costs.

Question: Explain Dow Theory.

Answer: Dow Theory, formulated by Charles Dow, is the foundation of modern technical analysis. Key tenets:

1. Three Concurrent Trends:
   • Primary Trend: Main direction (Bull or Bear) lasting 1 to several years.
   • Secondary Trend: Corrections lasting 3 weeks to 3 months, retracing 33% to 66% of primary move.
   • Minor Trend: Day-to-day fluctuations lasting under 3 weeks.
2. Phases of Primary Trend: Bull markets have Accumulation, Public Participation, and Distribution phases. Bear markets have Distribution, Panic Selling, and Discouraged Selling.
3. Confirmation Principle: The Industrial Average and Transportation Average must confirm each other's signals.
4. Volume Confirms Trend: Trading volume expands with the primary trend and contracts during corrections.

Question: Explain the Elliot Wave Theory of technical analysis.

Answer: Formulated by Ralph Nelson Elliot, Elliot Wave Theory posits that market price movements unfold in repetitive wave patterns reflecting human behavioral cycles. A complete market cycle consists of 8 waves:

• 5 Motive / Impulsive Waves (1, 2, 3, 4, 5): Moves in direction of main trend. Waves 1, 3, 5 are impulse moves; Waves 2 and 4 are corrective reactions. Rule: Wave 3 is never the shortest; Wave 4 never enters price territory of Wave 1.
• 3 Corrective Waves (a, b, c): Moves against the main trend. Waves a and c move down; Wave b is a counter-rally.

Waves adhere to Fibonacci Ratios (0.382, 0.500, 0.618, 1.618) for price targets and retracements.

Question: Explain the various indicators that can be used to assess the performance of an economy.

Answer: The barometric approach classifies economic time series into three groups:

1. Leading Indicators: Reach turning points ahead of the general business cycle (e.g., Stock market indices, New orders for durable goods, Money supply growth M3).
2. Coincidental / Coincident Indicators: Move in tandem with the aggregate economy (e.g., Gross Domestic Product GDP, Index of Industrial Production IIP, Manufacturing sales).
3. Lagging Indicators: Reach turning points after the aggregate economy has turned (e.g., Unemployment rate, Average prime lending rate, Outstanding commercial loans).

Question: Closing values of NSE Nifty from 6th to 17th day of January 2020 were as follows:

Required: Calculate the Exponential Moving Average (EMA) of Sensex during the period. The previous day EMA was 15,000. Take smoothing factor as 0.062 (for 31 days: $2/(31+1) = 0.062$). Give detailed analysis.

Solution:

Question: The closing value of a Stock Market Index for the month of October 2007 is given below:

You are required to test the weak form of efficient market hypothesis by applying the Run Test at 5% and 10% levels of significance ($$t_{5\%, 18df} = 2.101$$, $$t_{10\%, 18df} = 1.734$$).

Solution:

Step 1: Count Runs and Signs:

Sequence of signs: $$-, +, +, -, +, +, +, +, +, +, +, -, -, +, -, -, -, -, +$$

• Number of Positive changes ($$n_1$$) = 11
• Number of Negative changes ($$n_2$$) = 8
• Total changes ($$N = n_1 + n_2$$) = 11 + 8 = 19
• Total number of runs ($$r$$) = 8

Step 2: Expected Mean of Runs ($\mu_r$):

Step 3: Standard Deviation of Runs ($\sigma_r$):

Step 4: Hypothesis Testing & Acceptance Limits:

At 5% Level of Significance ($t = 2.101$ for $18$ df):

At 10% Level of Significance ($t = 1.734$ for $18$ df):