Part Two: How the Pros Play the Biggest Game in Town Flashcards
What’s technical analysis?
Technical analysis is using charts and trends to figure out where are stock may go. Hopping on the train hoping the upward trend continues, and hoping you can jump off(timed well enough)before it comes to a stop. Chartist’s believe that the market is a 90% psychological and 10% logic.
Whats’s fundamental analysis?
Fundamental analysis uses assets, expected growth rate of earnings and dividends, interest rates, and risk to determine the value of a stock. They believe the market is 90% logic and 10% psychology.
What are three explanations for technical analysis
- They believe that the market has crowd instinct of mass psychology makes trends perpetuate themselves.
- There may be unequal access to fundamental information about the company. It is alleged that the insiders are the first to know, and they act, buying the stock and causing its price to rise. The insiders then tell their friends, who act next. Then the professionals find out the news, and the big institutions put blocks of the shares in their portfolios. Finally, the poor slobs like you and me get the information and buy, pushing the price still higher. This process is supposed to result in a rather gradual increase in the price of the stock when the news is good and a decrease when the news is bad.
- Investor often under-react initially to new information. When earnings are announced that beat (trail) Wall Street estimates (positive or negative “earnings surprises”), the stock price reacts positively (negatively), but the initial adjustment is incomplete. Thus, the stock market will often adjust to earnings information only gradually, resulting in a sustained period of price momentum.
What do chartist’s believe?
Chartist’s believe that people remember what they bought a stock at. For example, suppose a stock sold for about $50 a share for a long period of time, during which a number of investors bought in. Suppose then that the price drops to $40.
The chartists claim that the public will be anxious to sell out the shares when they rise back to the price at which they were bought, and thus break even on the trade. Consequently, the price of $50 at which the stock sold initially becomes a “resistance area.” Each time the resistance area is reached and the stock turns down, the resistance level becomes harder to cross, because more investors get the idea that the market or the individual stock in question cannot go any higher.
Why might charting fail to work?
First, the chartist buys only after the momentum starts, and hopes to sell before it drops or sells believing it will drop and loses out on gains.
Second the process is self defeating. No buy or sell signal can be worth while if everyone tries to act on it simultaneously.
Also if someone has information about a company and its earning will double because of the discovery. And the stock price is at 20 and will go to 40 tomorrow when the information is unveiled. Because any purchases below 40 will provide a swift profit, Sam and his friends may well keep buying until the price hits 40, a process that could take no longer than a few minutes. The market may well be a most efficient mechanism. If some people know that the price will go to 40 tomorrow, it will go to 40 today.
What’s most important in determining the firm-foundation value of a stock?
the fundamentalist’s most important job is to estimate the firm’s future stream of earnings and dividends. The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive. The analyst must estimate the firm’s sales level, operating costs, tax rates, depreciation, and the sources and costs of its capital requirements.(basically they must be a prophet)
Fundamentalists believe in the value of a stock while technical analysts care about the current price.
What’s rule 1 to help estimate the proper value of a stock? What’s the corollary of rule 1?
An investor should expect to pay more, all else equal, the larger the growth rate of dividends and earnings.
Corollary: An investor should also expect to pay more for a share when extraordinary growth rates the longer they are expected to last.
What’s rule 2 to help estimate the proper value of a stock?
An investor should expect to pay more all else equal when the company is risk-averse
What’s rule 3 to help estimate the proper value of a stock?
An investor should expect to pay more all else equal when the company is risk-averse
What’s rule 4 to help estimate the proper value of a stock?
An investor should expect to pay more for a stock when interest rates are low.
What are the three caveat’s of the firm foundation value of a stock?
- Expectations about the future cannot be proven in the present
- Precise figures cannot be calculated from undetermined data
- What’s good for the goose is not always growth for the gander
Why might fundamental analysis fail to work?
One: The information and analysis may be incorrect
Two: The security analyst’s estimate of the ‘value’ may be faulty
Three: The stock price may not converge to its value estimate
Many analysts use a combination of fundamental and technical analysis together. What are the 3 rules of using them?
Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years.
Rule 2: Never pay more for a stock than its firm foundation of value.
Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.(a castle in the air floating on top of a firm foundation)
Why The Crystal Ball Is Clouded?(in reference to how well fundamental analysis works)
- The Influence of Random Events
- The Production of Dubious Reported Earnings through “Creative” Accounting Procedures
- Errors Made by the Analysts Themselves
- The Loss of the Best Analysts to the Sales Desk, to Portfolio Management, or to Hedge Funds
- The Conflicts of Interest between Research and Investment Banking Departments
Do security analysts pick winners or perform better than indexes?
NO, Simply buying and holding the stocks in a broad market index is a strategy that is very hard for the professional portfolio manager to beat.
The Wall Street Journal did an interesting story in 2009 showing how fleeting extraordinary investment performance is likely to be. The paper noted that fourteen mutual funds had beaten the S&P for nine consecutive years through 2007. But only one continued that feat in 2008, as is shown in the table below. It is simply impossible to count on any fund or any investment manager to consistently beat the market—even when the past record suggests some unusual investment skill.
